Minsky. Daniel H. Neilson
issuance. Securities dealers thus became more central to the flows of credit; their business was in turn supported by the growth in repurchase agreement (repo) markets. A sale-and-repurchase agreement is a short-term loan of cash, secured by a financial asset: the owner of the asset can post it, overnight or for a very short term, as collateral for a loan of cash. The repo market facilitated the short-term holdings needed by securities dealers.
As money-market funds seemed to improve on bank deposits, the market-based credit system seemed to improve on the bank-based system, and it grew accordingly. An innovation that would prove critical in 2008 was securitization: a group of financial assets was pooled, the cash flows generated by them assigned according to a structured issuance of securities. It is market-based banking taken to its logical conclusion – a purely financial entity that fit easily into the infrastructure and usages of market-based finance. There was much to argue in favor: as Minsky had said (two decades earlier), it “makes the steps in financing explicit. It allows separate organizations to carry out the steps that were previously folded into banks and other financial intermediaries. Securitization will obviously impose a dynamics to financing that may well lead to a greater decentralization and variety of forms of financing than now exists” (1990b, 65).
In a way, this is just banking: instead of a commercial bank funding a portfolio of loans with deposits, it is an investment vehicle funding a portfolio of bonds with securities. One innovation that seemed even to improve upon institution-based banking was that a single securitization vehicle could issue a range of liabilities with different levels of debt seniority. This was the most alchemical of achievements of the market-based credit system, for it meant that a set of even doubtful assets could be the basis for the issuance of high-quality, money-like securities, perfect for the portfolios of money-market investors seeking an alternative to cash. The most junior tranches of securitizations could even serve as the basis for a second-order securitization, thus the collateralized debt obligation (CDO).
Securitization reached its high-water mark in the US real-estate market; the steady origination of mortgages was a supply that could meet the steady demand for mortgage-backed securities. The availability of such wholesale funding supported the issuance of large amounts of new mortgage financing, which in turn supported a steady rise in home prices. The appreciation of real-estate prices meant that borrowers could readily sell into a rising market in the event of payment difficulties. As a result the increased lending seemed sustainable, and moreover seemed to support the wholesale financial innovations underlying the expansion of retail lending. In the final phase of the housing boom, demand for mortgage securitizations was great enough to impel a relaxation of lending standards: confident that any level of issuance would be absorbed, mortgage originators sought to lend to anyone and everyone, even those “subprime” borrowers with little or dubious credit history.
A final innovation that accompanied and enabled the rise in securitized finance was the use of credit-default swaps (CDS), which can be understood as insurance policies on market-based credit instruments. A CDS contract is written between a buyer and a seller, with reference to a security issued by a third party. The buyer of CDS pays the seller a periodic premium; in the event of default by the issuer, the seller of CDS pays the buyer a principal. It functions as insurance against default, but because one can take a position in CDS with no interest in the underlying security, such swaps also provided an inexpensive vehicle for speculation. CDS can be written against any security; CDS on mortgage-backed securities played an important role in the expansion of market-based credit before the crisis of 2008.
Elements of the market-based credit system had been tested, in particular during the 1970 crisis in the commercial paper markets, and the 1982 crisis in the repo market, but in retrospect these were little more than bumps in the road. Repo, commercial paper, securitization, and credit-default swap markets grew significantly over the subsequent decades, and became closely connected to the boom in residential construction and mortgage finance. In general, despite the anxieties of some, the US financial system seemed, in the early 2000s, more stable than at any time in the past, and the peaks and troughs of recessions had lessened, dubbed the “Great Moderation.”
The crisis unfolded in stages from early 2007 to its apex in September 2008. In the early stages of the crisis, payment problems associated with some of the most adventurous mortgages – the subprime segment of the market – began to emerge, casting doubts over the US real-estate market more broadly. Concerns simmered about the housing market, about the extent of market-based credit that had been extended on the basis of housing loans, and about the potential of losses in these markets to affect major financial institutions. Disruptions in funding markets were evident but the extent of the crisis was not yet widely known. Broadly speaking, owners of mortgage-backed securities were beginning to seek an exit from these positions, and securities dealers, as the proximate intermediaries supporting such business, accommodated this exit by purchasing the securities from those who wished to sell. The dislocation was evident in short-term interest rates, in particular in the cost of repo borrowing against Treasury collateral, which became very cheap relative to borrowing against mortgage-backed security collateral. Borrowing was still possible, but anxiety about financial stability was becoming widespread.
The Federal Reserve (the Fed) did not offer major interventions in the early stages of the crisis. In March 2008, however, the hastily arranged acquisition of investment bank Bear Stearns by its erstwhile competitor JPMorgan Chase marked a shift to a more acute period, and the central bank increased its efforts to support the financial system. Recognizing that the rise of securities-based finance meant that securities dealers were the key intermediary, evident in spiking borrowing costs and increasing dealer reliance on short-term borrowing, the Fed aimed to support a general exit from mortgage-related assets by easing dealer financing conditions. It offered a range of special credit facilities to shore up dealer finance directly or indirectly through dealers’ banks. Notably, the Fed deployed its own, pre-existing reserve of Treasury securities to fund these interventions, without expanding its balance sheet from its pre-crisis size of just under $1 trillion.
These interventions calmed markets for a time, but September 2008 brought a new wave of failures, bringing the crisis to its peak. The government-sponsored enterprises Fannie Mae and Freddie Mac, instrumental in providing mortgage finance in the US, were placed in receivership on September 7; investment bank Lehman Brothers, heavily exposed to mortgage-backed and other securitized credit, declared bankruptcy on September 15; and insurance company American International Group (AIG), with extensive CDS business, declared bankruptcy the following day. Other institutions, large and small, in the US and internationally, seemed to be in jeopardy. Financial markets came to a halt. The Fed responded with a much more direct presence in the market-based credit system. It rapidly expanded its support to banks and dealers, expanding its balance sheet by $1.4 trillion by December 2008 (with a further $2 trillion to come by January 2015). The special liquidity programs were unwound over the course of 2009, as the central bank settled eventually on the absorption of much of the US mortgage market onto its own balance sheet. By expanding dealer finance, and then acting as a dealer itself, the Fed absorbed major parts of the global money markets onto its own balance sheet; it purchased a huge swath of the market-based credit system (Grad, Mehrling, and Neilson 2011; Mehrling 2010).
The interventions did resolve the acute phase of the crisis, though the wider repercussions were still severe. It is difficult to bracket the endpoint of the crisis – in the US, it led to a major recession. The pre-crisis unemployment rate was not seen again until 2017; the pre-crisis employment-to-population ratio remains distant as of this writing (2018). In Europe, the US events contributed to an extended crisis in sovereign debt, in turn shaking the foundations of the eurozone and the European Union. The contraction and financial disruptions were felt around the world. The populist and proto-fascist political movements that have come to prominence in 2008’s wake surely owe some of their rise to resentments stemming from the crisis and its aftermath.
The crisis prompted wide reflection on the excesses of the boom, on the appropriate scale of the financial system, and on the sustainability of capitalism itself; these reflections continue as 2008 is interpreted in light of what has followed. As a consequence, the work of Hyman Minsky, who argued that “stability is destabilizing,” has been seen as relevant once again: his books were republished, and