The credit crunch began three years ago on 9th August, 2007. Yes, the roots of the crisis go farther back, but that was the day greed turned to fear, the Minsky Moment when lenders sniffed the air and got scared. We are still feeling its impact.
US real estate prices had begun to fall in the last quarter of 2005. In December 2006, Goldman Sachs began to short the sub prime market. In July 2007 Bear Stearns shut down two dodgy hedge funds specializing in subprime mortgage-backed securities. Still, on 8th August 2007, Mervyn King was confident enough to tell journalists there was no international financial crisis. The next day there was one.
It began with a simple announcement in Paris. BNP Paribas suspended redemptions in three of its hedge funds because it could not correctly price them due to lack of liquidty in the markets. Let’s rephrase that in English: a big French bank told investors they could not get their money out of its hedge funds because nobody wanted to buy their assets and so they couldn’t tell how much they were worth.
Banking is in part a faith-based enterprise. I deposit my money into a bank because I am confident I can get it out. But the bank doesn’t keep my cash sitting in a vault waiting for me. No, it lends almost all of it out. That is the function of banks, to turn liquid short-term liabilities into long-term illiquid assets. Usually, that’s no problem. We don’t all want our money at the same time, and the bank has enough cash at hand to deal with those of us that do.
But. Imagine if for some reason you believed your bank might run out of cash and would not let you withdraw your funds, maybe because a similar bank refused to. You would be desperate to get your money out and you certainly wouldn’t be depositing any more. That is what happened when BNP Paribas stopped redemptions on 7th August. Big lenders got scared. They day before, they were happy to deposit funds in all sorts of investment vehicles, confident they could withdraw their money at will. Now they figured they were better off keeping cash at hand. They figured, If BNP Paribas suspended redemptions, who knew who might…