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What Have We Learned from the Financial Crisis?

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Why do we need yet another discussion of the 2007-09 financial crisis and its aftermath? That question is asked and answered by Alan S. Blinder in his new book, After the Music Stopped: The Financial Crisis, the Response, and the Work Ahead. Blinder provides new details about this harrowing chapter in our financial history and valuable insights about the effectiveness of potential regulatory policies.

“A comprehensive history of this episode is yet to be written,” writes Blinder, an economics professor at Princeton and former vice chairman of the Board of Governors of the Federal Reserve. “The American people still don’t quite know what hit them, how and why it happened, or what the authorities did about it.”1

“One day,” he foresees, “some ambitious historian will put everything together in a two-thousand-page tome.”

Blinder’s goal is to be comprehensive but shorter. He succeeds rather well.

His book fills in many gaps, providing explanations of events and why they happened that are missing from other books about the crisis. A few surprising details emerge. Blinder takes definite positions about what he believes should have been done instead of what was done. These are positions he took publicly at the time. He also explains why others took opposite positions.

The pivotal events

The first pivotal events – which signaled subprime mortgage funds might not be worth what they were thought to be worth – occurred in July and August of 2007. Bear Stearns, the fifth-largest U.S. investment bank, admitted that July that one of its mortgage-related hedge funds might be worthless. Then on Aug. 9, the large French bank BNP Paribas suspended withdrawals from three of its subprime mortgage funds.

But it was not until over a year later, with the Lehman bankruptcy on Sept. 15, 2008, that the house of cards built on subprime mortgages abruptly fell.

Blinder explains why it was such a big deal when following that event, money-market funds “broke the buck,” meaning they were worth less than $1 per share. Several investment banks, to increase their leverage, had established off-balance-sheet structured investment vehicles (SIVs) to invest in collateralized debt obligations (CDOs). The banks funded these SIVs by issuing short-term commercial paper, implicitly backed by their sponsors – which included most notably Citigroup as well as Lehman and others. Their sponsors could, while still adhering to the capital requirements rules, leverage their capital in the SIVs by more than 50-to-1.

Meanwhile, money-market funds, searching for higher yield to compete with interest rates on ordinary bank account deposits, had begun investing in corporate commercial paper. Because of their higher yields, money funds had accumulated assets of $3.4 trillion in September 2008. When Lehman declared bankruptcy, the Reserve Primary Fund, the oldest money-market fund, had $785 million invested in Lehman commercial paper. Although this was only 1.2% of the fund, the Reserve Primary Fund could only redeem shares at 97 cents a share when investors came by the droves to redeem their funds.

See full article on What Have We Learned from the Financial Crisis? by Michael Edesess, Advisor Perspectives.

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