Pretty surprisingly, the burst of the housing bubble didn’t coincide exactly with the financial crisis. It’s only in 2007 that the economy did veritably feel the consequences of the burst of the housing bubbles. Banks started to suffer from heavy losses on the MBS and CDOs they were holding. As we have seen, banks were at that poing highly leveraged, which meant that a relatively small loss on their assets could potentially result in bankruptcy. On 9 August, the french bank “BNP Paris” was the first bank to forbid its clients to withdraw their money out of fear of a bank run. This climate of uncertainty made banks always more reluctant to lend to each others. On 15 September 2008, the collapse of Lehman Brothers truly lead the world economy into recession.
How is that the collapse of an after all relatively small bank has been able to poison the whole economy? The answer is simple, Lehman Brothers was only the peak of the iceberg.
To understand this, it is interesting to look at the operations of Lehman Brothers. The bank was doing activities that we call “repo”. Basically, this kind of bank finances itself on a very short term basis – often from one day to another – and hold long term assets – such as MBS -. Schematically, they finance themselves with long term investment. The structure of such banks made them inherently very sensitive to liquidity problems. As you may have already guessed, these repo operations were largely unregulated. It was then not rare to have as much debts as assets. All it needed was bad news to see the whole castle unravel. When it became clear that MBS were actually waste, banks that were lending began to ask for higher guarantee in the form of higher assets counterparts. As Banks such as Lehman Brothers were highly leveraged and didn’t have much liquidity, they had to sell some assets such as MBS in order to meet their liquidity requirements. By selling those assets, the price of MBS decrease even more, making lending banks even more reluctant to lend and the vicious cycle was launched. When trust is gone, all the banking system can collapse.
During the year 2008, consumer and firm spending collapsed. As there is no use in producing goods that consumers do not want, firms were forced to fire their employees. In such period of economic recession, the usual response of banks was to decrease interest rates in order to make investments attractive again. As we have seen, this kind of stimulus was extremely difficult in an environment where interest rates are already very low. Economists call such periods “liquidity traps”.