This paper summarizes and explains the main events of the liquidity and credit crunch in 2007-08. Starting with the trends leading up to the crisis, I explain how these events unfolded and how four different amplification mechanisms magnified losses in the mortgage market into large dislocations and turmoil in financial markets.

/pdf/deciphering-the-liquidity-and-credit-crunch-2007-08-3myt1ozynd.pdf

Deciphering the Liquidity and Credit Crunch 2007-08

The financial market turmoil in 2007 and 2008 has led to the most severe financial crisis since the Great Depression and threatens to have large repercussions on the real economy The bursting of the housing bubble forced banks to write down several hundred billion dollars in bad loans caused by mortgage delinquencies At the same time, the stock market capitalization of the major banks declined by more than twice as much While the overall mortgage losses are large on an absolute scale, they are still relatively modest compared to the $8 trillion of US stock market wealth lost between October 2007, when the stock market reached an all-time high, and October 2008 This paper attempts to explain the economic mechanisms that caused losses in the mortgage market to amplify into such large dislocations and turmoil in the financial markets, and describes common economic threads that explain the plethora of market declines, liquidity dry-ups, defaults, and bailouts that occurred after the crisis broke in summer 2007 To understand these threads, it is useful to recall some key factors leading up to the housing bubble The US economy was experiencing a low interest rate environment, both because of large capital inflows from abroad, especially from Asian countries, and because the Federal Reserve had adopted a lax interest rate policy Asian countries bought US securities both to peg the exchange rates at an export-friendly level and to hedge against a depreciation of their own currencies against the dollar, a lesson learned from the Southeast Asian crisis of the late 1990s The Federal Reserve Bank feared a deflationary period after the bursting of the Internet bubble and thus did not counteract the buildup of the housing bubble At the same time, the banking system underwent an important transformation The

/pdf/deciphering-the-liquidity-and-credit-crunch-2007-2008-3612pahtil.pdf

Deciphering the Liquidity and Credit Crunch 2007-2008

This paper documents that new loans to large borrowers fell by 47% during the peak period of the financial crisis (fourth quarter of 2008) relative to the prior quarter and by 79% relative to the peak of the credit boom (second quarter of 2007). New lending for real investment (such as working capital and capital expenditures) fell by only 14% in the last quarter of 2008, but contracted nearly as much as new lending for restructuring (LBOs, M&A, share repurchases) relative to the peak of the credit boom. After the failure of Lehman Brothers in September 2008 there was a run by short-term bank creditors, making it difficult for banks to roll over their short-term debt. We document that there was a simultaneous run by borrowers who drew down their credit lines, leading to a spike in commercial and industrial loans reported on bank balance sheets. We examine whether these two stresses on bank liquidity led them to cut lending. In particular, we show that banks cut their lending less if they had better access to deposit financing and thus they were not as reliant on short-term debt. We also show that banks that were more vulnerable to credit line drawdowns because they co-syndicated more of their credit lines with Lehman Brothers reduced their lending to a greater extent.

https://papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID1442021_code380705.pdf?abstractid=1297337&rulid=34284&mirid=5

Bank Lending During the Financial Crisis of 2008

https://gates.comm.virginia.edu/uvafinanceseminar/ivashina paper 09.pdf

During the 2008-2009 financial crisis, firms with high social capital, measured as corporate social responsibility (CSR) intensity, had stock returns that were four to seven percentage points higher than firms with low social capital. High-CSR firms also experienced higher profitability, growth, and sales per employee relative to low-CSR firms, and they raised more debt. This evidence suggests that the trust between the firm and both its stakeholders and investors, built through investments in social capital, pays off when the overall level of trust in corporations and markets suffers a negative shock.

https://onlinelibrary.wiley.com/doi/pdf/10.1111/jofi.12505

Social Capital, Trust, and Firm Performance: The Value of Corporate Social Responsibility during the Financial Crisis

This paper estimates the cost arising from information asymmetry between the lead bank and members of the lending syndicate. In a lending syndicate, the lead bank retains only a fraction of the loan but acts as the intermediary between the borrower and the syndicate participants. Theory predicts that private information in the hands of the lead bank will cause syndicate participants to demand a higher interest rate and that a large loan ownership by the lead bank should reduce asymmetric information and the related premium. Nevertheless, the estimated OLS relation between the loan spread and the lead bank's share is positive. This result, however, ignores the fact that we only observe equilibrium outcomes and, therefore, the asymmetric information premium demanded by participants is offset by the diversification premium demanded by the lead bank. Using exogenous shifts in the credit risk of the lead bank's loan portfolio as an instrument, I measure the asymmetric information effect of the lead's share on the loan spread and find that it has a large economic cost, accounting for approximately 4 percent of the total cost of credit.

https://papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID1012162_code380705.pdf?abstractid=849726&mirid=2

Asymmetric Information Effects on Loan Spreads

Asymmetric information effects on loan spreads

Theory predicts that there is a close link between bank credit supply and the evolution of the business cycle. Yet fluctuations in bank-loan supply have been hard to quantify in the time-series. While loan issuance falls in recessions, it is not clear if this is due to demand or supply. We address this question by studying firms’ substitution between bank debt and non-bank debt (public bonds) using firm-level data. Any firm that raises new debt must have a positive demand for external funds. Conditional on issuance of new debt, we interpret firm’s switching from loans to bonds as a contraction in bank credit supply. We find strong evidence of substitution from loans to bonds at times characterized by tight lending standards, high levels of non-performing loans and loan allowances, low bank share prices and tight monetary policy. The bank-to-bond substitution can only be measured for firms with access to bond markets. However, we show that this substitution behavior has strong predictive power for bank borrowing and investments by small, out-of-sample firms. We consider and reject several alternative explanations of our findings.

/pdf/cyclicality-of-credit-supply-firm-level-evidence-6io8s6s0sd.pdf

Victoria Ivashina

Papers

Bank Lending During the Financial Crisis of 2008

Bank Lending During the Financial Crisis of 2008

Asymmetric Information Effects on Loan Spreads

Asymmetric information effects on loan spreads

Cyclicality of Credit Supply: Firm Level Evidence