Modern News

Before we begin, note that banks and other financial institutions normally make their money by funding themselves in the short term market (deposits, very short-term borrowings) and lending or investing in longer-term markets, pocketing the difference in spreads.

The chart begins in the blissful summer days of 2007, with short term London Interbank Borrowing Rates (Libor) chugging along in the mid 5% range, fairly typical for a recovery.

Then came August 2007 and the advent of the hedge fund crisis. As major funds blew up, an event not widely followed at the time, it became clearer as time wore on that the system could not deal with its accumulated leverage. Particularly acute credit choke points are visible where the one month Libor rate passed the six month rate, indicating a scramble for short term funding in fearful environment. Banks began to retrench, shrinking credit and the demand for money. Short rates began to decline sharply. As credit declined, recessionary pressures began to be felt, accelerating the trend.

It looked like a pretty normal recession for a while. The “managed failure” of Bear Stearns caused only a minor downard ripple. A sense of illusory calm pervaded the street. Lehman assured the investment community that it would fix its liquidity problem. But as the scale of the leverage problem became clearer, Lehman quickly slipped down that slippery slope. And the poohbahs of the financial regulatory world miscalculated badly. Unlike the rather sweet deal they engineered for JP Morgan’s acquisition of Bear, they decided, in fit of virtuous concern over “moral hazard”, to let Lehman collapse. But they hugely underestimated the impact of Lehman’s enormous swap book, especially credit default swaps, would have on the system once Lehman became bankruptcy fodder.

The rest, as they say, is history. The sharp spike upwards in rates was rougly comparable to the danger posed by a surge in blood pressure for a stroke candidate. If financial institutions could not fund themselves in the short-term markets, they would go down- one by one, and quickly. So the feds had to engineer therapy in a hurry, including the infamous TARP program.

The enormous injection of liquidity was probably necessary to save the system. But, as usual, in crisis mode one tends to overpay. And the crisis was so severe that the monetary authorities appear quite content to have short rates that are essentially zero, trashing the dollar but allowing the remaining financial institutions to coin profits rapidly off of the now huge spread between where they borrow and where they invest.

It’s up to the financial historians now to decide: was this close enough for government work?

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