Financial Crisis? The Liquidity Crunch of August 2007

Financial Crisis? The Liquidity Crunch
of August 2007
September 21, 2007
Darryl E. Getter, Mark Jickling, Marc Labonte,
and Edward Vincent Murphy
Government and Finance Division

Financial Crisis? The Liquidity Crunch of August 2007
Summary
Firms are said to be liquid when they are able to meet current obligations or
short-term demand for funds. A firm is said to be solvent but illiquid when its assets
exceed its liabilities but it is unable to liquidate assets rapidly enough to meet current
obligations. Markets are said to be liquid when a large volume of financial securities
can be traded without price distortions because there is a ready and willing supply of
buyers and sellers. Liquid markets are a sign of normalcy.
In August 2007, liquidity abruptly dried up for many firms and securities
markets. Suddenly some firms were able to borrow and investors were able to sell
certain securities only at prohibitive rates and prices, if at all. The liquidity crunch
was most extreme for firms and securities with links to subprime mortgages, but it
also spread rapidly into seemingly unrelated areas. The stock market experienced
unusual volatility and investors rushed to buy the safest of all investments, U.S.
Treasury securities. On August 31, Federal Reserve Chairman Ben Bernanke noted
that “[a]lthough this episode appears to have been triggered largely by heightened
concerns about subprime mortgages, global financial losses have far exceeded even
the most pessimistic projections of credit losses on those loans.”
The spread of disruptions from housing into other debt markets is an example
of financial contagion, or systemic risk. Contagion spread among non-bank
institutions: mortgage lenders, hedge funds, and issuers of various types of securities,
including commercial paper, asset-backed securities, structured products, and debt
supporting leveraged buyouts and takeovers. As fear of risk has increased, these
institutions saw sources of credit vanish and struggled to meet existing financing
commitments, to post additional collateral, and to cope with portfolio losses. Some
financial institutions, primarily mortgage lenders and hedge funds, have been unable
to resolve liquidity problems and have closed. In the months ahead, there may be
more failures.
Central banks, including the Federal Reserve, have responded by providing
liquidity — injecting cash into the banking system and lowering interest rates — in
order to prevent financial disruptions from slowing real economic growth. While
financial “paper losses” have no direct effect on output or employment, there are
channels through which changes in financial conditions may be transmitted to the
real economy: for example, tight credit and equity markets restrain business
investment in plant and equipment.
In the wake of the liquidity crunch, policymakers may consider several areas for
reform. Could regulation have prevented current problems in the mortgage market?
Should credit rating agencies, like Moody’s and Standard & Poor’s, be subject to
more oversight by the Securities and Exchange Commission? Should the non-bank
institutions that have been central to this episode be subject to greater regulatory
supervision or information disclosure requirements? This report analyzes the causes,
progress, and broad policy issues raised by recent liquidity problems, but does not
address proposals to alleviate distress in the housing sector.

Contents
In troduction ......................................................1
How We Got Here.................................................1
The Housing Boom and Bust.....................................1
Was the Boom a Bubble?....................................4
Securitization in the Mortgage Market.............................5
Financial Problems for Lenders...................................6
Turmoil in Financial Markets........................................7
Problems for Hedge Funds and Investment Banks....................7
The Liquidity Crunch ..........................................9
The Response of Central Banks..................................12
Why Did It Happen?..........................................13
Policy Issues.....................................................15
Monetary Policy in a Liquidity Crunch............................16
Systemic Risk and Contagion...................................17
Could Problems in the Mortgage Market Have Been Averted?.........19
Financial Market Regulation....................................20
Rating Agencies..............................................21
Financial Markets and the Real Economy..........................22
List of Figures
Figure 1. Appreciation of House Prices, 1996-2007.......................2
Figure 2. Subprime Mortgage-Backed Securities.........................3
Figure 3. Yields on 3-Month Treasury Bills, May 1-August 31, 2007.........9
Figure 4. Dow Jones Industrial Average, April 25-August 31, 2007.........11

Financial Crisis? The Liquidity Crunch of
August 2007
Introduction
Financial markets suffered significant disruption in August 2007. Certain
financial instruments, especially mortgage-backed collateralized debt obligations
(CDOs), became illiquid, that is, they became difficult to sell at any price. Liquidity
problems then spread across other credit markets as investors feared that losses
linked to housing securities might affect a broad range of market participants. There
was a “flight to quality” as investors shifted funds into the least risky securities, such
as U.S. Treasury securities. As a result, many types of corporate and financial
borrowers — even some with few or no links to mortgage markets — had trouble
obtaining credit, whether to fund new projects or transactions, or to refinance existing
debt. The stock market experienced unusual volatility, although the Dow Jones
Industrial Average actually gained 156 points during August.
The financial volatility observed in August is particularly significant because it
illustrates how stress in one financial market — in this case, housing — may spread
to other markets, causing losses to investors and intermediaries not directly involved
in the market where the trouble originated. These events raise questions about the
ability of policymakers to respond to financial crises since an increasing share of
credit market activity now occurs outside the banking system, in unregulated
institutions such as nonbank mortgage lenders and hedge funds.
This report describes the preceding events that instigated the August 2007
liquidity crunch, followed by the major events that occurred during the crunch. It
then analyzes the structure of financial markets today to identify underlying causes
for the crunch. It ends by analyzing policy issues raised by the liquidity crunch
relating to macroeconomic stabilization policy and financial regulation.
How We Got Here
The Housing Boom and Bust
House prices in some regions grew rapidly after interest rates declined in 2001.
Adjusting for inflation, real U.S. house prices rose 34% during 2000-2005 (they rose
51% if not adjusted), which is more than double any five-year rate in the past 30
years. Specific regions experienced even faster appreciation; in 2004 alone, housing
in Miami, Los Angeles, and West Palm Beach appreciated more than 20% and Las
Vegas appreciated 35%. Figure 1 shows that the rate of house price appreciation,
year over year, reached 13% in 2006, and then plunged to 3% by mid-2007. There

are three important points to make about this figure. First, as of mid-2007, average
prices of single family homes were not yet falling, according to the Office of Federal
Housing Oversight’s home price index (although prices were already falling
according to some other data sources). Many housing analysts believe that prices in
this data set may be lagging actual prices, however. Second, national averages mask
regional differences. Prices in certain areas are still appreciating relatively rapidly,
whereas other areas are currently declining. Third, types of housing not covered by
this data series, such as condominiums, may have experienced a very different pattern
of appreciation.
Figure 1. Appreciation of House Prices, 1996-2007

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In rapidly appreciating regions, many borrowers refinanced their mortgages
quickly, both because they could tap this new equity for other purposes and because
the increased equity could improve their credit profile and allow them to borrow on
better terms. As a result, mortgage products designed to be refinanced after a short
period of time, such as so-called 2/28s, “interest only” adjustable rate mortgages
(ARMs), ARMs with “teaser rates,” and option ARMs,¹ became increasingly popular
¹ A “2/28” is an adjustable-rate mortgage where the rate is fixed for the first two years, then
adjusts for each of the next 28 years. “Interest only” ARMs have an introductory period
where no principal is paid off. “Teaser rates” refer to ARMs with an introductory interest
(continued...)

in hot regional markets. Subprime borrowers (i.e., borrowers with weak credit
profiles) were attracted to alternative mortgages to take advantage of growing
equity’s effect on their credit profile. Investors were attracted to alternative
mortgages because they allowed larger purchases with less money down, often with
little documentation (so-called low-doc or Alt-A mortgages).² As long as house
prices continued to rise, borrowers in hot markets easily refinanced their loans or sold
their homes at a profit, and delinquency rates remained low. Noting low delinquency
rates, more loans with lower underwriting standards began to be made. This can be
seen in the rapid growth of the subprime mortgage market, shown in Figure 2. In

2005, $507.9 billion in subprime mortgage loans were pooled and sold as mortgage-³

backed securities (MBS), compared with $18.5 billion in 1995.
Figure 2. Subprime Mortgage-Backed Securities

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When interest rates began rising and house price appreciation slowed, many
borrowers in the subprime market found it impossible to refinance on favorable terms
and were unable to maintain their mortgage payments when their loans reset. There
is now evidence that many borrowers in the Alt-A market are having similar
problems. At the same time, house sales fell rapidly, making it more difficult to
quickly exit a troubled mortgage by selling. Traditionally, delinquency and default
¹ (...continued)
rate that is below market rates. “Option ARMs (adjustable rate mortgages)” offer
homebuyers several payment options each month: interest, principal, both, or part of either.
² “Alt-A” most often refers to buyers who do not provide full documentation of income from
traditional employment, but who would otherwise be considered prime borrowers.
³ Inside Mortgage Finance, 2007 Mortgage Market Statistical Annual, vol. 1, p. 3.

rates have been closely tied to local economic conditions, but these rates are rising
today even in some areas that have relatively low unemployment and strong local
economies as well. In several formerly hot markets, prices began to fall even though
local unemployment remained low. For example, several Florida cities were among
the weakest housing markets even though Florida’s unemployment rate of 3.9%
remained below the U.S. average of 4.6% in July 2007.
Furthermore, surveys of mortgages originated in 2005 suggest that defaults and
foreclosures will rise even higher in late 2007 and the first half of 2008. As a result,
potential buyers of MBS now demand greater detail about the composition of their
securities in an effort to determine their exposure to poorly underwritten loans. In
the past, buyers might rely on the rating agencies to label the risk-level of a loan pool,
but events have shown that the ratings agencies underestimated the risk — there have
been several examples of MBS downgraded from the least-risky AAA rating to CCC
(near-default) overnight.⁴ Troubles in housing markets thus caused uncertainty in
financial markets and reduced the liquidity of loans and securities backed by loans.
Was the Boom a Bubble? In the aftermath of the housing boom, the
question that economists are heatedly debating is how much of the increase in
housing prices was due to economic fundamentals, and how much was due to a
bubble — a rise in price due to “irrational exuberance” about future price
appreciation, in the famous words of Alan Greenspan. A bubble would be consistent
with many borrowers taking on mortgages that they could not really afford in the
belief that they could borrow against the property when prices rose or “flip” the
property by quickly selling it at a profit after prices rise. These borrowers may find
their position untenable now that prices in local markets are instead flat or falling and⁵
sales have slowed. There were also reasons for house prices to rise based on market
“fundamentals,” however, such as rising incomes and falling mortgage rates.
As discussed above, mortgage rates during the housing boom were low by
historical standards, but that does not necessarily imply that they would stay low.
This raises two questions about housing market behavior. First, why did borrowers
increasingly use ARMs rather than locking in a relatively low fixed rate, which
would have had no risk of future interest rate increases? Second, why did mortgage
lenders and investors not factor in rising rates when estimating the future probability
of ARM delinquencies? Default is costly to the holder of a mortgage, as well as the
borrower. The answer to either question could be based on fundamentals or a bubble
mentality.
^!The Yield Curve: The first question — borrower choice — may be
due to borrowers taking advantage of the difference between short
and long-term interest rates, called the yield curve. The greater the
difference between short and long term rates, the greater the
incentive for a borrower to use an ARM, which is tied to short rates,

⁴ Mark Gilbert, “Unsafe at Any Rating,” Bloomberg.Com, August 30, 2007.
⁵ Just as liquidity plays a crucial role in securities markets, liquidity is important when
housing is bought for investment purposes. Investors whose financial plans are based on
being able to sell a house promptly may run into difficulties when sales slow.

rather than a fixed rate mortgage, which is tied to long rates —
especially if the borrower plans to sell or refinance the house after
a short period of time. The relatively wide spread between short and
long rates from 2001 to 2004 may explain the popularity of ARMs
earlier in the decade, but more recently the spread between short and
long rates has become small, so that the rates available on ARMs are
no longer much lower than fixed rate mortgages. The continuing
popularity of ARMs in light of the fall in spreads since 2005
suggests that many borrowers might have been motivated by the
prospect for short-term financial gain instead.
^!The Global Savings Glut: The second question — lenders’ and
investors’ willingness to finance — depends in part on expectations
of future interest rates. In hindsight, we know that interest rates
have been trending up in global markets. At the time, however,
many analysts believed that a world surplus of savings would hold
down interest rates. Among the proponents of this view was the
current Chairman of the Federal Reserve, Ben Bernanke.⁶ Economic
growth in countries with high savings rates, such as China, was
forecast to add to this surplus of world savings and hold down
interest rates. (Note that interest rates in Japan, for example, have
been near zero for almost a decade.) Financial returns for investors
in real estate and MBS looked favorable when compared to
prevailing interest rates and compared to the risk in stocks following
the bear market of 2000-2002. Investors increasingly turned to
riskier types of MBS, and these investments performed well as long
as house price appreciation held down mortgage defaults.
Securitization in the Mortgage Market
Changes in the structure of mortgage financing may have contributed to market
volatility. Securitization allowed mortgage lenders to bypass traditional banks.
Securitization pools mortgages or other debts and sells them to investors in the form
of bonds rather than leaving loans on lenders’ balance sheets. The MBS market
developed in part because long-term fixed rate mortgages held in banks’ portfolios
place banks at significant risk if interest rates rise (in which case, the banks’ interest
costs could exceed their mortgage interest earnings).⁷ MBS were popular with
investors and banks because it allowed both to better diversify their portfolios. But
because the MBS market was growing rapidly in size and sophistication, accurate
pricing of its risk was difficult and could have been distorted by the housing boom.

⁶ See Ben Bernanke, “The Global Saving Glut and the U.S. Current Account Deficit,” the
Sandridge Lecture, Virginia Association of Economics, March 10, 2005, available on the
Federal Reserve Board of Governors website. For a discussion, see CRS Report RL33140,
Is the Trade Deficit Caused by a Global Saving Glut?, by Marc Labonte.
⁷ This was the problem behind the savings and loan crisis in the 1980s: inflation and rising
interest rates required lenders to pay their depositors more than they were earning on their
fixed-rate mortgage assets.

There are several forms of MBS. The simplest are called pass-throughs —
interest and principal payments from homeowners are collected by the lender (or a
service firm) and passed through to the owner of the MBS. More complex securities
are created by pooling MBS as well as mortgages, and by giving investors a menu of
risk and return options. A mortgage pool may be split into parts (called tranches) to
allow cautious investors to purchase safer portions and aggressive investors to
purchase the riskier, high-return tranches (e.g., tranches that bear initial losses).
Finally, mortgage cash flows may be combined with derivative instruments that link
payment levels to the performance of financial variables, such as interest rates or
credit conditions. These securities — combinations of traditional bonds and
derivatives — are called structured products.
The growth of securitization meant that more loans could be originated by non-
banks,⁸ many of which are not subject to examination by federal bank examiners and
not subject to the underwriting guidances issued by federal financial regulators.
Studies of loans securitized in 2005 outside federal lending oversight suggest that the
average subprime debt-to-income ratio rose to 40%, well above prudent levels in
federal guidances. As the 2/28 or 3/27 loans with interest-only (I/O) periods and
adjustable interest rates reset their monthly payments in 2007, many borrowers have
been unable to meet their now higher monthly payment, while falling prices make it
difficult to sell the house except at a loss. Forecasts of the coming resets suggest that
the problem is likely to worsen in the second half of 2007 and the first half of 2008.
The fall of 2008, however, is forecast to have far fewer reset problems because
underwriting guidelines tightened significantly starting in August 2005.
Financial Problems for Lenders
One of the first signs that the slowdown in house price appreciation could have
wider financial effects was the early stress on mortgage originators. As discussed
above, securitization facilitated specialty non-bank mortgage lenders that operate
outside the banking reserve system. Beginning in late 2006, some of these non-bank
mortgage lenders suffered significant losses and their lines of credit began to dry up.
For example, Ownit Mortgage reportedly could not cover its early payment defaults,
which triggered a promise by Ownit to repurchase the nonperforming loans.⁹
Lenders such as Ownit depend on continuing loan sales to replenish their lines of
credit and issue new mortgages. As subprime delinquency and defaults continued to
rise in early 2007, the willingness of investors and securitizers to purchase mortgages
from non-bank originators declined and lines of credit began to disappear. Subprime
lending contracted severely and at least 90 lenders have gone out of business since
the beginning of the year.¹⁰

⁸ For example, securitization meant that non-banks needed to obtain financing only until a
mortgage was sold on the secondary market, so deposits were not needed to finance
mortgages.
⁹ Julie Creswell and Vikas Bajaj, “A Mortgage Crisis Begins to Spiral and Casualties
Mount,” New York Times, March 5, 2007, p. C1.
¹⁰ Economist Intelligence Unit, “Heading for the Rocks,” August 2007, p. 13.

Turmoil in Financial Markets
A significant downturn in the housing market would be expected to cause
economic distress among mortgage lenders, homeowners who expected to refinance,
sellers, and related sectors such as construction. But it is not inevitable that even a
severe disruption in housing should lead to a crisis in the broad financial market. In
the summer of 2007, however, the global credit markets suffered a “liquidity crunch”
that went well beyond the mortgage market, and the relatively small subprime
segment of the market where stresses were concentrated up to then. As Federal
Reserve Chairman Ben Bernanke noted, “[a]lthough this episode appears to have
been triggered largely by heightened concerns about subprime mortgages, global
financial losses have far exceeded even the most pessimistic projections of credit
losses on those loans.”¹¹
In retrospect, it appears that easy credit (caused by the “saving glut”) and
underestimation of risk were not confined to the mortgage market. Spreads between
risky corporate debt (such as junk bonds issued to finance takeovers) and safe
obligations like U.S. Treasury securities were very low by historical standards —
investors were willing to take risks without demanding correspondingly high interest
rates in return. With both stocks and traditional fixed-income markets producing low
yields after 2001, pension funds and other institutional investors were driven by their
actuarial needs and competition to seek out higher-yielding investments, creating a
market for hedge funds and other investment managers using exotic and complex
securities and strategies. Long-term rates did not rise much even after the Federal
Reserve began raising the federal funds (overnight) rate in 2004, implying that the
market anticipated a plentiful supply of credit to continue into the future. This
perception may have encouraged the overuse of leverage, or borrowed money, to
boost returns. For example, until August, leveraged buy-outs (corporate takeovers
heavily financed by debt) had soared in recent years.
A financial market adjustment need not cause widespread disruptions. Lenders
could tighten their standards, debt holders could re-price their securities to reflect an
updated view of risk and take the balance-sheet losses, and reckless speculators could
simply go out of business, all without interrupting the mainstream of credit flows that
support the global economy. But instead of such an orderly adjustment, financial
markets experienced what various observers have called a rout, a panic, a crash, a
bursting bubble, or a crunch. Losses have already exceeded even pessimistic
expectations, as Chairman Bernanke noted, and there may be more to come. The rest
of this section examines how liquidity problems spread through the financial system
in August 2007.
Problems for Hedge Funds and Investment Banks
In mid-June 2007, the investment banking firm Bear Stearns announced that two
of its hedge funds that invested heavily in subprime MBS were in difficulty. The

¹¹ “Housing, Housing Finance, and Monetary Policy,” Remarks by Chairman Ben S.
Bernanke at the Federal Reserve Bank of Kansas City’s Economic Symposium, Jackson
Hole, Wyoming, August 31, 2007.

securities were estimated to have lost 28% of their value since the beginning of the
year. Although the funds held only about $600 million in investor capital, a
negligible amount in terms of the whole U.S. mortgage market, the announcement
caused alarm for several reasons.
First, the MBS held by the funds had been originally classified as very safe and
low-risk by the bond rating agencies.¹² The revelation that they had lost much of
their value over a very short period raised doubts about the ratings of all similar
bonds, and appeared to confirm what many believed: that during the boom, many
market participants had significantly underestimated the risks of lending. The
announcement suggested that other holders of subprime MBS might be experiencing
similar, but as yet undisclosed, losses. Thus, traders and lenders became less willing
to deal with any fund or financial institution known (or suspected) to be a holder of
subprime MBS. Additionally, there is a large credit derivatives market for MBS,
multiplying the prospects for losses stemming from MBS volatility.¹³
Second, although (as noted above) the interest rates on subprime MBS are
relatively high compared to other debt securities, they do not by themselves provide
the kind of returns that hedge fund investors expect. Therefore, hedge funds
commonly use leverage — borrowed funds and derivative instruments — to boost
returns. This means that losses in hedge funds are not only a problem for their
investors — who by law must be wealthy individuals or financial institutions
presumably able to bear risk and loss — but for their creditors and counterparties as
well. (The Bear Stearns funds had borrowed about $6 billion from other firms,
including Merrill Lynch, Goldman Sachs, Bank of America, and Deutsche Bank.)
Since hedge funds are unregulated and do not disclose their sources of funds, this
created uncertainty about which institutions were exposed to credit risk from hedge
funds. Many derivatives markets are also largely unregulated, which means that the
identities of a hedge fund’s counterparties are not widely known. Thus, the Bear
Stearns announcement led many to infer that other hedge funds were likely facing
difficulties (which proved to be the case) and raised uncertainty about which
associated brokers, lenders, and derivatives dealers might also face losses.

¹² Bond rating agencies, of which Moody’s and Standard & Poor’s are the best-known, are
private firms that assign grades to debt securities, indicative of the raters’ estimates of the
probability that interest and principal will be paid on schedule. The ratings are important
not only to investors trying to select a portfolio that matches their risk preferences, but they
are also written into many federal laws and regulations. For example, the amount of
regulatory capital banks are required to hold to cover the risk of loss to their bond holdings
is determined by the rating assigned by the agencies, and thrift institutions are not allowed
to own bonds rated below investment grade. In 2007, many blame the rating agencies for
failing to downgrade subprime MBS in a timely way in response to negative information
about rising defaults and imminent resets that became available early in the year.
¹³ Credit derivatives are essentially bets that a debt security or firm will default, be
downgraded by a rating agency, or experience another “credit event.” They provide
insurance for bondholders, and speculative opportunities for those who believe that the
bonds’ credit quality are deteriorating.

The Liquidity Crunch
Firms are said to be liquid when they are able to meet current obligations or
short-term demand for funds. A firm is said to be solvent but illiquid when its assets
exceed its liabilities but it is unable to liquidate assets rapidly enough to meet current
obligations. Markets are said to be liquid when a large volume of financial securities
can be traded without price distortions because there is a ready and willing supply of
buyers and sellers. Liquid markets are a sign of normalcy — typically, investors can
take liquidity for granted.
On August 9, 2007, liquidity abruptly dried up for many firms and securities
markets. Suddenly some firms were able to borrow and investors were able to sell
certain securities only at prohibitive rates and prices, if at all. The liquidity crunch
was most extreme for firms and securities with links to subprime mortgages, but it
also spread rapidly into seemingly unrelated areas. The apparent triggers for this
liquidity crunch were losses related to U.S. housing at a French and a German bank,
which followed on the Bear Stearns hedge fund announcement discussed above.
Clearly, losses at two European banks alone would not be enough to cause a global
liquidity crunch. Rather, news of these losses led to a sudden change in expectations
among market participants that made them unwilling to lend to firms or buy
securities at prevailing rates and prices. Beyond the sudden undesirability of firms
and securities related to subprime mortgages, there was a general increase in risk
aversion — investors suddenly required a much higher premium in order to be
induced to hold risky assets — and a corresponding “flight to quality.” This may be
seen in the sudden plunge in the yields on 3-month Treasury bills, shown in Figure
3. Typically, three-month Treasury yields are relatively close to the federal funds
rate, since overnight bank lending is also considered to have very little risk. On
August 20, three-month Treasury yields were more than two percentage points below
the federal funds rate.
Figure 3. Yields on 3-Month Treasury Bills, May 1-August 31, 2007

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Throughout August, there were reports of problems in other markets and
financial institutions around the world, often with no apparent or previously-known
connection to subprime mortgages. Although initial losses were reported in high-
risk operations like hedge funds, many of the later headlines involved markets
generally thought of as stable and low-risk:
^!Commercial paper, often referred to as “corporate IOUs,” is a
substitute for short-term bank borrowing. Some commercial paper
is backed by assets, including mortgages. The market for
mortgage-backed commercial paper dried up, causing liquidity
strains for issuers and various financing vehicles and conduits, some
of which are owned by banks. During the flight to quality, investors
became reluctant to buy any commercial paper from issuers other
than the highest-rated.
^!Money market funds are considered safe; they invest in very short-
term securities. In July, there was an influx of money (over $1
trillion, by some accounts) into the funds. In August, however,
several funds were revealed to be holding mortgage-backed
commercial paper, and there was a surge in withdrawals, not limited
to the named funds. Some funds froze redemptions rather than be
forced to liquidate assets at prices they believed to be temporarily
driven far below fundamental values.
^!Alt-A and jumbo mortgages are non-conforming loans to
borrowers normally considered less risky than subprime
homebuyers.¹⁴ In August, however, aversion to risk spread into
these sectors of the mortgage market, as investors became less
willing to purchase any MBS not issued (and guaranteed) by Fannie
Mae or Freddie Mac. This caused interest rates on mortgages that
those institutions could not purchase to rise, and led to calls to
remove legal and regulatory limits on Fannie and Freddie’s ability
to buy mortgages.¹⁵ Doubts about the solvency of mortgage lenders¹⁶
grew, including Countrywide Financial, the nation’s largest.
Another set of market participants subject to a sudden reevaluation were private
equity firms. Over the past several years, private equity has had a strong track record
of earning high profits by buying companies, restructuring their finances and
operations, and reselling them to public investors. They attracted billions in capital
from conservative investors like pension funds and nonprofits. Their deals depend

¹⁴ Jumbo loans are non-conforming because they are larger than Fannie Mae and Freddie
Mac are allowed to purchase.
¹⁵ See. e.g., Lawrence Summers, “This Is Where Fannie and Freddie Step In,” Financial
Times, August 27, 2007, p. 11. (Fannie and Freddie cannot buy mortgages of over $417,000,
and their underwriting standards limit their purchases of Alt-A and subprime loans.)
¹⁶ In an effort to reassure the market, Countrywide obtained a large cash infusion from Bank
of America. See “Countrywide Receives $2 Billion Strategic Equity Investment From Bank
Of America,” Countrywide Financial Corporation Press Release, August 22, 2007.

heavily on borrowed funds, which suddenly became scarce, causing stress not only
for the funds themselves, but for the institutions that had promised intermediate
bridge financing for deals already in the pipeline. Private equity purchases of stock
are widely believed to have been a strong factor in the recovery of the stock market
since 2002; similarly, the retrenchment may have negative impact.
Turmoil in the debt markets was soon reflected in the stock market. Figure 4
shows daily highs and lows for the Dow from April 25, 2007, when the index closed
above 13,000 for the first time, through the end of August. As Figure 4 illustrates,
volatility increased markedly: triple-digit movements up or down in the Dow Jones
Industrial Average became common, and the upward momentum seen earlier in the
year, which had sent prices to record levels, was lost. Many stock markets abroad
showed similar losses, although their housing markets are typically at very different
cyclical positions. Price volatility produced another set of victims: hedge funds and
others using computer models to trade on short-term price swings. The models could
not cope with the whipsawing prices in July and August, and several “quant funds”
failed.
Figure 4. Dow Jones Industrial Average, April 25-August 31, 2007

¹⁴⁵⁰⁰
¹⁴⁰⁰⁰
¹³⁵⁰⁰
¹³⁰⁰⁰
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^Source:^Y^a^ho^o^Fi^na^nc^e^.
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Each of these phenomena can be plausibly explained in terms of fundamental
financial conditions and factors affecting the particular markets or firms involved.
What may be more important, however, is the cumulative effect they had on market
psychology and, ultimately, behavior. During August, market participants did not
have leisure to analyze the fundamentals behind each new headline, and the
professional appraisers of risk, such as the rating agencies, appeared less trustworthy
with each new revelation. Thus, to many investors and creditors, the sequence of
events began to seem more and more the product an overarching panic, or contagion.
Financial contagion is said to occur when financial shocks are transmitted — from

firm to firm, market to market, or country to country — in a way that does not appear
to be explained by fundamental supply or demand linkages.
Lawrence Summers, former Secretary of the Treasury, put it this way: “as
investors rush for the exits, the focus of risk analysis shifts from fundamentals to
investor behavior.”¹⁷ If investors believe that other investors are likely to sell, they
have a strong incentive to sell even assets they believe are undervalued. As prices
fall, collateral demands and margin calls force more selling, leading to cascading
liquidations and a market crash.
A key issue for whether the liquidity crunch has lasting economic effects will
depend on whether it becomes (or already has become) a credit crunch, which is
defined as a situation where creditworthy borrowers are unable to borrow at all on
terms that are consistent with economic fundamentals.¹⁸ When the panic is on, the
fundamentals do not matter. When asset prices fall sharply, creditors become fearful
not only about the value of their collateral, but about the solvency of their borrowers.
According to a Moody’s economist, “a big problem is that lenders don’t know which
of their clients is likely to default because the system is so opaque, so they stop
lending to everybody.”¹⁹ From a policy perspective, higher risk premia may be a
warranted market adjustment, but a true credit crunch could be problematic were it
to emerge since it could reduce economic output.
The Response of Central Banks
Central banks across the world, including Europe, Japan, and the United States
acted quickly to restore liquidity to the financial system following August 9. One
sign of the liquidity crunch could be seen in the U.S. federal funds market, a private
market where banks borrow and lend reserves to each other on an overnight basis.
The Federal Reserve implements its policy decisions by targeting the federal funds
rate; since the federal funds rate is determined by supply and demand in the federal
funds market, the federal funds rate will only match the Fed’s target if the Fed
supplies as many or few reserves to the federal funds market as are needed (a process
referred to as open market operations).²⁰ To add or subtract reserves from the federal
funds market, the Fed buys or sells U.S. Treasury securities.
On a normal day, the Fed might need to buy or sell a couple billion dollars of
Treasury securities to keep the federal funds rate within a few one-hundredths of a
percent of its target. Suddenly on August 9, the federal funds rate approached 6%,
and the Fed was forced to purchase $24 billion of Treasury securities in order to add
enough liquidity to bring the federal funds rate back down to its target of 5.25%. On

¹⁷ “This Is Where Fannie and Freddie Step In,” Financial Times, August 27, 2007, p. 11.
¹⁸ Since economic fundamentals can be difficult to accurately measure, it is harder to
identify a credit crunch with confidence than a liquidity crunch.
¹⁹ Shawn Tully, “Risk Returns With a Vengeance,” Fortune, vol. 156, September 3, 2007,
p. 50.
²⁰ For a primer, see CRS Report RL30354, Monetary Policy and the Federal Reserve:
Current Policy and Conditions, by Marc Labonte and Gail Makinen.

August 10, the Fed needed to purchase an additional $38 billion to keep the rate at
its target, and issued a statement that began, “The Federal Reserve is providing
liquidity to facilitate the orderly functioning of financial markets.” The European
Central Bank provided 156 billion euros ($215 billion) of liquidity to markets on
August 9 and 10. Normalcy soon returned to the federal funds market, although other
parts of the financial system remained illiquid.
How should the Fed’s actions of August 9 and 10 be characterized? The Fed’s
actions cannot be classified as a policy change since it left the federal funds target
rate unchanged for over a month.²¹ Nor can it be considered unusual that the Fed
bought Treasury securities to keep the federal funds rate at its target — the Fed does
this on a daily basis. What was unusual about the incident was the initial sharp
increase in the federal funds rate above its target, and the magnitude of liquidity the
Fed needed to add to bring the rate back down to its target.
On August 17, the Fed took further actions to restore calm to financial markets
when it reduced the discount rate at which banks can borrow directly from the Fed
from 6.25% to 5.75%. The change in the discount rate might seem unusual since the
liquidity crunch does not seem to be concentrated in the sector (depository
institutions) with discount window access. It is believed, however, that banks
extended lines of credit and bridge financing to many of the entities suffering from
the liquidity crunch, so the extent of the banking sector’s exposure to the crunch is
still unclear. In any case, discount window lending is dwarfed by open market
operations.
On September 18, the Fed reduced the federal funds target rate by 0.5
percentage points to 4.75%, stating that the change was “intended to forestall some
of the adverse effects on the broader economy that might otherwise arise from the
disruptions in financial markets....” At the same time, the Fed lowered the discount
rate to 5.25%.
Why Did It Happen?
There are two ways to think about the causes of financial market disorder. First,
recent events can be seen as part of the standard narrative of cycles endemic to credit
markets: during periods of relative stability, lenders become complacent and
gradually overconfident, and the profit motive increasingly pushes aside the fear of
loss. Then the credit boom comes to an end suddenly, triggered by some random
event, and lenders and investors become more (and perhaps overly) cautious. Then
the cycle begins again.
Financial markets had been unusually calm for a sustained period prior to
August’s events. The prolonged period of low and smooth interest rates was
probably responsible for the notable widespread drop in risk premia, as investors may
have been lulled into a false sense of confidence. History suggests that this period of
placidity would inevitably end at some point. Once rates rose and became more

²¹ Although no change in the targeted rate was announced, the Fed allowed the actual federal
funds rate to fall below 5% on most days over the next month.

volatile, investors’ tolerance for risk diminished. Changes in investor sentiment can
be sudden and seemingly disproportionate to the proximate causes of the change. In
such circumstances, investors may even take positions that are based more on their
perceptions of herd behavior (e.g., selling an asset in anticipation of a panic) than
underlying fundamentals. Investors may take liquidity for granted until the rare
occasion when it unexpectedly disappears. When markets have been calm for a
sustained period, liquidity premia tend to fall, and when it dries up, the price of less
liquid assets may suddenly fall. In a liquidity crisis, firms may be forced to sell assets
for less than their fundamental value to stave off insolvency.
Second, many observers attribute the current episode to additional factors that
are byproducts of the ways that markets and institutions have evolved over the last
few decades. Low interest rates made highly leveraged positions relatively more
profitable, and highly leveraged market participants have grown quickly in size and
importance. Hedge funds, the proprietary trading desks of investment and
commercial banks, private equity firms, and others frequently magnify their positions
through borrowing, the use of derivatives, repurchase agreements, or short sales.
Highly leveraged positions will generate higher positive returns on average, but also
have more potential for generating large losses. Large or unexpected losses by
highly-leveraged institutions can have widespread consequences. As the President’s
Working Group on Financial Markets noted in its 1999 report on the Long-Term
Capital Management hedge fund near-collapse,
When leveraged investors are overwhelmed by market or liquidity shocks,
the risks they have assumed will be discharged back into the market. Thus, highly
leveraged investors have the potential to exacerbate instability in the market as
a whole. The outcome may be direct losses inflicted on creditors and trading
counterparties, as well as an indirect impact on other market participants through
price changes resulting from the disappearance of investors willing to bear higher
risks. The indirect impact is potentially the more serious effect. Volatility and
sharp declines in asset prices can heighten uncertainty about credit risk and
disrupt the intermediation of credit. These secondary effects, if not contained,
could cause a contraction of credit and liquidity, and ultimately, heighten the risk²²
of a contraction in real economic activity.
Much financial intermediation has migrated from the banks — which are closely
supervised and insured by federal regulators — to lightly or unregulated non-banks,
and as a result the financial system has become more opaque. Similarly, the use of
ever more complex financial instruments — derivatives, CDOs, structured products,
etc. — both permits risks to be transferred quickly from one market or institution to
another and makes it difficult to discern where the ultimate risk exposure lies. For
example, MBS investors have had difficulty telling whether the mortgages underlying
their securities are at risk. This opacity is not a problem when markets are
functioning smoothly, and indeed the consensus view is that the ability to unbundle
and transfer risk has made the financial system more robust and efficient. But the
downside is that when losses do occur there is greater uncertainty about who might
be affected and the extent of the damage, potentially leading to greater panic.

²² “Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management,” Report
of The President’s Working Group on Financial Markets, April 1999, p. 23.

Some economists have speculated that the growing complexity of and turnover
in financial markets can exacerbate rare periods of extreme volatility. For example,
when highly leveraged positions go sour, the process of unwinding those positions
can drive asset prices even further down. Highly sophisticated hedges based on assets
that are normally uncorrelated may suddenly become correlated during episodes of
instability. For example, a hedge based on the assumption that two asset prices will
not fall simultaneously could become costly to unwind if all prices are falling.
Liquidity is crucial for many of these transactions to work — when it disappears, they
fall apart. Relatively new classes of securities may have too short a history for a
comprehensive knowledge of their risk profile, so that unexpected events lead to a
sudden and dramatic repricing of the securities.
As discussed above, the downturn in the housing market has been unfolding for
some time, and it was always likely that it would result in financial market
adjustment for securities related to the housing market. Perhaps what was surprising
was how sudden and extreme that adjustment turned out to be, although asset bubbles
have often burst suddenly. At this point, the adjustment seems to be based more on
anticipation of a future (rather than actual) rise in mortgage delinquencies, and so
actual delinquencies could turn out to be higher or lower than current financial
markets reflect. (The recent increase in subprime delinquencies remains a small
portion of the total mortgage market.) If so, there will be further financial market
adjustment, for better or worse.
What is not yet clear is whether recent events (which were much more broadly
based than just the mortgage market) will lead to permanent changes in asset pricing
due to a change in underlying fundamentals, or whether recent financial losses are
mostly the result of panic and will eventually be reversed as calm is restored. To a
large extent, this question revolves around whether permanent financial adjustment
is limited to the mortgage market or whether the mortgage market represents the
proverbial “tip of the iceberg.” It could prove to be the latter if the period of a “global
liquidity glut” and low risk premia was an aberration that has come to a close. Data
suggest that low global interest rates were always being driven more by low
investment demand than high saving.²³ If so, it was always likely that investment
demand would eventually recover, and, when it did, interest rates would be driven
up.
Policy Issues
The liquidity crunch of August 2007 raises a number of policy issues. The
fundamental question underlying them is whether the crunch and the current policy
approach to its resolution has exposed the economy to an acceptable level of risk.
If the liquidity crunch leaves no lasting harm, and the policy response (mainly, the
Fed’s attempt to replenish the financial system’s lost liquidity) is effective and has
no negative side effects, then some would argue that the natural ups and downs of
financial markets are a useful and necessary way to ensure that capital is allocated

²³ See CRS Report RL33140, Is the U.S. Trade Deficit Caused by a Global Saving Glut?,
by Marc Labonte.

efficiently. In the famous words of Joseph Schumpeter, the credit crunch may
represent capitalism’s “creative destruction.” But the 2007 credit crunch has raised
issues in a number of policy areas where economists have questioned whether policy
changes could have averted the crunch, or at least tempered its more destructive side
effects, without undermining market efficiency.
The first part of this section evaluates the macroeconomic response, namely the
efficacy of the Fed’s current approach to provide liquidity to financial markets when
it dries up. The rest of the section focuses on regulatory issues that have been raised
by August’s events — the fear of financial contagion, finding the proper degree of
regulation for modern financial markets, and potential shortcomings with rating
agencies and the regulation of mortgage markets — with an eye on preventing their
reoccurrence. Finally, to understand why a liquidity crunch merits policymakers’
attention, the report links financial unrest to its ultimate effect on the real economy.
Monetary Policy in a Liquidity Crunch
With the potential to flood the market with virtually unlimited amounts of
money, the Fed can in effect offset any loss in overall liquidity in financial markets.²⁴
But adding too much liquidity would undermine the Fed’s long-term goals of
maintaining low inflation and stable economic growth. So when faced with financial
unrest, the Fed’s options for restoring calm in the short-term are constrained by its
unwillingness to undermine its long-term goals. Since monetary changes feed
through to inflation only gradually, the faster excess liquidity is withdrawn after calm
is restored to financial markets, the less of a threat it poses to low inflation.
If a liquidity crunch is the market outcome resulting from the decisions of
private investors, why should the Fed intervene? Some have argued that when the
Fed does restore liquidity, it increases moral hazard, the economic term for the idea
that people take greater risks when they are insured against adverse outcomes. In this
case, in the words of the head of Britain’s central bank, “The (recent) provision of
such liquidity support undermines the efficient pricing of risk by providing ex-post
insurance for risky behavior. That encourages excessive risk-taking and sows the²⁵
seeds of a future crisis.” These critics argue that more efficient investment
decisions would be made in the long run if the Fed allowed liquidity crunches to run²⁶
their course and imprudent investors took losses.
The effectiveness of the Fed’s efforts to restore liquidity is limited by the fact
that the Fed’s actions only affect market liquidity at the broadest level. As long as

²⁴ While the Fed can increase the availability of credit, there is always the rare possibility
that lenders will not use it, in which case the Fed’s efforts to restore liquidity could be
stymied. This scenario is referred to as a “liquidity trap.”
²⁵ Carter Dougherty, “British Central Bank Critical of Cash Infusions,” New York Times,
September 13, 2007. Soon after, the British central bank appeared to reverse its stance by
providing financial markets with significant liquidity.
²⁶ This argument should not be overstated. Investors will only be “bailed out” in instances
when their losses correspond with steps by the Fed to restore liquidity, and plenty of
investors still experienced losses during recent events despite the Fed’s actions.

investors shun classes of borrowers or assets, those markets will remain illiquid and
out of line with underlying fundamentals. As a result, monetary policy cannot make
all markets function smoothly all the time. This reduces moral hazard, however,
since it means that the Fed’s actions do not interfere with market rewards and
punishments for specific risk-taking behavior.
The drawback to the moral hazard critique is that allowing a liquidity crunch to
run its course could run counter to the Fed’s long-run goal of maintaining economic
stability. If the liquidity crunch were to lead to recession, not only would overly risky
investors take losses, but so would efficient firms that saw demand for their products
drop solely because of the cyclical downturn. Some would argue that liquidity has
characteristics of a positive externality, whose benefits to society exceed the benefits
to private firms who provide it. If so, enough liquidity can be provided only through
government intervention, in this case by the Fed.
Although the positive externality argument is generally consistent with
mainstream economic thought, it and the moral hazard critique are not mutually
exclusive. Traditionally, government programs that create moral hazard are
complemented by government regulations to reduce risky behavior. For example,
deposit insurance creates the incentive for banks to take on excessive risk, so bank
regulations restrict the amount of risk that banks are allowed to take. As will be
discussed below, if moral hazard really is being created by the Fed, there may not
currently be corresponding regulations to offset the extra risk it generates.
The decision to lower rates is similar to the 1998 experience. Similar to today,
the U.S. economy had been experiencing a sustained expansion when financial
turmoil suddenly erupted in September 1998 in response to the Russian debt default,
the second round of Asian crises, and financial difficulties at a hedge fund called
Long-Term Capital Management.²⁷ In response, the Fed cut interest rates by 0.25
percentage points on three separate occasions over the next two months, then held
rates constant until June 1999. Following these actions, calm was restored and the
economic expansion and bull market continued for another two years. In hindsight,
some economists have argued that cutting interest rates in 1998 was the wrong
decision, because it caused the economy to overheat, inflation to rise, and a stock
market bubble to grow. They argue that the economic downturn and stock market
decline that began in 2001 could have been mitigated had the Fed not acted in 1998.²⁸
Systemic Risk and Contagion
The events of August are an example of financial contagion, which occurs when
financial shocks are not confined to the markets where they originate, but are
transmitted to other firms, markets, or countries with no fundamental link to the
original problem. Trouble in the U.S. subprime mortgage market has triggered
systemic risk, or repercussions throughout the global financial system. Is systemic

²⁷ See CRS Report RL30232, Systemic Risk and the Long-Term Capital Management
Rescue, by Mark Jickling.
²⁸ See CRS Report RL33666, Asset Bubbles: Policy Options for the Federal Reserve, by
Marc Labonte.

risk too high in today’s financial system? If so, what options do policy makers have
to reduce the incidence of contagion, or systemic risk?
In general, markets are self-correcting and self-stabilizing. The price mechanism
ensures that when asset prices fall far enough, new buyers will be found and a new
equilibrium established. In the United States, some of the largest financial markets
— trading in foreign exchange and U.S. Treasury securities, for example — have
functioned very well with virtually no government regulation.
True systemic risk episodes are rare events, and when they do occur, there may
not be significant damage to the real economy. It is impossible to know whether
instances where the Fed has successfully stepped in to quell financial turmoil, such
as October 1998 and August 2007, were narrowly averted “near misses” or whether
calm would have been restored anyway without government intervention.
Nevertheless, financial regulators spend considerable time thinking about worst-case
scenarios, because of the possible severity of the macroeconomic consequences. In
the United States, modern banking and securities regulation both have their roots in
and derive their basic principles from the lessons of the Great Depression, when the
stock market crash of 1929 and a banking panic accompanied a decade of economic
contraction and stagnation.
In economic terms, systemic risk is an externality to individual market
participants. All firms have an incentive to limit their own risk taking to avoid a loss
of their capital, but none has an adequate incentive to limit risk taking to reduce
instability in the system at large. In the recent housing boom, decisions made by
individual borrowers and lenders may have been entirely reasonable given the
information available at the time, but, at the systemic level, those choices produced
an unstable situation.
Should financial regulators try to reduce systemic risk by setting limits on
private risk taking? There are difficulties in this approach. First, if regulators want
to mandate that market participants hold more capital as a cushion to enable them to
better withstand financial shocks, no one knows how much additional stability any
given capital increase will yield. The problem is analogous to writing earthquake
insurance policies: with a low-frequency, high-severity event, there is not enough
historical data to support a robust model of the likely cost of the next unlikely
occurrence. Prudential regulation imposes costs, but the systemic benefits are
uncertain.
Second, financial markets are extremely dynamic, creating a moving target for
regulatory attempts to reduce systemic risk. In recent years, there has been a massive
movement of capital out of regulated entities like mutual funds and banks, into
unregulated hedge funds and private equity. The spread of new instruments to
manage, unbundle, and redistribute risk has been noted above. Furthermore, in
modern financial markets, assets may be held for very brief periods of time, making
regulation technically difficult. Where innovation is rapid, risk models can quickly
become outdated.
Thus, there is no easy option for regulators to use to reduce the frequency of
systemic crises in advance. The best available policy may be the current one, which

is to rely on the Federal Reserve to step in after the fact, to provide liquidity, and, if
need be, to act as lender of last resort to bail out institutions whose failure would
have unacceptable systemic consequences. As discussed in the previous section, the
main drawback of this approach is the potential for moral hazard to increase.
Could Problems in the Mortgage Market Have Been Averted?
Several factors contributed to the housing boom and bust, and only time will tell
which factors played the largest role. In hindsight, many borrowers took on loans
that were unsustainable, especially loans with introductory rates and interest-only
periods, whose use peaked in 2005. Evidence shows that loans originated by banks
subject to federal safety and soundness regulators were more likely to maintain
prudent underwriting.²⁹ The non-bank lenders, in contrast, appear to have been more
likely to extend imprudent loans. Potential reasons on both the borrowing and
lending side could include
^!relative lack of financial sophistication by borrowers in the subprime
market, which is disproportionately conducted by non-banks;
^!deceptive or misleading loan marketing techniques by mortgage
brokers and lenders with little long-term financial interests in loan
performance;
^!inflated appraisals during high refinance periods by appraisers
seeking repeat business;
^!weak underwriting criteria of lenders speculating on continued house
price appreciation to hold down defaults;
^!insufficient data and weak default models used by ratings agencies
to estimate financial risks; and
^!lack of due diligence by overconfident investors in mortgage backed
securities.
Each factor suggests a different, but not mutually exclusive, response. Better
financial education and improved disclosure laws, which would apply to both bank
and non-bank lenders, might have improved the judgment of borrowers who took out
unsustainable loans. Improved supervision of mortgage brokers and lenders could
have resulted in tighter lending standards. More accurate and objective estimations
by parties paid for their opinion, such as appraisers and ratings agencies, could have
led to a more accurate pricing of value and risk, which would minimize the current
need for a correction. More prudent underwriting standards among non-banks, either
through better due diligence by securities investors or regulation by federal bank
examiners, could have reduced the volume of unsustainable loans. The latter option
would mark a break from current policy.

²⁹ Some critics have argued that banks would have made more prudent loans if they did not
routinely securitize them, but instead held them on their balance sheet as they did in the past.

Although federal disclosure laws apply to all mortgages, not all lenders are
subject to federal scrutiny for safety and soundness. Federal financial regulators
concerned for the safety and soundness of the banking system issue guidances that
encourage prudent lending. These guidances do not apply to many subprime and
jumbo loan lenders that choose to securitize their loans. The underwriting standards
of these lenders depend on the willingness of investors in MBS to purchase the loans.
While house price appreciation was holding down defaults, MBS securities
performed well, investment demand for them was strong, and underwriting standards
loosened. Average debt-to-income ratio for subprime loans, for example, rose from
36% in 1998 to 40% in 2005. It appears at this time that problem loans originated
disproportionately in the unregulated channel.
When considering whether non-bank mortgage lenders should face the same
regulatory scrutiny as banks, it is useful to recall the purpose of bank regulation.
Because of deposit insurance, banks face little scrutiny from depositors regarding the
riskiness of their lending. “Safety and soundness” bank regulation reduces risk, and
thereby the costs of deposit insurance, in the face of moral hazard. It was not meant
to protect borrowers. The traditional rationale for why other financial institutions
face less regulation than banks is because they face nothing analogous to the moral
hazard created by deposit insurance.
Financial Market Regulation
According to Axel Weber, president of the German central bank, “the current
turmoil ... has all the characteristics of a classic banking crisis, but one that is taking
place outside the traditional banking sector.”³⁰ In pre-deposit insurance days, if one
bank got in trouble, depositors at the bank across the street would line up to withdraw
their money, not because they had new information about the condition of their own
bank, but simply as a precautionary measure: the cost of withdrawing funds was
minimal; the cost of waiting too long might be high. What is happening now, in
Weber’s analysis, is comparable, except that instead of banks, the affected
institutions are mainly conduits and investment vehicles raising funds in the
corporate bond market. These institutions have borrowed short-term (e.g., using
commercial paper) to finance long-term investments (MBS), and they are as
vulnerable to runs as a bank (in the absence of deposit insurance) with illiquid assets
(loans) financed by short-term borrowing (deposits). Most notably in the case of
subprime MBS, some of the assets are now at higher risk of default, but investors are
having difficulty telling which ones, so they are avoiding the entire asset class. One
of the original rationales for banking regulation was to reduce the cyclicality of the
credit markets, and other parts of the financial sector have shown themselves to be
no less prone to cyclicality.
Hedge funds, non-bank mortgage lenders, private equity firms, issuers of
commercial paper, and their ancillary credit suppliers have also faced liquidity
problems as investors have sought to move into safer, more liquid assets. A policy
question is whether certain non-bank financial institutions ought to be brought under

³⁰ Krishna Guha, “Credit Turmoil ‘Has Hallmarks of Bank Run’,” FT.Com, September 2,

2007.

the federal safety net, in exchange for accepting some form of prudential regulation.
A problem with the current approach is that the Federal Reserve can only inject
liquidity into the financial system through the banking sector. If banks are under
stress — one estimate is that they have had to take $1.3 trillion in risky assets back
onto their balance sheets in recent months³¹ — they may not be in a position to pass
liquidity to the non-bank sectors that most need it. According to one commentator,
the Federal Reserve could in that situation find itself “pushing on a string.”³² The
objections to widening the safety net, based on the concept of moral hazard, are
discussed above. But even if the federal safety net were not extended, an argument
for extending regulation could be made based on the moral hazard created by the
Federal Reserve’s actions to maintain liquidity.
The SEC has sought (unsuccessfully to date) to impose disclosure requirements
on large hedge funds. The word “opaque” appears often in writing about the current
liquidity crunch, including this report: perhaps more disclosure by currently
unregulated financial institutions would reduce uncertainty. As noted above, a key
motivation for the recent “flight to quality” appears to be that investors are unable to
tell whether the assets they are holding are in danger. Investors might be expected
to demand greater disclosure in return for the use of their funds, but at least until
August, investment was migrating to sectors with the least disclosure. The limitation
to increasing disclosure is that it is most useful when financial positions are relatively
simple and stable: when they are dynamic and complex, disclosed information
becomes rapidly outdated.
Rating Agencies
Bond rating agencies, of which Moody’s and Standard & Poor’s are the
best-known, are private firms that assign grades to debt securities, indicative of the
raters’ estimates of the probability that interest and principal will be paid on
schedule. The rating agencies have been of interest to Congress since the Enron
collapse, when bonds of many companies were not downgraded until long after their
management and accounting problems had become public knowledge. Congress
passed the Credit Rating Agency Reform Act of 2006 (P.L. 109-291) to address the
perceived problems created by the absence of statutory regulation of credit rating
agencies.³³ The act attempts to increase competition in the rating industry, by making
it easier for an agency to obtain Securities and Exchange Commission (SEC)
certification. The SEC, however, does not exercise any direct regulatory supervision
over the rating agencies.

³¹ Comments of Paul McCulley, managing director of Pimco, ibid. When the market for
securitization dried up, banks were forced to hold loans and other debt assets that they had
expected to sell. Banks also provide bridge financing for a variety of transactions, including
private equity deals: when those deals are not completed, loans intended to be short-term
may become long-term.
³² Lawrence Summers, “This Is Where Fannie and Freddie Step In,” Financial Times,
August 27, 2007, p. 11.
³³ For a summary of this legislation, see CRS Report RS22519, Credit Rating Agency
Reform Act of 2006, by Michael V. Seitzinger.

In 2007, the rating agencies have been widely blamed for missing looming
problems in subprime MBS, causing first a false sense of security among investors,
and then widespread insecurity as investors lost faith in rating designations.³⁴ What
are the options for additional reforms?
One approach would be new legislation to bring the rating agencies under some
form of SEC regulation. The SEC could be authorized to examine (or require
disclosure of) rating methodologies, and perhaps prescribe standards for revising
ratings in response to new information or changes in market conditions. The SEC
could also monitor possible conflicts of interest; critics have charged that the rating
agencies may sometimes adjust their ratings for competitive purposes (that is, to win
business from a rival by offering a more favorable rating since issuers pay for
ratings), and that issuers seeking ratings may be pressured to purchase various
consulting services offered by rating agency affiliates. (There have been no public
allegations that such practices underlie the problems with subprime MBS ratings.)
An opposing view is that efforts to improve the quality of the ratings are likely
to produce only limited results. Markets react to new information quickly and
continuously: is it realistic to think that rating agencies can have superior information
about each of the thousands of rated debt securities? The rating agencies employ
highly skilled analysts, but basic financial theory holds that no single individual or
firm — or the SEC, for that matter — can do a better job of valuation than the market
as a whole.
If rating agencies’ decisions sole purpose was to guide private investment
decisions, one could argue that questions concerning the quality of ratings were of
no concern to public policy. The rating agencies are a concern, however, because
many regulations hinge on an asset’s rating. Among the legal consequences of a
rating change may be higher capital requirements (for banks or securities
broker/dealers) or forced divestment of certain assets (for example, by federally-
insured thrifts that are forbidden to hold below investment grade (or “junk”) debt).
An alternate approach, then, would be for Congress to reconsider the numerous
provisions in regulation and statute that refer to private rating decisions. Those
doubting the usefulness of rating agencies might argue that the role of ratings in
public policy should be diminished.
Financial Markets and the Real Economy
The overarching goals of the government’s macroeconomic policies are not to
prevent financial losses but to maintain low inflation and stable economic growth.
As long as the financial system as a whole remains stable, losses for some investors
are needed for capital to be allocated most efficiently and the economy to prosper.
Maintaining some degree of financial stability is a policy goal not in and of itself, but
because it is required for economic stability.

³⁴ In their defense, rating agencies have noted that a relatively small share of rated tranches
have defaulted so far.

Although financial “paper losses” have no direct effect on economic output or
employment, there are channels through which changes in financial conditions are
transmitted to the real economy. Most importantly, physical capital investment is a
key component of gross domestic product (GDP), and a firm’s decision to invest in
physical capital (plant or equipment) is influenced by borrowing costs, access to
capital markets, and its stock price. If these three determinants deteriorate, then firms
are likely to reduce their physical investment, and GDP growth would eventually fall,
all else equal. Given that mortgage-related asset prices have fallen most significantly
in the recent episode, any decline in physical investment may turn out to be
concentrated in residential investment (house building). Even if firms and
individuals would still like to borrow after a financial downturn, financial firms that
have suffered losses may curb their lending to improve their balance sheets.
Another channel from which financial losses can lead to lower GDP growth is
through household consumption. If household wealth declines, households may
eventually increase their saving — equivalently, reduce their consumption — in order
to replenish it. Consumption remained relatively strong, however, during the stock
market decline from 2001 to 2003, which was much larger than recent losses to date.
Households with mortgage difficulties — a small fraction of the total — may be
forced to reduce consumption as a result of lost access to credit. Households may
also reduce their consumption as a result of declining confidence, and financial
turmoil may cause confidence to decline.
If investment or consumption were to decline, it may be partly offset by an
improvement in the trade deficit. Foreign capital inflows have played an important
role in financing U.S. investment spending in the past few years, and if investment
spending were to fall, foreign capital inflows might also fall. By accounting identity,
net foreign capital inflows are equal to the current account deficit, of which the trade
deficit is the largest part. Lower net capital inflows would reduce the value of the
dollar, which would make exports and import-competing goods relatively less
expensive. While the trade deficit would improve, foreign capital outflows could
prevent interest rates from falling, however.
As the examples of the stock market decline on October 19, 1987 — the largest
single day percentage decline in history — and the financial turmoil in 1998
demonstrate, financial losses need not lead to economic recessions. Nor is the
direction of causation obvious in cases where stock market declines and recessions
have coincided. For example, while the stock market decline preceded the 2001
recession, it might have been caused by investors’ recognition that the economy was
weakening, as opposed to causing the recession itself. In general, historical
experience suggests that prolonged bear markets, not transient financial unrest, are
associated with recessions