As discussed earlier, the term “contagion” denotes the spread of run-like behavior from one financial institution to an expanding number of other institutions, reducing the aggregate amount of funding available to the financial system.1 Contagion can also spread to short-term capital markets that fund the complex and growing assortment of nondepository financial institutions in the financial system. The special feature that distinguishes contagion from other causes of systemic instability is the tendency of contagious runs to propagate indiscriminately. Contagion is “indiscriminate” when it afflicts healthy markets and solvent institutions.2
Financial institutions are vulnerable to contagion due to their dependence on short-term borrowing to fund long-term investment activity. When short-term debt investors suddenly refuse to extend funding, institutions relying on such funding may fail and lead to destabilizing fire sales. Runs of short-term creditors may be rational or irrational and need not be indiscriminate. A run by short-term creditors can be targeted to a single or limited number of financial institutions, for example, those known to have incurred significant losses.3 During a contagious and indiscriminate run, however, investors may also withdraw funding from multiple institutions or markets that are not themselves facing any objective business distress. In such an environment, the decision to exit is made not on the basis of specific information but rather because investors possess insufficient information to differentiate their risks from those that others are—or appear to be—facing. This dynamic, one central banker has warned, may “lead to failures of other financial intermediaries, even when [they] have not invested in the same risks and are not subject to the same original shocks.”4 If these intermediaries fund themselves using short-term capital instruments, contagion effects may spread to the markets where these instruments trade. Sudden demand for liquidity by investors in intermediaries that normally hold these instruments or a refusal on the part of interbank lenders to renew their funding can trigger liquidations or freeze-ups in these markets, triggering fire sales, decimating asset prices, and halting lending activity.
Until recently, studies of contagion focused primarily on its effects upon the depository banking system.5 The past 30 years have witnessed growing intermediation of financial markets via derivatives, asset securitization, and structured finance products, introducing a new universe of credit intermediaries and suppliers of short-term credit.6 These nonbank financial institutions perform largely the same economic role as the conventional banking system7 and are often collectively referred to as the “shadow banking” sector8 or “securitized banking system,”9 although such terms are imprecise and must be deployed with caution.10
Like traditional depository institutions, many of these “shadow” intermediaries conduct maturity transformation (or intermediate the process of maturity transformation through ownership of short-term liabilities issued by other maturity-transforming firms). Unlike depository institutions, however, they do not accept deposits. Nonbank financial intermediaries fund themselves in a variety of wholesale short-term borrowing markets, including commercial paper, asset-backed commercial paper (ABCP), unsecured interbank lending, and secured repo borrowing. Money market funds, unregulated investment funds, and various securities lenders are particularly significant purchasers of such instruments.11
Banking conventionally involves a single intermediary that originates long-term loans and issues short-term deposit accounts or other funds. By contrast, nonbank institutional credit creation often entails multiple layers of intermediation, resulting in greater amounts of short-term liabilities to finance assets held by intermediaries at each layer.12 For example, one scholar has identified at least seven representative stages in the process of originating, warehousing, and funding long-term assets.13 In the first stage, loan origination is conducted by nonbank finance companies funded in the commercial paper markets and by longer term notes.14 Loans are subsequently warehoused in a variety of funding conduits financed using ABCP before undergoing securitization through special purpose vehicles created by broker-dealers.15 Next the asset-backed securities are warehoused temporarily on broker-dealer trading books funded with short-term secured repo and structured into asset-backed or synthetic CDOs.16 They may undergo further intermediation through structured investment vehicles, credit hedge funds, and other conduits funded in the repo and ABCP markets and by longer term bond markets.17 Finally, the collection of commercial paper, ABCP, and repo funding issued to finance various stages in the intermediation process are absorbed by wholesale funding markets through regulated money market funds, unregulated enhanced cash funds, and direct investors in money markets, among other cash investors.18 The short-term instruments created as byproducts of this intermediation process are also susceptible to, and can serve as a conduit for, contagion, as they may represent a vital source of funding to originators farther up the intermediation chain. Longer term liabilities created in the process may be purchased by mutual funds, pension funds, and other long-term investors.19
Although the actual number of steps in the intermediation of financial assets varies,20 the economic outcome of the process is virtually identical to the depository banking intermediation process: long-term assets are converted to short-term debt instruments, often with exceptionally short maturities. In 2008, for example, 69 percent of total outstanding commercial paper had maturities of one to four days and 75 percent of nine days or less.21
Nonbank credit origination is also distinctive in that it is financed by the capital markets: short-term commercial paper, unsecured and secured repo borrowing, and bonds and other long-term capital instruments. Unlike bank deposits, these liabilities are uninsured, although “some investors seem to believe that implicit guarantees [of money market funds] exist, either from the management company or from the U.S. Government.”22 Due to their role in transforming short-term maturities into long-term capital, such short-term financing sources are subject to the same collective action problems and run risks that have historically plagued uninsured bank deposits.23 Thus nonbank financial intermediaries, including money market funds, are vulnerable to both runs and contagion. This vulnerability also extends to major commercial and investment banks, which heavily depend on large quantities of uninsured deposits and nondeposit wholesale funding, as exhibited by table 7.1.
Taken together, the size of the nondeposit wholesale funding markets eclipses the sum of insured deposits outstanding in the US financial system. Estimates of the total amount of nondeposit banking liabilities outstanding range from $11 trillion24 to $16 trillion.25 At the end of 2008, money market funds alone managed $3.8 trillion in assets,26 as against $4.8 trillion of deposits insured by the FDIC.27
Assets and liabilities of major US commercial and investment banks, 2008 (USD millions)
Note: See JPMorgan Chase, (Form 10-K); Bank of America Corporation, 2008 Annual Report (Form 10-K); Wells Fargo & Co., 2008 Annual Report (Form 10-K); Goldman Sachs, 2008 Annual Report (Form 10-K); Morgan Stanley, 2008 Annual Report (Form 10-K).
a. Includes federal funds purchased and sold, securities borrowed, loaned, or sold under repurchase agreements, plus other collateralized borrowing.
b. Includes trading and derivative liabilities, payables to customers, counterparties, brokers, dealers, and clearing services.
c. Includes reserves for unfunded commitments, allowances for credit losses, and other payables. d. For JPMorgan includes borrowing associated with the Federal Reserve AML facility.
Chairman Bernanke succinctly described the influence of panic behavior on nondepository credit intermediaries and money markets in a 2009 speech:
Panics arose in multiple contexts last year. For example, many financial institutions, notably including the independent investment banks, financed a portion of their assets through short-term repo agreements …. As we saw last fall, when a vicious funding spiral of this sort is at work, falling asset prices and the collapse of lender confidence may create financial contagion [in repo markets], even between firms without significant counterparty relationships. In such an environment, the line between insolvency and illiquidity may be quite blurry …. Panic-like phenomena occurred in other contexts as well. Structured investment vehicles and other asset-backed programs that relied heavily on the commercial paper market began to have difficulty rolling over their short-term funding very early in the crisis, forcing them to look to bank sponsors for liquidity or to sell assets. Following the Lehman collapse, panic gripped the money market mutual funds and the commercial paper market …. More generally, during the crisis runs of uninsured creditors have created severe funding problems for a number of financial firms. In some cases, runs by creditors were augmented by other types of “runs”—for example, by prime brokerage customers of investment banks concerned about the funds they held in margin accounts. Overall, the role played by panic helps to explain the remarkably sharp and sudden intensification of the financial crisis last fall, its rapid global spread, and the fact that the abrupt deterioration in financial conditions was largely unforecasted by standard market indicators.28
The Lehman bankruptcy and ensuing breaking of the buck by the RPF highlight the centrality of nonbank financial institutions in the contagion context.29 Contagion effects spread from the money market funds to the ABCP, interbank lending, and secured repo markets as well as to other areas of the nondepository banking system.
On the day Lehman filed in US bankruptcy court, the RPF received approximately $25 billion in redemption requests.30 Like in a classic bank run, sudden demand for immediate liquidity from investors forced the RPF into a fire-sale liquidation of assets, crystallizing the actual losses whose imagination prompted investors to rush to exit in the first place. By September 19, investors demanded redemptions totaling $60 billion from the RPF.31 The RPF’s suspension of redemptions compounded the panic in other funds. Other money market funds in The Reserve Fund family experienced significant withdrawals “even though they had not broken the buck and had no investments in Lehman paper.”32 Unlike the flood of deposits to risk-free accounts issued by JPMorgan, the RPF’s safest funds underwent outflows. At least 36 of the 100 largest US prime money market funds faced a decline below the $1.00 NAV level and required sponsor support.33 Investors in prime money market funds generated self-fulfilling contagious runs immediately after the Lehman collapse: investors were more inclined to run on their own fund if another fund in the same fund complex was experiencing a run.34 Clearly, investors were running as a result of general panic and not concern over a particular fund’s fundamentals. As of September 18, 2008, $142 billion of institutional investment money had been withdrawn from prime funds (amounting to 16 percent of prime money market fund holdings).35 As of the end of the week, a total $300 billion of investment in prime money market funds had been liquidated by investors.36
Although prime funds had already begun to reduce their investment in commercial paper prior to Lehman’s failure, they continued to hold “about 40 percent of their assets in commercial paper, with about 25 percent of their assets in bank notes and certificates of deposit.37 As investment continued to shift out of commercial paper instruments and into risk-free government securities, “the flight … stressed commercial paper … markets, causing second-tier thirty-day commercial paper rates to double within two days.”38 Appetite for commercial paper contracted severely, with annual average daily issuance volume plummeting from approximately $150 billion per day in 2008 to under $100 billion in 2009.39 As depicted in figure 7.1, the contraction in commercial paper was sustained across all segments of the market, with the sharpest declines seen in asset-backed and financial commercial paper outstanding.40
The scaling back of investment in commercial paper caused overnight spreads to leap to unprecedented highs.41 The total value of commercial paper outstanding continued to fall even after the US Treasury announced on September 29, 2008, that it would guarantee money market fund investments.42 The decline in the overall commercial paper market was largely due to financial commercial paper—the corporate commercial paper market suffered much less disruption, although major corporate issuers such as Coca-Cola, General Electric, and WellPoint replaced commercial paper financing with higher yielding long-term debt43 and also reacted by drawing on balance sheet cash and reducing overhead expenditures.44 The impact on money market funds and the partial paralysis of commercial paper markets in the aftermath of the RPF debacle thus began to spill directly into the nonfinancial economy as contagion effects were transmitted to capital markets for corporate borrowing. Testifying before the FCIC, bankruptcy attorney Harvey Miller observed that “[w]hen the commercial paper market died, the biggest corporations in America thought they were finished.”45
The post-Lehman contagion also afflicted short-term interbank lending and the repo market. LIBOR borrowing costs rose sharply and in unison. One-month US dollar LIBOR rose to 3.43 percent by September 24, 2008, its highest level since the beginning of the year.46 euro and pound LIBOR rates exhibited similar increases.47 The LIBOR-OIS spread, a measure of interbank credit risk, rose sharply.48 The TED spread, another important indicator of the cost of interbank borrowing,49 widened dramatically, registering an all-time high of 464 basis points on October 10, 2008, thirteen times its level two years earlier on December 31, 2006, and six times its median level through December 31, 2009.50 The market for unsecured lending vanished.51 Many banks simply discontinued lending to each other altogether.52 Inability to obtain financing from crippled interbank borrowing markets exacerbated the decline in bank stock prices that had been underway for over a year.53 Ordinary depositors of well-known consumer banks, including Wachovia and Washington Mutual, reacted by initiating so-called silent runs, withdrawing funds electronically en masse,54 compounding the drain on funding. Both institutions ultimately failed and were acquired by Wells Fargo55 and JPMorgan,56 respectively.
Repo markets were also seized by contagion, with borrowing rates increasing across the board.57 The quantity of collateral demanded by lenders in interdealer repo markets skyrocketed.58 An index of haircuts on interdealer repo borrowing indicates that haircuts on less liquid collateral leapt from an average of 25 to 45 percent during September 2008, after already having risen from 0 percent as of January 2007.59
Contagion in short-term capital markets shook confidence in the ability of the surviving investment banks to continue funding themselves. Hedge funds and other prime brokerage customers of Morgan Stanley, Goldman Sachs, and Merrill Lynch reacted by withdrawing assets on deposit and diverting them to JPMorgan, Credit Suisse, and Deutsche Bank.60 Morgan Stanley may have sustained $20 to $120 billion in outflows in the weeks surrounding the Lehman bankruptcy filing.61 Interviews with Morgan Stanley executives by the FCIC indicate that hedge funds requested $10 billion in redemptions on Monday, September 15 and as much as $32 billion on Wednesday, September 17, 2008.62 Withdrawals of prime brokerage assets by hedge funds were partly driven by investor redemptions underway at hedge funds themselves, which averaged 20 percent of assets in the fourth quarter of 2008.63 Furthermore hedge funds and other institutional clients began to insist on segregated accounts and refused to allow the rehypothecation of their collateral.64 As a result prime brokers saw a dramatic decline in their holdings of pledgable collatezral. In particular, from August 2008 to November 2008, Morgan Stanley’s holdings fell from $877 billion to $294 billion, while Goldman Sachs’s fell from $832 billion to $579 billion.65
The outflows from prime brokerage and mounting skepticism about the future of the independent investment banking business model pushed CDS spreads on Goldman Sachs and Morgan Stanley upward.66 For example, the cost of insuring $10 million of debt issued by Morgan Stanley rose 88 percent between September 12 and September 15, 2008.67 The share prices of both banks plummeted, falling 12 and 14 percent, respectively, on September 15, a further 2 and 11 percent on September 16, and 14 and 24 percent on September 17,68 prompting speculation that Morgan Stanley would seek a merger with a commercial banking partner.69 The run on both investment banks continued even after the Federal Reserve approved the conversion of each to a bank holding company on September 21,70 and was finally averted only after the FDIC issued guarantees of new unsecured senior bank debt the next month through the Temporary Liquidity Guarantee Program (“TLGP”) program,71 after which the share price decline at both banks began to stabilize.
The unprecedented government response to the financial crisis began even before the contagion triggered by Lehman Brothers. On December 12, 2007, the Federal Reserve announced the term auction facility (“TAF”), which auctioned funds to all banks, to avoid the reluctance of banks in trouble to get conventional loans for fear knowledge of their borrowings would exacerbate their problems.72 On March 7, 2008, the Fed initiated a series of single-tranche 28-day term repurchase agreements (“ST OMO”), to provide funds to primary dealers in exchange for Treasury securities, agency debt, or agency MBS (collateral accepted in conventional open market operations).73 On March 11, 2008, the Federal Reserve launched the Term Securities Lending Facility in which primary dealers could temporarily exchange program-eligible collateral, which included nonagency AAA/Aaa-rated private-label residential MBS in addition to agency MBS, for Treasury securities.74 On March 16, 2008, the Fed then extended access to the discount window to primary dealers including investment banks through the Primary Dealer Credit Facility (“PDCF”) in connection with the acquisition of Bear Stearns by JPMorgan.75
Following the September 15, 2008 bankruptcy of Lehman Brothers, the number and scale of government programs grew. On September 16, 2008, the Federal Reserve approved an $85 billion secured revolving credit facility for AIG under Section 13(3) of the Federal Reserve Act.76 According to Secretary Paulson, this was like a temporary “bridge loan,”77 which can be likened to the Japanese authority to provide bridge financing to insolvent financial institutions, as described in part V of this book. On September 22, 2008, the Federal Reserve launched the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (“AMLF”), which lent to banks so they could purchase asset-backed commercial paper from money market funds.78 On September 29, 2008, the Treasury launched the Temporary Guarantee Program (“TGP”), which was funded by the Exchange Stabilization Fund, and provided approximately $3.2 trillion in guarantees for “liabilities” of money market funds to “address temporary dislocations in credit markets.”79 The Emergency Economic Stabilization Act was enacted on October 3, 2008, and permitted the Treasury, under the Troubled Asset Relief Program (“TARP”), to inject equity into failing financial institutions.80 It also permited the Treasury, through the Capital Purchase Program (“CPP”) to restructure the Federal Reserve’s emergency support for AIG.81 On October 14, 2008, the FDIC instituted the TLGP, which consisted of (1) the Transaction Account Guarantee Program (“TAGP”) to provide unlimited guarantees to domestic noninterest-bearing transaction deposits and (2) the Debt Guarantee Program (“DGP”) to provide limited guarantees of new senior unsecured debt issued by banks and thrifts.82 On October 3, 2008, the limit on federal deposit insurance coverage was raised temporarily from $100,000 to $250,000.83 On October 27, 2008, the Federal Reserve launched the Commercial Paper Funding Facility (“CPFF”), which authorized the New York Federal Reserve Bank to purchase highly rated unsecured and asset-backed commercial paper.84 On November 25, 2008, the Federal Reserve launched the Term Asset-Backed Securities Loan Facility (“TALF”), which authorized the New York Federal Reserve Bank to lend up to $200 billion to holders of certain ABS, and was intended to encourage lending by promoting the issuance of new ABS.85
Finally, the Federal Reserve Bank acted as international lender of last resort through swap lines in which the Fed loaned US dollars to foreign central banks, which were then lent to foreign institutions.86 Four foreign central banks had unlimited access to these swap lines during the crisis—the Bank of England, the Bank of Japan, the ECB, and the Swiss National Bank.87 The swap lines reached an aggregate amount of $583 billion in December 2008.88
Government responses to contagion
Less well known than the actions of the Fed, FDIC, and the Treasury was the role of the Federal Home Loan Bank system (“FHLBank system”) in providing liquidity to depository institutions—commercial banks as well as thrift institutions. The FHLBank System is a government-sponsored enterprise established in 1932 whose public purpose is to provide US thrifts and commercial banks, “with financial products and services, most notably advances i to assist and enhance financing of housing and community lending … by providing a readily available, competitively priced source of funds for housing and community lenders.”89
The FHLBank system consists of twelve regional Federal Home Loan banks and a central body that coordinates the issuance of public debt obligations, which funds FHLBank advances.90 As a government-sponsored enterprise, the FHLBank system can typically issue debt at favorable interest rates due to their implicit government guarantee.
Contrary to popular understanding, recipients of FHLBanks are not required to use loans just for housing. Indeed empirical evidence provided by Frame, Hancock, and Passmore (2007) suggests that FHLB advances are just as likely to fund other types of bank credit as to fund residential mortgages.91 However, there are several important restrictions on FHLBank advances. First, FHLBanks can only lend to banks that meet minimum capital requirements, as prescribed by their prudential regulator.92 For example, in order to qualify for an FHLBank advance a commercial bank must have a CAMELS rating of 3 or higher. Additionally FHLBank advances must be fully collateralized by US Treasury and GSE debt or residential mortgage-related assets (whole loans and mortgage-backed securities).93 As part of each advance, a borrower must also purchase FHLB stock in an amount ranging from 2 to 6 percent of the advance (as dictated by the individual FHLB’s capital plan).94
Between the third and fourth quarters of 2007, FHLBank advances outstanding grew by $235 billion, a 36.7 percent increase, and continued to grow through most of 2008, peaking at over $1 trillion by the end of the third quarter of 2008.95 Shockingly, during this time, US commercial banks and thrifts received more in cash from FHLBank advances than from the Fed in discount window loans. This is because from the perspective of US thrifts and commercial banks, there were distinct advantages of using FHLBank advances instead of the discount window, as interest rates on FHLBank advances were lower than the rates on discount window loans and the terms of the FHLBank advances were longer.96 According to a Federal Reserve study, the cost of an advance from the New York FHLB was between 30 and 80 basis points lower than a comparable discount window loan.97 Of the $235 billion increase in FHLB advances during the second half of 2007, $205 billion carried an original maturity of greater than one year (87.4 percent).
However, by late 2008 US commercial banks and thrifts demand for FHLB advances waned, as FHLB advances had become more expensive than the Federal Reserve discount window.98 This occurred for two reasons. First, the Federal Reserve had repeatedly reduced the discount rate in 2008, and implemented liquidity facilities, like the TAF, that lent at market rates instead of penalty rates. Second, there was a negative change in investor attitudes toward FHLB debt issuances, which increased the FHLBank’s funding costs thereby requiring the FHLBanks to increase the interest rates on FHLBank advances. As recognized in the Federal Reserve study on the FHLBank’s role during the financial crisis, “events in 2008 revealed … [that] relying on market funding using an implicit government guarantee is unlikely to be sufficient for a lender of last resort to be entirely effective during a financial crisis—exactly when you need one most.”99