The big surprise, when Lehman failed, was how fast the disaster spread across the global financial markets and economy. We are gradually understanding more about why that happened. Brad Setser recently identified a crucial piece of the puzzle.
One other point. The fact that several of AIG’s largest counterparties are European financial firms is by now well known. What is I think less well known is that the expansion of the dollar balance sheets of “European” financial firms — the BIS reports that the dollar-denominated balance sheets of major European financial institutions (UK, Swiss and Eurozone) increased from a little over $2 trillion in 2000 to something like $8 trillion …— played a large role in the US credit boom.
As the BIS (Baba, McCauley and Ramaswamy) reports, many European banks were growing their dollar balance sheets so quickly that many started to rely heavily on US money market funds for financing. And if an institution is borrowing from US money market funds to buy securitized US mortgage credit, in a lot of ways it is a US bank, or at least a shadow US bank.
Consequently I think it is possible to think of AIG as the insurer-of-last resort to the United States’ own shadow financial system. That shadow financial system just operated offshore. There was a reason why investors in the UK were buying so many US asset backed securities during the peak years of the credit boom.
Let me explain the implications of what Brad is saying. U.S. households and households boosted their holdings of money market mutual funds by roughly $700 billion between 2004 and 2007 (the inflow continued into the first half of 2008 as well). Everyone thought that money was completely safe…but in fact according to the new report from the BIS that Setser refers to, the U.S. money market funds were investing much of that money in short-term securities issued by non-U.S. banks in order to get higher returns. In fact, the BIS authors calculate that
US money market funds’ investment in non-US banks reached an estimated $1 trillion in mid-2008 out of total assets of over $2 trillion.
Are you with me so far? U.S. money market funds were sending money overseas.
But that’s not where it stopped. Those same non-U.S. banks, in turn, were using this short-term funding from U.S. money markets funds to finance roughly $8 trillion of U.S. dollar assets—-which would include things like subprime mortgage-backed securities, bonds issued by U.S. banks, and all sorts of odd things. That’s up from roughly $5 trillion in 2004.
Yowza. The U.S. money market funds could not get away with investing directly in these risky long-term assets. So instead, they sent the money overseas, where the foreign banks did the dirty work for them of investing in the risky assets.
Meanwhile (and this is just supposition), the savings of German and French households were probably being lent to Eastern Europe.
So when Lehman failed, that triggered a run on money market funds which had bought Lehman paper. That, in turn, squeezed European banks which depended on U.S. money market funds for their dollar funding. And that, in turn, forced European banks to pull back on their funding for Eastern Europe.
To me, this whole crisis flows out of the lack of a global central bank. To evade regulation, financial institutions hopscotched their money across national borders and back again. In the process they gained a bit higher returns, at the cost of greatly expanding the complexity and opacity of the financial system.
If we don’t at least take steps towards better global tracking of financial flows—at least—we are doomed to have this happen time and again.