Twin Crises: In Public Confidence and in the Housing Market

The underpinnings of the financial crisis of 2008 in the United States and globally have been linked to a variety of potential factors. Possible causes that have been discussed in the press include the liberal lending policies of Fannie Mae and Freddie Mac, the investment of banks in mortgage-backed securities and collateralized debt obligations (CDO’s), significant counterparty risk involved with credit default swaps in the absence of a clearing house, the dependence of European banks on short-term lending markets, and, in general, a significant mismatch between income and steeply rising housing prices that led to the demand for non-traditional types of mortgages. While the financial crisis was rooted in issues such as these, the crisis would not have grown to its current magnitude if the public had not become increasingly anxious and lost confidence in the financial markets.

The public lost confidence in the financial system largely because so many financial institutions, such as Lehman Brothers, AIG, and Bear Stearns, collapsed with little warning. Such unanticipated failures caused consumers to doubt the quality of the information that they were receiving. Was the top management misinformed in the months prior to their collapse? Did they not understand the risk involved in their holdings of mortgage-backed securities or the counterparty risk involved in credit default swaps? Or was information withheld from the public? For example, Lehman Brothers’ conference call to investors on September 10, five days prior to its bankruptcy, did not suggest the disastrous nature of its condition. Moreover, investigators are examining whether Lehman accurately valued its commercial real estate holdings on its balance sheet, as well as whether it accurately portrayed the auction-rate securities that it sold to investors.

As the crisis proceeded, it became clear that banks did not trust each other, and the public did not trust banks. Indeed, the collapse of Washington Mutual, which became the largest bank failure in U.S. financial history, was precipitated by rapid withdrawals by investors—$16.7 billion in deposits over 9 days—while IndyMac’s collapse over the summer was precipitated by depositor withdrawals of $1.3 billion over two weeks. Wachovia experienced increased pressure to obtain a buyer when customers withdrew $5 billion in deposits in one day. Following the collapse of Lehman Brothers, the three month dollar LIBOR—a key rate at which banks lend to each other—skyrocketed. The spread of the three month LIBOR over the three month Treasury bill rate reached 464 basis points, one of the largest spreads in history. These high rates were a result of banks’ mistrust of each other as borrowers. The high rates themselves made banks reluctant to borrow, and credit markets froze. The commercial paper market, which involved short-term debt issued by companies to meet payroll, etc.—also contracted since few institutions were willing to buy commercial paper because of fears of default. During the week ending October 1, the commercial paper market contracted by the largest amount since the Federal Reserve began tracking it in 2001. Even companies with a limited involvement in the finance sector, such as AT&T, were forced to borrow at higher rates as concerns over the rapid failures of institutions extended beyond the financial sector. The increase in rates caused problems for firms reliant on commercial paper as a source of short-term funding.

In order to work, any policy intended to eliminate the credit crisis would have to restore confidence. The Paulson plan, as originally understood when it passed, did not contain many of the key measures to restore confidence that were later undertaken. Indeed, when the original $700 billion asset repurchase plan, in which the government would purchase mortgage-backed securities from financial institutions, was finally passed on October 3, the Dow Jones fell by 157 points. By the end of the following week, the Dow had fallen by 18.2%—its worst weekly percentage decline in history. Fortunately, markets responded more favorably to steps taken the following week. The US and European governments announced greater protection of consumer deposits at banks, guarantees on money market funds, sovereign guarantees on bank debt, purchases by the U.S. government of commercial paper issues, and FDIC guarantees in the U.S. on loans made by banks to each other. Markets responded very favorably because these measures protected banks and the public from the rapid collapse of other banks. On the day that the European governments agreed to guarantee the loans that banks made to each other, European markets staged a historic rally and the S&P 500 rose 11.6%, which was its biggest one day gain since the Depression. These measures were not as directly linked to the mortgage-backed securities as the original Paulson plan, but rather were more of a solution for the other, non-housing crisis—the crisis in confidence.

The relationship between the crisis in confidence and the crisis in the housing market is complex. The crisis in confidence can worsen the crisis in the housing market. For example, homeowners with mortgages that have a floating rate based on LIBOR may be in trouble if the high LIBOR rates that result because banks don’t trust each other persist. If these homeowners cannot pay the new floating rate linked to LIBOR, they may have to go into foreclosure. At the same time, steps to address the crisis in confidence may worsen the housing crisis. For example, when the Treasury announced that it would buy bank equity and guarantee bank debt in an effort to calm the crisis in confidence, investors began buying the existing bank debt. Then, investors began selling the securities issued by Fannie Mae and Freddie Mac because they had lower yields. These sales depressed the prices and increased the yields on Fannie and Freddie’s debt, which increased mortgage rates. If this continues higher mortgage rates could worsen the underlying housing crisis and limit refinancing of existing homes and new home purchases.

In many ways, the crisis in confidence is a crisis in the quality of information reaching consumers and, as such, parallels the informational challenges facing consumers during the corporate scandals of 2002 involving companies such as Enron, WorldCom, and Tyco. In those crises, as in this one, complicated financial instruments were a major cause. This crisis, however, is even more severe because it involves the financial institutions with which most consumers do business. As long as financial institutions collapse with little warning, consumers will worry about the quality of their information. Tighter regulations, such as Sarbanes Oxley, in the wake of Enron have helped in this regard, but more needs to be done. In the meantime, the market and the banks are likely to respond to policies that will protect them if a key financial institution collapses without warning. The U.S. and the global economy are facing twin crises now, and, hopefully, despite the significant financial costs, these crises will provide us with a positive legacy of more transparent information flows and greater oversight

Nayantara D. Hensel is Assistant Professor at the US Naval Postgraduate School.  Her expertise includes mergers, IPO's, derivatives, domestic and international banking and venture capital.