The 2007-08 chain: BNP to Northern Rock to Bear to Lehman to AIG

A Paris fund manager stops answering the phone

Most economists and central bankers date the start of the global financial crisis to 9 August 2007. On that day, BNP Paribas Investment Partners suspended redemptions on three funds, together worth around €2bn, that held subprime mortgage-backed paper. The bank's own explanation was a "complete evaporation of liquidity" in the market for that paper: it could no longer produce a reliable price for the assets. Nothing about the loans behind the funds had necessarily gone bad overnight. What had changed was that no one would quote a price for them, and that alone was enough to turn a valuation problem into a funding problem.

The freeze crosses the Channel

The freeze reached the United Kingdom within weeks. Northern Rock, a UK mortgage lender, had grown by funding long-term mortgages with short-term wholesale borrowing, much of it rolled every few days in the money markets that had just seized up. On 14 September 2007 the Bank of England confirmed it was providing emergency liquidity support to the bank. The announcement did not calm depositors; it triggered exactly the run it was meant to prevent. Queues formed outside branches, and depositors withdrew an estimated £4.6bn within days, on top of large withdrawals on the first day alone. This was the United Kingdom's first bank run in more than a century. Two private rescue bids failed, and the government nationalised Northern Rock on 22 February 2008.

The same funding logic, a much bigger balance sheet

Bear Stearns' collapse six months later applied the same funding logic to a much larger, much more leveraged balance sheet. Bear financed its holdings of mortgage and structured credit assets overnight, through repurchase agreements (repo) that had to be renewed continuously. In the second week of March 2008, its repo counterparties simply stopped rolling. The firm's pool of liquid assets collapsed from about $18.1bn to about $2bn in a matter of days, and on 13 to 14 March 2008 Bear told the Federal Reserve Bank of New York it would file for bankruptcy the next morning without help. A rescue followed instead. JPMorgan Chase agreed to acquire Bear Stearns, backed by New York Fed financing, at an initial price of about $2 a share on 16 to 17 March 2008, later revised upward to about $10 a share once the deal drew criticism as too cheap.

One week in September

The chain reached its worst point in a single week in September 2008. On 15 September, Lehman Brothers Holdings filed for Chapter 11 bankruptcy, the largest bankruptcy filing in US history, with about $639bn in assets and $619bn in debt. The very next day, the Federal Reserve authorised up to $85bn in emergency lending to keep the insurer AIG from collapsing, after its Financial Products unit had written enormous amounts of protection, economically similar to insurance, on senior tranches of mortgage-backed CDOs. That same day, 16 September, the Reserve Primary Fund, a money market fund marketed to investors as almost as safe as cash, "broke the buck": its net asset value fell to $0.97 a share because of a $785m position in Lehman commercial paper that had to be marked to zero. Even instruments treated as cash-equivalent were exposed to a single counterparty's failure. Three weeks later, on 3 October 2008, the US Congress passed the Emergency Economic Stabilization Act, creating the $700bn Troubled Asset Relief Program (TARP) to try to stop the chain going any further.

The slow decline underneath

Behind all of this sat a housing market that was simply declining, quietly, in the background. The S&P/Case-Shiller US National Home Price Index fell by around 27% from its mid-2006 peak to its 2012 trough. That slow-moving decline is what eventually made the mortgage-backed paper at the centre of the crisis worth much less than its face value.

No single derivative contract anchors this case. The chain is instead the connective tissue between several course ideas, all bearing on the same underlying constraint: funding, not solvency, is what broke first at every institution in the chain.

Repo as a margined position

The underlying position was the same shape at every institution in the chain: long positions in mortgage-backed and structured credit bonds, including the tranched securities covered under Lecture 8's securitisation material, financed short-term through commercial paper conduits and repo. That is a maturity mismatch, financed the same way a margined derivatives position is financed: with short-dated, collateralised borrowing that has to be rolled continuously. Overnight repo works exactly like a margined futures position. The borrower posts collateral and a haircut, and if the lender raises the haircut, or simply refuses to roll, the borrower must find cash immediately or sell the asset into an already falling market. Bear Stearns' collapse is a textbook margin-liquidity spiral: haircuts on structured collateral rose from a few per cent to double digits within weeks, and a firm whose business model depended on continuous overnight rollover could not survive a run by its own lenders.

A leverage ratio with almost no room in it

Leverage decided how much room each firm had before that spiral turned fatal. Bear Stearns entered 2008 with roughly 35 times leverage. A small percentage loss in asset value was therefore enough to wipe out shareholder equity entirely, the same lesson found in the course's interest-rate and duration material on how leverage magnifies a given price move.

When the mark itself disappears

The BNP Paribas suspension is the cleanest illustration of model risk in the whole chain. The funds were suspended not because the underlying loans had necessarily defaulted, but because no reliable price could be produced for the tranches. When a model's inputs, comparable trades and dealer quotes, disappear, the mark itself disappears, and a valuation problem becomes a funding problem overnight.

One seller holding the tail risk

AIG illustrates what happens when a large, correlated tail risk is concentrated with one seller. AIG Financial Products had effectively sold protection, economically similar to insurance, on senior tranches of CDOs at a scale that concentrated risk that should have been spread across many counterparties into one firm. This course keeps credit default swap mechanics out of scope; the simple version holds: insurance on the bundles, written by one seller, at a very large scale.

The run reaches instruments marketed as cash

The Reserve Primary Fund extends the same funding-run logic from banks to corporate treasury cash management. Money market funds are widely treated as cash-equivalent, but that trust was misplaced in this case: the fund's 1.26% exposure to Lehman commercial paper was enough to break a fund holding $62.5bn in assets. Even "safe" collateral carries counterparty risk.