Financial Crisis: Impact on Institutions, Liquidity, and Risk

Introduction

The financial crisis that began in 2007 has been reviewed by a number of researchers, many of whom have offered conflicting interpretations of events and of the factors that led to the crisis in the first place (Healy, Palepu & Serafeim, 2009; Laux & Leuz, 2010; Young, 2008). While mainstream journalists like Lewis (2010) focused on the more sensational narrative of players orchestrating a "big short" in the housing market bubble through credit default swaps (CDS), others have focused more intently on the role that mark-to-market accounting played in exacerbating conditions that ultimately fueled the collapse of financial institutions like Bear Stearns and Lehman Brothers (Flegm, 2008). This paper examines the causes of problems for financial institutions during the financial crisis, discusses the impact of the crisis on financial market liquidity, and addresses the issue of whether sound risk management was demonstrated by those who participated in the market for mortgage-backed securities (MBS).

Causes of Problems for Financial Institutions

The background causes of the problems faced by financial institutions during the financial crisis are complex. Not only had the groundwork for a housing market bubble been set by a relaxation of lending standards, but the Financial Accounting Standards Board (FASB) had also given the green light to fair value accounting—that is, mark-to-market accounting—which allowed firms to adjust the book value of assets based on current market prices. It has been argued that this opened the door to financial irregularities that exacerbated marketplace instability and led financial institutions into regulatory traps. These traps arose from unforeseen market panic when demand for previously highly liquid assets like collateralized debt obligations (CDOs) dried up and demand for CDS soared (Flegm, 2008; Healy et al., 2009; Posen, 2009).

Regulation of the financial industry is meant to reduce the risk of instability among financial institutions. Ensuring that financial institutions have adequate capital to manage stress is one of the objectives of the Federal Reserve. Yet systematic regulation of financial institutions with regard to capital adequacy may have actually had the same effect on financial markets as forest fire prevention has had on forests: by over-regulating what should be a more natural process with manageable downside risk, regulators create an environment in which downside risk becomes explosive when unnatural market conditions prevail and then burst all at once (Posner, 2014).

The demand for yield brought about by low interest rates caused investors to buy up risk assets like CDOs in the run-up to 2007 and equities at all-time high valuations in the run-up to the COVID collapse of 2020. A combination of fair value accounting practices and regulatory capital-adequacy requirements placed certain constraints on institutions once markets turned down in both cases. A dramatic shift in sentiment in 2007 and again in 2020 was followed by crashing valuations, which in turn forced institutional selling, which in turn begat more selling as investors sought to escape a collapsing market at any price. Financial institutions saw a liquidity crisis forming in 2019, and the Federal Reserve intervened at the time by injecting liquidity into repo markets.

How These Problems Might Have Been Avoided

Though regulations are meant to ensure quality in the market, Posner (2014) has argued that they hurt more than they help because they handcuff institutions and prevent them from using capital as they see fit. Regulations essentially deny financial institutions the ability to make decisions and live or die by the consequences. Rather than a free market, the effect produced is a command economy in which centralized control of the market is held by a power such as the Federal Reserve or the federal government, which writes the regulatory legislation.

Another way the problem could have been avoided is through interest rate policy: the Federal Reserve could have raised interest rates, giving investors an alternative to risk-on, high-yield assets in the run-up to both 2007 and 2020. By keeping interest rates near zero, the Federal Reserve aligned with other central banking policies around the world, but the problem is that such rates are artificial and do not reflect actual market sentiment. Central banks purchase sovereign debt in massive quantities—the Federal Reserve's balance sheet soared by trillions of dollars following March 2020 alone—in order to prop up demand that the private market will not provide. If no private buyers emerge for sovereign debt, yields rise precipitously, since yield is determined by the market. Thus the Federal Reserve, like other central banks, becomes the buyer of last resort and seeks to control the market.

The issue of what happens when so much money is created—causing inflation—further exacerbates market conditions by driving investors into assets that track inflation (precious metals, real estate) while simultaneously encouraging purchases of equities and bonds out of fear that prices will only rise as new money enters the system. The spillover effect from bonds to equities has been duly noted in prior research (Bernhard & Ebner, 2017). In the end, extremes are reached as available funds are leveraged, volatility becomes a serious concern, and any crack in market conditions is enough to unleash a flood of selling that essentially crashes the market—whereupon central banks are called upon to intervene once more and repeat the act of "saving" the economy.

Banning mark-to-market accounting could also have helped prevent the situation. Institutions' books would not have appeared as damaged, since losses are not recorded until assets are sold—as opposed to recording movements in market sentiment under fair value accounting practices. The issue of high-frequency trading (HFT) also exacerbates market movements because of the rapidity with which computer algorithms execute trades and shift strategies. Things happen fast in the world of HFT, and institutional funds must ensure they are positioned on the right side of market sentiment. HFT will impose severe costs on those that are not. If a firm lacks the liquidity to cover its positions, it may be forced to close out others, which can lead to monumental losses given the extent to which the firm is leveraged. Leverage laws governing rehypothecation are another matter altogether; suffice it to say, the causes and possible preventions of the crisis are myriad and complex.

Impact of the Financial Crisis on Market Liquidity

The link between the financial crisis and the lack of liquidity in financial markets can be found in the simultaneous inactivation of debt markets, the suppression of interest rates, and the halt of IPO activity. Without liquidity in the marketplace, the spread between the bid and the offer grows too wide, and a great deal of damage can occur as financial institutions are forced to adjust their holdings based on market movements. Leveraged funds cannot deleverage simultaneously without triggering further cascading losses.

Debt markets become inactive in times of financial crisis because there is a shift from risk-on to risk-off strategies. Firms are reluctant to buy the debt of others—whether corporate, junk, or sovereign—without guarantees against the risk of default or without a substantial discount on the debt purchase. Investors know that a company badly in need of money and forced to tap the debt market will pay a higher yield than a company that does not require a liquidity injection to sustain operations. In 2007, the situation was acute: issuing new debt became a problem as a sudden risk-off mentality emerged and companies like Lehman Brothers and Bear Stearns were forced into bankruptcy. Today, with bankrupt companies like Hertz having nearly issued debt to investors in order to pay prior debt holders—stopped only by the bankruptcy court—it is no wonder why debt markets become inactive in a time of crisis. Investors do not invest with the intention of becoming bag holders.

To prevent a run on financial institutions, central banks drive down interest rates by engaging in purchasing programs like quantitative easing. In 2007, the Federal Reserve purchased trillions of dollars' worth of MBS and government debt. Supplying demand in this manner ensured that yields would not rise to a point where equity investors would perceive a safer return by shifting to bonds. By suppressing interest rates, the central bank signals to investors that the only effective play for return on investment is to go "all in" on risk assets. Pension funds, mutual funds, sovereign wealth funds, and hedge funds generally respond to this signal by bidding up prices, thus commencing the "V-shaped recovery" seen following the 2007–2008 crisis and the March 2020 COVID collapse. By September 2020, markets had reached new all-time highs—a direct effect of hyper-intervention by the Federal Reserve through both the suppression of rates and the infusion of liquidity.

In response to worsening market conditions, IPO activity came to a halt. No private company wants to make an initial public offering when there is a risk-off market mentality, since the fear is that shares will not price as highly as they could in a risk-on environment. Thus, in 2007, IPO activity came to a screeching halt, just as it did in 2020. AirBnB, for instance, had plans to go public in 2020, but those plans were shelved in the wake of the COVID collapse. With the worst believed to be over, the company subsequently reconsidered moving forward with its IPO. The dynamic is ultimately a matter of risk-off versus risk-on sentiment, and the furious rebound in equity markets driven by central bank intervention clearly influenced firms' appetite for going public.

Conclusion

Regulation could be reformed to limit excessive risk-taking by being substantially rolled back. Allowing small institutions to compete with large ones in an open marketplace, and allowing so-called too-big-to-fail firms to fail when they engage in excessive risk-taking and are caught wrong-footed when the market turns against them, would restore genuine market discipline. Institutions should pay for their mistakes. To consistently reward the largest firms with bailouts undermines the concept of a free market and creates an environment of moral hazard that persists to this day. Actions should carry consequences, regardless of how those consequences affect pension funds, mutual funds, and insurance companies. If the entire financial system were to collapse as a result, perhaps market participants would then begin to reconsider their risk-reward profiles and the systemic incentives that encourage reckless behavior in the first place.

References

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Healy, P. M., Palepu, K., & Serafeim, G. (2009). Subprime crisis and fair-value accounting. HBS Case No. 109-031.

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