Timeline#

I. Where Did the Dry Kindling of the Financial Crisis Come From?#
"Firefighting: The Financial Crisis and Its Lessons" is a book co-authored by three former U.S. officials—Ben Bernanke, Timothy Geithner, and Henry Paulson. It primarily explores the background, process, and consequences of the 2008 financial crisis, sharing experiences and lessons learned in responding to the crisis.
Book Information
Title: Firefighting: The Financial Crisis and Its Lessons
Authors: Ben Bernanke, Timothy Geithner, Henry Paulson
One unique aspect of this book is that it describes the financial crisis as a fire. Therefore, when the three firefighters reflect on the crisis a decade later, the first thing they need to analyze is where the dry kindling of the financial crisis came from.
0x1: The Origin of the Subprime Mortgage Crisis
The three authors believe that the trigger for the 2008 financial crisis was not problems within the banking system, but rather the irresponsible lending practices of the U.S. subprime mortgage industry.
It replayed the inherent pattern of past financial crises: from euphoria to panic, and then to collapse. The difference is that modern markets are more complex, making financial panic harder to predict. There were also some deeper underlying factors behind this crisis.
First, lending was extremely reckless.
It can be said that this crisis began with reckless lending. From 2001 to 2007, borrowers continuously took out large loans, while lenders continuously issued large amounts of credit.
During the boom in financial markets, it seemed that everyone's behavior was rational. Whether borrowing or lending, there was money to be made, and there was no risk. However, once there was a hint of trouble, confidence would waver, quickly manifesting as market panic or even collapse.
The second factor was the excessively high leverage ratio.#
Before the crisis began, due to continuous oversized lending and insufficient collateral, both policy-oriented and commercial financial companies were effectively in a state of high leverage, posing extreme risks. The most troublesome aspect was that most leveraged loans existed in the form of highly liquid short-term debt.
Why is this troublesome? It relates to the fragility of the traditional deposit and loan model. If everyone deposits money in the bank as demand deposits that can be withdrawn at any time, but the bank uses those deposits for medium- to long-term loans, once depositors rush to withdraw their funds, the bank may not have enough liquid assets, leading to a bank run.
This applies not only to banks but also to other fund companies and lending institutions. The entire financial industry has always been wary of "short-term deposits and long-term loans." Therefore, a more prudent capital operation involves managing the "term transformation" between various funds and loans, allocating funds reasonably to maximize returns while controlling risks.
How do traditional banks avoid bank runs? Like most countries, the U.S. has various regulatory requirements to limit banking risks.
For example, banks are required to maintain a capital adequacy ratio between 8% and 10%. If their own funds are insufficient, they cannot engage in more deposit and loan business.
Additionally, the government has established a deposit insurance system to ensure that depositors do not suffer losses.
Unfortunately, before the 2008 financial crisis, many financial institutions on Wall Street, especially non-bank financial institutions, took advantage of regulatory loopholes to issue large amounts of high-risk subprime mortgages due to profit incentives.
This brings us to the third point: regulatory failure.
Logically, when these abnormal lending behaviors that violate financial common sense began to emerge, if financial regulatory agencies were sufficiently sensitive and acted promptly, such financial risks would not be difficult to regulate, especially for traditional commercial banks.
However, regrettably, before 2008, Wall Street, through various financial innovations, packaged these high-risk subprime loans into financial derivatives, concealing the financial risks within the subprime loans.
This led to the later controversial issue of "shadow banking." In this area, relevant regulatory legislation was severely lacking, and no one dared to intervene to curb this rampant financial innovation.
Note
Thus, reckless lending led to increasingly high leverage ratios, while the regulatory measures that should have prevented reckless lending were absent, laying the roots of disaster.
Important
0x2: How Subprime Loans Spread
Beyond the macro perspective of the financial system, from a micro level, especially the soaring mortgage debt of ordinary households, led to a rapid increase in debt in the U.S. at that time.
The authors analyze that a key factor is the formation of a subprime loan debt chain around residential mortgages among low- to middle-income groups. These subprime loans underwent layers of transformation through financial innovation, ultimately becoming massive "toxic assets."
What are subprime loans? They typically refer to "subprime mortgages," which are loans provided by lending institutions to borrowers with poor credit and low income levels. In simple terms, these are loans obtained by low- to middle-income individuals for home purchases or consumption, with less stringent review processes.
Why did such higher-risk loans appear in large numbers in the U.S. before 2008? This is related to the bursting of the internet bubble in 2000. In 2001, the U.S. economy experienced a significant recession, prompting the Federal Reserve to continuously lower interest rates in hopes of stimulating economic growth.
As a result, the U.S. economy showed some recovery, but the housing market became even more active, experiencing a new boom under historically low interest rates. It is important to note that this did not mean that Americans suddenly became wealthier; rather, there were significant changes in U.S. real estate credit.
A large number of low- to middle-income individuals gained access to low down payment loans to buy homes, and with low mortgage rates and easy approvals, this led to a massive increase in subprime loans.
The biggest change was the continuous decline in down payment ratios. Initially, the down payment was 20%, which dropped to 10%, 5%, and even later to zero down payment. A large number of individuals with insufficient credit only needed to repay a loan equivalent to their rental costs each month to live in their own homes. Sounds good, right?
Note
However, the result of such lax subprime lending was a rapid rise in household debt in the U.S. Relevant data shows that from 2001 to 2007, U.S. household mortgage debt skyrocketed by 63%, with the speed of household debt growth far outpacing that of household income.
Many low- to middle-income families with unstable future income, once faced with reduced income or unemployment, would have to stop repayments.
0x3: How Lending Institutions Shift Risks#
Originally, these lending institutions had already shifted the risks away. They had an expectation that the U.S. real estate market would continue to prosper. When issuing loans, these lending institutions used the homes purchased by borrowers as collateral. Therefore, as long as they expected home prices would not drop immediately, even if borrowers defaulted, the lending institutions could sell the mortgaged homes to repay the loans, making the risk essentially zero.
At that time, lending institutions also took action by immediately repackaging the mortgages after issuing loans, designing them into a type of financial derivative that could be traded in the market.
At that time, these financial derivatives had excellent short-term investment returns and were very popular in the market. Therefore, for lending institutions, the more subprime mortgages they issued, the more tradable derivatives they could package.
If the problem had stopped there, the subsequent troubles would not have been so severe. As the trading of these derivatives became hot, even more complex financial derivatives emerged, which were even more sought after.
Important
Thus, from loosening lending conditions and issuing large amounts of subprime loans to designing complex subprime mortgage-backed securities, and then designing even more complex financial derivatives, it seemed that every link pushed the risk to the back, allowing for profit, but it accumulated a large amount of risk on the financial derivatives.
If the U.S. real estate market continued to prosper, this cycle could operate healthily. But the facts show that starting from 2001, the continuous years of real estate prosperity not only attracted low- to middle-income Americans to take out unrealistic loans to buy homes, but even mortgage brokers and Wall Street bankers could not resist pouring their own money into real estate.
At this point, the U.S. was actually caught in a one-sided speculative frenzy, and market rationality had vanished; it only took a spark for the dry tinder in the market to ignite.
Sure enough, on July 9, 2007, the first spark came: BNP Paribas announced the freezing of three funds holding U.S. subprime mortgage-backed securities.
This news immediately triggered market unrest, indicating that subprime mortgage-backed securities were depreciating, and banks began hoarding cash.
Some panicked investors' first thought was to redeem their investments in funds holding subprime mortgage securities, and runs began to appear. More funds had to freeze redemptions, which triggered new panic, marking the first flame of this massive financial crisis.
[!IMPORTANT]
It can be said that the 2008 financial crisis was essentially a confidence crisis triggered by a large-scale bank run that spread throughout the entire system. The run was caused by panic, and the panic stemmed from the irrational rise of the real estate market, but it was ultimately unsustainable.
0x4: Summary#
[!WARNING]
- The trigger for the 2008 financial crisis was not problems within the banking system, but rather the irresponsible lending practices of the U.S. subprime mortgage industry. Under reckless lending, high leverage ratios, and regulatory failures, the roots of disaster were laid.
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Before the crisis fully erupted, U.S. debt rapidly increased, especially the sharp rise in ordinary household debt, primarily due to mortgage debt from home purchases.
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From loosening lending conditions and issuing large amounts of subprime loans to designing complex securities and financial derivatives, a large amount of risk accumulated, and a single spark could ignite a towering inferno.
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How Did the Subprime Flame Spread into a Financial Inferno?
Combining the three authors' analysis, the financial crisis can be divided into three stages from the appearance of the first flame to the spread of the fire, spanning from August 2007 to October 2008.
So how did the subprime flame spread into a financial inferno throughout this process? What key turning points should we be wary of? Why were U.S. regulators unable to prevent the disaster from escalating at critical moments?
0x1: Ignition Period: The Outbreak of the Subprime Crisis#
Let's first look at the first stage, the ignition period, which lasted from August 2007 to March 2008.
During this stage, the risks triggered by subprime loans began to erupt, but many people at the time did not realize that disaster had begun, and the U.S. government did not intervene in a timely manner.
Yesterday we discussed that from 2001 to 2007, the U.S. real estate market was overheated, and a series of financial derivatives related to subprime mortgages were highly sought after on Wall Street, but systemic risks gradually became apparent.
On July 9, 2007, BNP Paribas announced the freezing of three funds holding some financial derivatives related to the U.S., temporarily preventing investors from redeeming their investments. This major move by the bank raised concerns among some investors, but it did not immediately trigger government intervention. The authors explain that this is because if there is a hint of danger, the government has a habit of providing assistance, which not only creates moral hazard but may also encourage more speculative behavior.
However, the authors also point out that based on historical experience, insufficient early government intervention is costlier than overreacting and more harmful.
Tip
However, the authors also point out that based on historical experience, insufficient early government intervention is costlier than overreacting and more harmful. In this regard, experts studying the Great Depression, such as Bernanke, have analyzed that a timid central bank governor who does nothing will only lead the Great Depression deeper into the abyss. In other words, regulation should intervene in a timely manner.
What Bernanke refers to is a consensus formed among central banks in Europe and the U.S. since the late 19th century:
Caution
When a financial crisis occurs, central banks should immediately lend generously to ensure market liquidity, especially to lend to institutions that are stable and can provide quality collateral; at the same time, interest rates should be high to ensure that loans are given to institutions that truly need them. So why did the Federal Reserve under Bernanke and the New York Federal Reserve Bank under Geithner not lend heavily to alleviate market liquidity when signs of a crisis appeared in August 2007?
Important
The authors provide an important explanation in the book: capitalism relies on "creative destruction," and financial markets are no exception. Allowing a financial crisis to persist for a while is not a bad thing; it helps to clear the weeds within the financial system and improve its resilience. In other words, let the bullets fly for a while.
At that time, the three of them did not act at the early stage of the crisis because they did not want to convey the message that the government would support any large company in trouble.
[!IMPORTANT]
However, unexpectedly, as subprime mortgage derivatives fell out of favor, a "E. coli effect" began to emerge on Wall Street. Just as someone who got sick from eating meat would stop eating meat altogether, even avoiding food altogether. At that time, both investors and creditors were doing the same, avoiding all categories of financial products, regardless of whether these products were related to subprime mortgages.
But the financial market is like this: when panic begins to spread, it will quickly ferment. These scattered sparks of financial risk quickly ignited. At this time, the debate over regulation was still ongoing.
0x2: Spread Period: The Collapse of Bear Stearns and the Crisis of Fannie Mae and Freddie Mac
Then we entered the second stage, the spread period, from March 2008 to September 2008. The first typical sign was the collapse of the investment bank Bear Stearns.
In March 2008, the panic in the financial market had already forced President Bush to speak out, trying to restore public confidence. However, Paulson still advised Bush not to disclose an emergency rescue plan. Some institutions did not need to be rescued and might not be able to be saved.
Sure enough, on March 14, 2008, Bear Stearns, the fifth-largest investment bank on Wall Street with a history of 85 years and assets of $400 billion, announced its collapse. This was the first major financial institution to fall during the 2008 financial crisis, shocking the world.
However, the three authors believe that Bear Stearns brought this upon itself. This institution had long disregarded the rules that restricted commercial banks, operating with high leverage for a long time, and the danger signals of major problems had appeared as early as August 1, 2007.
At this point, the principle of controlling systemic risk began to take effect. The Federal Reserve tolerated the collapse of Bear Stearns but did not dare to completely ignore it.
Thus, the Federal Reserve intervened, persuading Wall Street giant JPMorgan Chase to acquire Bear Stearns at a price of $2 per share, totaling $236 million. At the same time, the Federal Reserve provided a $30 billion loan to deal with Bear Stearns' subsequent operations and debt issues.
It turned out that the Federal Reserve's intervention in Bear Stearns' bankruptcy restructuring temporarily calmed the market. Although this move was controversial at the time, the ultimate beneficiary was the U.S. government, while Bear Stearns did not benefit from it.
But before they could breathe a sigh of relief, a bigger problem arose, which was the second iconic moment of this period. The Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) were in dire straits, and these were two policy-oriented lending institutions.
By July 2008, these two institutions held and guaranteed mortgage debt exceeding $5 trillion, and their asset scale was several times that of Bear Stearns. If they also collapsed, the financial system on Wall Street would inevitably collapse.
Therefore, there was no choice but to rescue them. However, the discussion was about how to rescue them: direct loans were one way; injecting capital and taking over was another.
Ultimately, Paulson proposed a plan for government capital injection and then takeover, which would alleviate the funding pressure on these two institutions while restructuring their operations and imposing mandatory regulation.
Caution
The U.S. Treasury and the Federal Reserve soon discovered that these two companies were technically bankrupt and had internal issues such as accounting fraud. After obtaining authorization from Congress, the U.S. Treasury injected $100 billion into each of these institutions while conducting a strong overhaul. Although this damaged the reputation of the two companies, it ultimately avoided the fate of bankruptcy.
0x3: Inferno Period: The Collapse of Lehman Brothers
The first two stages seemed serious, but the most difficult third stage, the inferno period, saw the full outbreak of the subprime crisis in September and October 2008. The most iconic event was the collapse of the investment bank Lehman Brothers, turning the financial market into a raging inferno, forcing the U.S. government to take drastic rescue measures.
From the authors' perspective, counting from August 2007, this financial crisis lasted for a year before Lehman Brothers collapsed; but in the eyes of the public, this crisis began with the collapse of Lehman Brothers. This is a professional and non-professional understanding bias, and it also indicates the systemic importance of Lehman Brothers.
In the global investment banking community, Lehman Brothers had always been a dazzling presence. Founded in 1850, this investment bank operated globally for 158 years, having endured multiple crises on Wall Street, and in 2008 its asset scale exceeded $600 billion, 1.5 times that of Bear Stearns. In the eyes of Americans, Lehman Brothers was almost an impossible financial institution to fail.
But in the 2008 crisis, Lehman Brothers, due to its deep involvement in mortgage derivative trading and risky use of excessive leverage, accumulated debts exceeding $610 billion and suffered severe losses, with its stock price plummeting.
Following the method used to rescue Bear Stearns, Bernanke and others attempted to find a buyer for Lehman Brothers. However, this time, negotiations did not go smoothly.
On September 15, 2008, the desperate Lehman Brothers officially filed for bankruptcy, marking the largest corporate bankruptcy filing in U.S. history, and the negative impact of this event can be described as devastating.
The shockwaves first hit the financial industry. Investment banking giants like Goldman Sachs and Morgan Stanley, commercial banks like Citigroup, and insurance giants like AIG all fell into financing and trading difficulties. Investors rushed to redeem their funds, and runs occurred one after another, with Wall Street's stock market accumulating a decline of over 50%.
Ultimately, this shockwave spread worldwide: foreign financial institutions and industrial companies related to the U.S. financial market were severely impacted. Even the People's Bank of China and China Investment Corporation, which held large amounts of dollar assets at the time, had to take emergency measures to avoid greater losses.
It can be said that the collapse of Lehman Brothers was the peak event of the 2008 financial crisis, turning the financial market into a raging inferno. Faced with a severe crisis, the U.S. government was forced to take drastic rescue measures, and Bernanke, Geithner, and Paulson stepped onto the front lines of firefighting.
0x4: Summary#
- The 2008 financial crisis can be divided into three stages, from the appearance of the first flame to the spread of the fire, spanning from August 2007 to October 2008.
- The first stage was from August 2007 to March 2008, during which the risks triggered by subprime loans erupted, but the U.S. government did not intervene in a timely manner.
- The second stage was from March 2008 to September 2008, when financial panic began to explode, with the collapse of Bear Stearns and the crisis of Fannie Mae and Freddie Mac, leading to government intervention.
- The third stage was in September and October 2008, marked by the collapse of Lehman Brothers, turning the financial market into a raging inferno, forcing the U.S. government to take drastic rescue measures.
3. What Complex Games Were Involved in the Crisis Response?#
0x1: Troubled Asset Relief Program#
As early as the late 19th century, when facing financial crises, the general rescue model for European and American countries was for central banks to lend more and inject liquidity into the market to avoid a complete collapse.
However, in addressing the 2008 financial crisis, the firefighting trio did not simply apply this principle. Because this crisis was different from previous ones, it was driven by massive speculation in subprime loans and related derivatives, resulting in huge amounts of troubled assets. As the crisis continued to spread, many large institutions would be unable to operate effectively and even face bankruptcy. Therefore, whether to allow them to fail became a key discussion at the time.
The public's biggest criticism was that these large financial institutions had major issues with risk control and should be held accountable. However, this criticism overlooked the fact that the collapse of large institutions would trigger a chain reaction.
Moreover, the biggest problem at the time was the public's psychological panic and loss of confidence. Investors avoided all securitized products related to mortgage loans and companies holding such products.
After summarizing the rescue examples of large investment banks like Bear Stearns and Lehman Brothers, the firefighting trio felt that to rescue more troubled financial institutions, they needed greater authority and to take more significant measures.
Thus, in the spring and summer of 2008, Paulson, representing the U.S. Treasury, proposed the Troubled Asset Relief Program (TARP), frequently communicating between the White House and Congress; at the same time, he, Bernanke, and Geithner dealt with the two largest bank failures, Washington Mutual and Wachovia.
Ultimately, the Federal Reserve, the U.S. Treasury, and Congress gradually reached a consensus to address the crisis caused by troubled assets through the "Troubled Asset Relief Program," using various methods to provide relief.
In the fall of 2008, Congress approved a $700 billion bailout plan. For the firefighting trio, how to use this money to reduce systemic financial risks became a huge challenge.
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First, they injected capital directly into systemically important financial institutions facing difficulties. This was different from the Federal Reserve's approach of releasing liquidity to the entire market; through capital injection, the government could directly intervene or take over troubled financial institutions.
Then, the Federal Reserve, along with major central banks worldwide, took collective action to coordinate a 0.5 percentage point interest rate cut. Although the effects of the coordinated rate cut did not manifest immediately, the commitment of central banks worldwide to ease monetary policy alleviated market liquidity fears. -
Next, the firefighting trio pushed those financial institutions receiving government capital injections to undergo necessary management optimization and efficiency improvements. For example, any institution with severe troubled asset issues had to strictly limit the CEO's compensation.
Finally, the U.S. Treasury injected capital in the form of preferred shares, with a stipulated dividend rate of around 5% to 9%. This indicated that the government’s capital injection was intended to alleviate the company's capital pressure, not to intervene in the daily management of financial institutions in the long term. As long as these institutions improved their operational conditions, private capital could replace government capital at any time. -
Through these constraints, the Troubled Asset Relief Program was advanced. However, they soon discovered that the $700 billion budget was insufficient, and they needed an additional $680 billion for relief.
This further triggered public doubts, with people worried that the government's spending was a bottomless pit. More voices calling for the bankruptcy of high-risk financial institutions began to emerge.
After careful screening, especially examining the systemic importance of each financial institution, Paulson invited the CEOs of nine important financial institutions to the U.S. Treasury for a meeting, hoping these institutions would accept around 3% of Treasury capital injection.
After careful screening, especially examining the systemic importance of each financial institution, Paulson invited the CEOs of nine important financial institutions to the U.S. Treasury for a meeting, hoping these institutions would accept around 3% of Treasury capital injection.
This was crucial for fully implementing the rescue plan; without government capital injection, there would be no government guarantee. For the nine systemically important financial institutions to survive, they had no choice but to accept the Treasury's capital injection and join the Troubled Asset Relief Program.
As a result, once the news was announced, on October 13, 2008, the Dow Jones Industrial Average on Wall Street surged by 936 points, marking the largest single-day gain at that time; on October 28, the Dow rose again by 889 points, an increase of 10.88%, halting the previous stock market plunge.
Taking advantage of this opportunity, the firefighting trio continued to advance the rescue actions, injecting capital into nearly 700 small banks, which also stabilized the entire banking system and reduced market panic. In this battle between the government and public opinion, the government's rescue plan began to show initial results.
However, the effects of the rescue plan still needed time to manifest. In the fourth quarter of 2008, U.S. economic growth remained weak, with nearly 2 million people laid off nationwide, and personal and corporate debts were rampant. The public's difficulties further exacerbated Wall Street's problems, and at this time, two super-large financial institutions faced survival difficulties.
In the fall of 2008, AIG announced massive losses, and to resolve this issue, the Troubled Asset Relief Program had to be implemented. Subsequently, the U.S. government decided to inject $40 billion into AIG to enhance its credit rating and market confidence.
Another troubled financial giant was Citigroup, which had assets as high as $2 trillion. Should it also be rescued?
After repeated communications, the U.S. Treasury and the Federal Reserve used $20 billion to purchase Citigroup's preferred shares, with a dividend as high as 8%, thus increasing Citigroup's capital. They then isolated Citigroup's worst-performing assets of over $300 billion from its normal assets, ultimately providing government guarantees for 90% of Citigroup's losses to prevent the entire system from collapsing. Through these measures, external concerns about Citigroup were greatly reduced.
0x3: Summary#
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In the fall of 2008, the U.S. Congress approved a $700 billion financial rescue plan. How to effectively use this money to address the problems in the financial system and balance the relationship between the public and the government became a huge challenge for the firefighting trio.
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In the early 2009 government transition process, the U.S. made three efforts to continue rescuing the crisis: first, to rescue large industrial companies in trouble; second, to conduct "stress tests" on financial institutions; and third, to implement a quantitative easing monetary policy. This effectively curbed market panic.
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Complex systemic financial risks cannot be resolved solely by the market; it is necessary to follow legal procedures and coordinate key resources from political, economic, and social systems to solve the problem.
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What financial risk lessons were reflected upon after extinguishing the fire?
0x1: Structural Reflection#
From the perspective of understanding and judging financial crises, we must always maintain a high level of vigilance against them.
Important
The authors believe that financial crises can never be completely avoided; human emotions and behaviors will not always remain rational, and judgments will not be precise, leading to inevitable deviations. As regulators and policymakers, humans will inevitably make mistakes. Moreover, financial markets heavily rely on individual emotions, which can be contagious.
This makes predicting financial risks extremely difficult. Sometimes it aligns with rational logic, but more often it is influenced by unexpected factors, especially human emotions. Since financial crises are hard to predict, prevention and response are also not easy, and we must not be self-righteous.
Warning
Secondly, from the lessons of decision-making and actions, any excessive indulgence in financial markets and overemphasis on market freedom may be very detrimental to risk prevention. An unconstrained financial market cannot go far. Therefore, financial markets need regulation.
Thirdly, from the cultural and public opinion perspective, speculation is the enemy of financial stability. In technological innovation, we tolerate risk and exploration, but in the financial field, we cannot indulge speculation.
Have you noticed that compared to other mature market economies, such as Germany, Japan, France, and the UK, financial crises often start on Wall Street after the 19th century? This is related to the rise of the U.S. economic power and is closely linked to the prevalence of speculative culture on Wall Street.
Speculation is most likely to thrive in under-regulated financial markets and will inevitably evolve into a catastrophic disaster in such markets with loopholes.
Therefore, for Wall Street, the U.S., and even the global financial market, rethinking and advocating for sustainable business values, transitioning from a speculative culture to an investment culture, and shifting from short-termism to long-termism are crucial for reducing financial crises.
To achieve this positive transformation, financial institutions, regulatory departments, opinion leaders, and various media need to reposition themselves and communicate cautiously. At the same time, there should be continuous in-depth research on historical financial crises to draw lessons.
Thus, rethinking the 2008 financial crisis from the perspectives of cognitive judgment, decision-making actions, and cultural public opinion reveals many lessons worth reflecting on. It reminds us once again that financial risks are no small matter, and we must pay more attention to them.
0x2: Regulating the Subprime Mortgage System#
Well, what we just discussed was mainly a structural reflection on the financial industry as a whole. Now, returning to the micro level, the trigger for the 2008 financial crisis was the irresponsible mass lending by subprime mortgage institutions and extensive leveraged trading, resulting in an uncontrollable situation.
From this perspective, subprime mortgages related to real estate are essentially high-risk products that violate financial common sense and should be subject to stricter regulation. The forces that stimulated the large-scale issuance of such real estate loans are also worth being wary of.
Why do mortgage loans worldwide require a certain percentage of down payment, ranging from 10% to 50%? This is because real estate prices are subject to cyclical fluctuations, and lending institutions must consider not only the prosperity brought by rising prices but also the losses caused by falling prices.
Thus, the key role of down payments is to prevent losses to lending institutions caused by falling prices. Therefore, the less optimistic the outlook for future housing prices, the higher the down payment ratio; even if the outlook is relatively optimistic, the down payment ratio for long-term financial products like mortgages should not be too low.
However, before the 2008 financial crisis, subprime lending institutions, during the prosperous period of the U.S. real estate market from 2001 to 2007, maintained an overly optimistic expectation that housing prices would continue to rise, thus continuously lowering down payment ratios and interest rates, even to zero down payment. This was extremely risky.
Another force driving the rapid growth of subprime mortgages was the unrealistic encouragement from the U.S. government since the 1990s for more low- to middle-income earners to buy homes through subprime mortgages.
The result was that these individuals did not possess the economic strength to purchase homes, and once there was any disturbance or unemployment, they could not repay their mortgages, leading to bankruptcy or even homelessness.
For a long time, the homeownership rate among U.S. residents hovered around 50%-60%, which is relatively reasonable and comparable to developed countries like Germany and Japan. In these developed countries, residents who cannot afford homes can solve their housing problems through affordable housing options.
However, starting from the 1990s, several U.S. administrations, from George H.W. Bush to Clinton to George W. Bush, set increasing homeownership rates as an important policy goal. The homeownership rate among Americans gradually rose. After 2001, subprime mortgages rapidly increased, and by 2005, the homeownership rate among U.S. residents had reached nearly 70%, a historical high.
This figure was politically impressive but exceeded the actual purchasing power of lower- and middle-income residents. A large number of subprime mortgages were irresponsibly issued, with low down payments and interest rates. Ultimately, this temporary prosperity proved unsustainable, leading to a return to reality during the crisis.
Although having a mortgage means that real estate has financial attributes, if the pursuit of homeownership is excessive, a tragedy similar to the U.S. subprime mortgage crisis may repeat itself, which is a risk we must be wary of.
0x3: Strict Regulation of Financial Derivatives#
Previously, we discussed how financial institutions, after issuing loans, immediately repackaged mortgages into financial derivatives for trading in the market. This transferred the risks of these loans through financial derivatives.
Therefore, after the 2008 financial crisis, whether you or regulatory agencies should maintain a high level of vigilance toward those complex high-risk financial products.
We mentioned earlier that lending companies like Fannie Mae and Freddie Mac were not unaware of the higher risks associated with subprime mortgages, but they still issued large amounts of loans precisely because these high-risk subprime loans could be packaged and converted into tradable securities.
As long as the real estate market remained prosperous, the short-term trading prices of these derivatives would rise, and speculators would dare to intervene for short-term gains. Such speculative trading, which clearly does not consider the long term, usually involves leveraging several or dozens of times, amplifying short-term returns.
However, when these securities became overheated and risks increased, even more complex financial derivatives were designed based on these securities. The trouble became even greater. Ordinary investors could hardly understand them, but institutional investors, especially hedge funds, were eager to leverage and speculate in these high-risk financial derivatives, rapidly accumulating risks.
Ten years later, reflecting on the 2008 financial crisis, the three authors clearly realized that regulatory agencies had not fulfilled their responsibilities in overseeing financial derivatives.
In the wave of financial freedom, during those years, both the Federal Reserve and the U.S. Securities and Exchange Commission were actually overly indulgent toward these financial innovations that had detached from the real economy.
This crisis once again demonstrated that when troubles are significant enough, regulatory agencies and government departments can only step in and spend large amounts of money to clean up the mess, facing severe criticism from taxpayers. Given this, can we effectively strengthen regulatory thinking and defensive systems?
0x4: Summary#
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Reflecting on the 2008 financial crisis, we must always maintain a high level of vigilance against financial crises; from the perspective of decision-making and actions, government intervention should be timely and sufficient; from the cultural and public opinion perspective, we must abandon speculative culture.
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Reviewing the triggers of the 2008 financial crisis can lead to two deep reflections: one is to regulate the real estate mortgage loan system, and the other is to strictly regulate financial derivatives.
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For those complex financial products that are severely detached from the real economy and excessive financial innovations, both you and regulatory agencies must maintain a high level of vigilance.
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How to Defend Against Systemic Financial Risks in the Future
As the three authors said, no one knows exactly what the next financial crisis will look like. In my view, this speaks to the inevitability of financial risks and the unpredictability of financial crises.
After experiencing the test of the 2008 financial crisis, the U.S. government and market recognized that there are many regulatory gaps in the financial sector that need to be filled. For example, there is insufficient restriction on high-leverage financing speculation, insufficient sensitivity to excessive financial innovations, inadequate regulation of the transfer of financial risks to "shadow banks," and insufficient coverage of the Federal Reserve's emergency safety net, among others.
Therefore, establishing a more robust systemic risk defense system has become an important goal for the U.S. government and the Federal Reserve after 2008. Now, after years of effort, how has this defense system been constructed? What emergency response mechanisms or resources are still lacking? Let's take a look together.
0x1: Establishing a Systemic Risk Defense System#
Combining the authors' explanations in the book, the systemic risk defense system led by the U.S. focuses on strict risk limitations from three aspects, aiming to reduce systemic financial risks in the entire economy.
First, let's look at corporate financing.#
After the crisis, Bernanke and Geithner believed that the most important measure was to require companies to reduce leverage. Therefore, companies must hold more liquid assets. For example, lending companies must hold more cash and other liquid assets to reduce reliance on short-term financing to avoid new runs.
At the same time, strict limits should be placed on the debt ratios of large companies. There need to be stricter constraints on companies' risk-bearing and financing scales; those companies with systemic importance must be strictly prevented from triggering financial risks due to excessive debt.
Next, let's look at derivative trading.#
On one hand, traditional commercial banks, securities brokers, and non-bank financial institutions must significantly reduce leverage.
On the other hand, specific financial derivative trading must be publicly traded on exchanges and cannot be negotiated privately, which reduces the hidden dangers caused by the lack of transparency in risk information.
At the same time, newly passed relevant legislation has also increased the margin for leveraged trading to curb excessive speculation. In 2008, Wall Street's daily securities lending reached $2.5 trillion, but by 2015, this figure had dropped to $1 trillion.
Through these restrictive regulations, some high-risk financing tools that had troubled institutions like Bear Stearns and Citigroup during the 2008 financial crisis were eliminated and have not reappeared since. In other words, high-risk financial derivatives can indeed be regulated.
Finally, let's look at the banking system.#
The core of the reform is to prevent the collapse of systemically important banks. To this end, the U.S. has promoted relevant regulatory legislation from both international and domestic perspectives.
Internationally, the U.S. promoted and achieved the Basel III Accord, the core provision of which requires banks' minimum capital to be raised to three times the original level, with large banks increasing to four times the original level, along with clear requirements for core capital adequacy ratios, comprehensively enhancing banks' risk resistance capabilities.
The U.S. has resolutely implemented this, and China has also proactively followed suit. Because preventing systemic risks in large banks is a regulatory consensus that must not be ambiguous.
Domestically, the largest banks are required to hold more capital than smaller banks, reducing operational leverage and increasing buffer capacity. For example, it is explicitly required that a bank's total debt cannot exceed 10% of the financial system, which essentially limits the size of banks.
Based on this legislation, the U.S. also established a new agency: the Consumer Financial Protection Bureau. It merged the consumer protection departments of various regulatory agencies into a larger new department. If you want to redeem your investment or savings, or file a lawsuit for compensation, this protection bureau can back you up.
Through these reforms, the regulatory system for defending against systemic risks in the U.S. has been strengthened, reducing the probability of crises, and large financial institutions hold more high-quality capital.
0x2: Strengthening the Disposition Authority of the Federal Reserve and the Treasury
However, in the view of the three authors, while implementing these rules and regulations can enhance the government's and regulatory agencies' ability to warn against systemic financial risks, it cannot prevent all financial crises.
To prevent financial crises from escalating, the monetary policy tools of the central bank and the fiscal measures of the Treasury must be strengthened. Because the Federal Reserve's ability to intervene in crises is limited. This is also why, during the 2008 financial crisis, Paulson had to lobby Congress to approve a $700 billion bailout plan.
The three authors propose that when a serious financial crisis occurs, since we cannot rely on the market to restore normalcy automatically, the Federal Reserve and the Treasury must have stronger and more flexible disposition authority in terms of monetary policy and fiscal policy.
For the Federal Reserve, it is necessary to increase the emergency lending authority, which should not require temporary applications to Congress but should be authorized from the beginning so that it can be used flexibly.
However, the three authors believe that the Federal Reserve's authority as a lender of last resort is still subject to many constraints. For example, when lending to target companies, in addition to collateral, more information disclosure is required. Although this helps increase the transparency of the Federal Reserve's lending, it may also trigger market panic due to excessive negative information disclosure.
At the same time, the U.S. Congress has explicitly prohibited the Treasury from using the foreign exchange stabilization fund for guarantees, and also restricted the executive branch and the Federal Reserve from jointly assuming credit risks.
Therefore, overall, the U.S. has established stronger safeguards against panic after the 2008 crisis, but the Federal Reserve's and Treasury's authority in emergency response to financial panic remains weak.
Why do we say this? Because these frontline crisis managers cannot inject funds, guarantee debts, or purchase assets without obtaining congressional authorization.
Thus, if it were not for the fact that before the 2008 crisis, the Federal Reserve had sufficient room to cut interest rates and could also ease monetary policy through quantitative easing, the handling of the 2008 crisis would not have been so smooth.
Therefore, they insist on suggesting that while the crisis is calming down, reforms should continue to fill the regulatory and authorization gaps in defending against systemic financial risks, actively responding to future financial crises.
0x3: Integrating the Financial Sector Regulatory System
In addition to the specific defense system and regulatory authority, the final reflection and suggestion of the three authors point to the financial sector regulatory system, which has been operating in the U.S. for a long time based on different business types and institutional subjects. So how should it be optimized and improved?
This involves the repeated changes in the U.S. financial regulatory system over the past century. Before the Great Depression in 1929, traditional commercial banks and investment banks were combined. However, this led to a situation where when riskier investment banks encountered problems, stable commercial banks would also be dragged down.
Therefore, according to the U.S. Banking Act of 1933, commercial banks and investment banks must be separated and regulated by different institutions, with different regulatory rules. However, the 2008 crisis demonstrated that financial sector regulation can create regulatory vacuums.
Efforts to reduce the problems among various financial regulatory agencies have made it necessary to further improve the financial regulatory system. For example, the previously mentioned protection of financial consumers' rights has been legally merged and reorganized. However, how to better integrate more financial sector regulations is clearly a huge project.
At the same time, the complex political and economic ecology of the U.S. also hinders the reform of the financial regulatory system and emergency authorization. Therefore, the three authors call for: considering the importance of the U.S. financial system and the dollar, can the emergency response authority of the Federal Reserve and the Treasury be larger? This question remains to be discussed.
0x4: Summary#
- The systemic risk defense system led by the U.S. focuses on strict risk limitations from three aspects: corporate financing, derivative trading, and the banking system.
- To prevent financial crises from escalating, the Federal Reserve and the U.S. Treasury must have greater authority in monetary policy and fiscal measures.
- To avoid the problems arising from financial sector regulation, it is necessary to reduce the overlap of responsibilities and territorial disputes among various financial regulatory agencies.
"13 Bankers: The Wall Street Takeover and the Next Financial Meltdown"#
Every Friday for months, the Federal Deposit Insurance Corporation (FDIC) would publish the list of failed banks. The shareholders and management of these banks might be envious, as America's elite banks are considered "too big to fail," enjoying protections that smaller financial institutions cannot access. The bank that failed last Friday, Appalachian Community Bank, was simply closed by regulators, who arranged for another bank to take over its customers' deposits. In other cases, as described by Simon Johnson and James Kwak in their upcoming book "13 Bankers: Wall Street Takeover and the Next Financial Meltdown," the privileged bankers running institutions deemed "too big to fail" do not suffer the same fate as smaller bankers. Although this book does not provide a comprehensive account of the financial crisis, nor is it an epic behind-the-scenes story like Andrew Ross Sorkin's "Too Big to Fail," it offers valuable insights.
Overview of Involved Institutions#
III. The Impact of Lehman's Bankruptcy#
- Freezing Lehman's clients' funds led to increased market panic.
Lehman's History
(A) Family Control Phase#
- The Lehman Brothers—Cotton and Railroad Bond Trading
- Development over Three Generations
- Family Marriages
- Trading Techniques
- Family Marriages
(B) Professional Managers#
- Infighting
- Living Under Others → Splitting into "Boutique Investment Banks"
- Richard Fuld
In 2007, Lehman was not doing poorly; in fact, it stood out as a strong stock amidst the cries of the subprime crisis, rising against the trend.
Not only as an intermediary but also buying and selling to earn interest spreads.
→ Buying Funds—High Leverage
- Problems:
- Solutions (Cosmetic): REPO 105
Principle: Using repo 105 transactions to transfer assets off the balance sheet before the reporting date to reduce leverage and maintain stability.
The Practice of Cooking the Books#
- REPO 105 Off-Balance Sheet
Using repurchase agreements to temporarily package subprime assets and using cash obtained from transactions to pay off short-term loans, resulting in simultaneous declines in assets and liabilities.
- Accounting Standards
U.S. accounting policies stipulate that 98%-102% is the repurchase borrower, and this transaction is still listed as a liability on the balance sheet; but if it meets the standards of "SFAS 140.98," the repurchase transaction can be classified as a derivative and included in assets.
But according to U.S. disclosure regulations, this part needs to be added back when disclosing leverage → Utilizing differences in multinational policies.
- Utilizing differences in accounting and disclosure policies between the UK and the U.S.
The entity transaction was conducted through related transactions in the UK, and the U.S. group consolidated it.
Law Firm: Linklaters
Multiple Collaborations:
2007-2008 Explosions
Overly optimistic bottom-fishing in subprime loans, with liquidity in subprime continuously decreasing, and repo 105 could no longer cover up → game over.
Lehman Investigation Report Volumes 1-6, 2200 pages
https://web.stanford.edu/~jbulow/Lehmandocs/menu.html
Lehman Financial Statements 2007
https://mattmg83.github.io/cynicalcapitalist/documents/%5BLehman%5D%20Lehman%20Brothers%202007%20Annual%20Report.pdf
For those interested in reading the original text of over 2000 pages, see
www.jenner.com/lehman
- The financial market began to affect the real economy.
- U.S. money market funds fell below a net asset value of $1, leading to withdrawals and bank runs, resulting in the acquisition of several commercial banks.
IV. The AIG Crisis (Too Big to Fail)#
V. The Last Two Investment Banks#
Goldman Sachs and Buffett
Morgan Stanley and Mitsubishi UFJ
VI. The TRAP Plan#
Purpose: Restore market liquidity
First Version: Cash for Trash
Second Version: Direct Capital Injection
Note: Goldman Sachs and Morgan Stanley insured their own trash; they not only suffered minimal losses but also made profits. The key figure in the Goldman scandal is the magician Fab. On December 16, 2008, Goldman Sachs Group Inc. (NYSE: GS) announced an annual net income of $22.22 billion for the year ending November 28, 2008, with a net profit of $2.32 billion. After adjustments, earnings per share were $4.47, down from $24.73 in fiscal year 2007. The average return on tangible common equity for fiscal year 2008 was 5.5%, and the annual average return on common equity was 4.9%. The net income of the equities division reached $9.21 billion. This segment's net income and record commission income this year reflect Goldman Sachs' solid client service network. The asset management division's net income reached a record high of $4.55 billion, with management fees and other fees reaching a record $4.32 billion. The securities services division's net income reached $3.42 billion, a 26% increase over the historical record of fiscal year 2007, setting a new historical high.
III. The Impact of Lehman's Bankruptcy#
-
Freezing Lehman's clients' funds led to increased market panic.
-
The financial market began to affect the real economy.
-
U.S. money market funds fell below a net asset value of $1, leading to withdrawals and bank runs, resulting in the acquisition of several commercial banks.
IV. The AIG Crisis (Too Big to Fail)#
V. The Last Two Investment Banks#
Goldman Sachs and Buffett
Morgan Stanley and Mitsubishi UFJ
VI. The TRAP Plan#
Purpose: Restore market liquidity
First Version: Cash for Trash
Second Version: Direct Capital Injection
However, the authors present a compelling case supporting the idea that financial institutions should not be allowed to reach a point of systemic risk.
When the 2008 economic crisis erupted, analysts at a Wall Street investment bank discovered significant flaws in the company's asset valuations that would soon lead to the bank's bankruptcy. The company's executives held an emergency meeting overnight in hopes of saving the company.
Historical Background#
The authors briefly review the history of the U.S. financial system, tracing back to the debates between Thomas Jefferson and Alexander Hamilton. Jefferson viewed America as a decentralized agricultural society, while Hamilton favored a strong central government actively supporting economic development, a viewpoint that has existed since the founding of the republic. Although Jefferson believed that the U.S. Bank violated the Tenth Amendment, which states that the federal government can only engage in activities explicitly outlined in the Constitution, Hamilton and his allies ultimately won the debate. President Washington concluded that the bank was permissible under the commercial clauses of the Constitution.
If this debate sounds familiar, it is because similar arguments are often made today regarding the appropriate role of the federal government in society. A good example is the constitutional issues raised by opponents of "individual mandates to purchase health insurance." This is not a power explicitly granted in the Constitution, but if we accept the proponents' argument, it can be justified through a broader interpretation of the commercial clauses.
The End of "Boring Banking"
The authors trace the current system's problems back to the deregulation that began in the 1970s and peaked in the late 1990s with the repeal of the Glass-Steagall Act, which eliminated the last barriers between commercial and investment banks. In this process, readers can also briefly review the savings and loan crisis of the late 1980s and early 1990s, as well as the growing political power of the banking industry as bankers and politicians increasingly "cross-pollinated" in the corridors of Washington and New York. Regulatory capture is a clear issue that occurs when an industry is regulated by individuals who have previously worked in that industry or hope to return to it in the future.
Policy Prescription#
The authors advocate addressing the "too big to fail" issue by prohibiting financial institutions from expanding beyond a certain size and breaking up existing institutions that exceed size limits. They also call for the establishment of broad consumer protection laws to curb some of the abuses that emerged during the mortgage crisis in recent years.
Many opponents of this view argue that the U.S. needs very large institutions to compete in the modern economy, and we cannot "turn back the clock." The authors suggest setting a hard cap on size, stating that no institution's assets should exceed 4% of GDP, which is about $570 billion today. Additionally, due to the higher risks associated with investment banks, they call for a size limit of 2% of GDP, or about $285 billion.
Important
"The 4% cap would only roll back time to the mid-1990s. At that time, the largest commercial banks—Bank of America, JPMorgan Chase, Citibank, and National Bank—each held assets roughly equivalent to 3-4% of U.S. GDP. In terms of investment banks, Goldman Sachs and Morgan Stanley only broke through the 2% threshold in 1997 and 1996, respectively; at that time, they were the two top investment banks globally, and no one thought they could not meet customer needs." Page 216, pre-publication draft.
The six banks affected by this proposal are: Bank of America, JPMorgan Chase, Citigroup, Wells Fargo, Goldman Sachs, and Morgan Stanley.
Of course, we cannot ignore the fact that regulatory agencies have been moving in the completely opposite direction in recent years. The "solution" to the 2008 fall financial crisis was to encourage or force financial institutions to merge, leading to larger banks and further entrenching the "too big to fail" situation. The Financial Crisis and the Evolution of the Asian Financial System
The history of regulatory changes since the 1970s, especially the shift in "Greenspan's put" policy, and how these changes led to regulatory failures and financial crises.
The U.S. banking industry played a key role in the 2008 financial crisis, yet it became larger, more profitable, and more resistant to regulation. The authors emphasize that large banks gained significant political capital through their size, which was used to lobby the government for looser regulations. They argue that this accumulation of political capital is a major cause of regulatory failure and recommend strict size limits on banks to prevent them from manipulating regulations.
The failure of the Obama administration to effectively regulate large banks is linked to the work of Hyman Minsky. Many members of Congress still cling to the belief in free markets, making genuine reform difficult. They advocate a Jeffersonian view that the importance of small businesses should replace Hamiltonian supremacy of large enterprises.
Free Market Regulation#
The authors of this book lean towards the political left, especially when they advocate for consumer protection laws, which are more about protecting individuals from self-harm than maintaining the stability of the entire financial system. From a free market perspective, comprehensive disclosure of consumer products and prohibiting deceptive or fraudulent lending practices are entirely appropriate, but a complete ban on financial products should be scrutinized. Protecting informed individuals from the consequences of their poor decisions is a questionable use of regulatory power.
On the other hand, regulation aimed at preventing the collapse of the entire financial system is entirely within the proper powers of government, as the alternative is to continue with taxpayer-funded bailouts. Blocking regulations, such as prohibiting the merger of two institutions (which would lead to a "too big to fail" group) or even preventing the dissolution of existing institutions, can be seen as a means to prevent greater harm to society. Moreover, this type of blocking regulation reduces the need for "micro-management," which would otherwise be necessary to prevent the collapse of large institutions.
Free market advocates (including the authors of this article) need to recognize that our current system is not a true "free market," as "too big to fail" institutions enjoy the upside benefits while the downside risks are socialized through taxpayer bailouts. A free market must include the consequences of failure, and free market advocates should support regulatory efforts that move in this direction. It is unclear whether the authors of "13 Bankers" propose the best policy solutions, but they make a significant contribution to this debate.
Disclosure: The authors own shares in Berkshire Hathaway, which has investments in Bank of America, Wells Fargo, and Goldman Sachs.
Long Time No See~#
Is the Plaza Accord Really the Culprit of Japan's Lost 30 Years?#
I recommend reading Gu Zhaoming's "The Great Recession: The Other Half of Macroeconomics," which explains very well why Japan is currently in a dilemma.
References#
"This Time Is Different: Eight Centuries of Financial Folly" (This Time Is Different)#
This Time Is Different, Data Table by Carmen M. Reinhart and Kenneth S. Rogoff
1. This book tells the history of financial crises that have appeared in various forms in quantitative language, covering a wide range of data (66 countries and regions across Africa, Asia, Europe, Latin America, North America, and Oceania), spanning a long time (over 700 years of history, tracing back to the independence of most countries and some countries' colonial and semi-colonial periods), and involving a wide range of variables (including external and internal debt, trade, national income, inflation, exchange rates, interest rates, and commodity prices). However, it should be noted that due to the availability and authenticity of data and defaults, the data span of this book mainly focuses on after 1800, with more emphasis after 1900.#
Thus, the following statements are relatively moderate, and the examination clues of this book will take us through the history of financial crises, from bank runs in Europe during the Napoleonic Wars to the subprime crisis in the U.S. in 2007.
In fact, this book mainly focuses on debt crises, including sovereign debt defaults, banking crises, inflation, and exchange rate crises. The two types of crises that are particularly emphasized are the sovereign debt crisis and the banking crisis, both of which have centuries of history and span multiple regions. The history of sovereign debt crises is longer, while banking crises tend to be more destructive and pervasive, affecting all countries equally. However, it is important to note that the authors always believe that modern data is not very reliable, and the transparency of debt, especially government-guaranteed debt, remains a problem.
-
This book helps clarify some of our previous confusions and even misconceptions about financial crises, and it can weave a picture that helps us better understand financial crises based on historical analysis and empirical research. One of its main purposes is to criticize the tendency of people to become overly optimistic cyclically, always believing that due to technological innovations (such as internet technology), institutional changes (such as central banks and FDIC), and accumulated experience (we will become smarter, structural reforms and good policies promote prosperity), the economy can escape the troubles of financial crises, and the appearance of prosperity makes us believe we have a solid foundation, i.e., "this time is different." In fact, as this book points out, before the Great Crash of 1929 and the emerging market debt crises of the 1930s, the Latin American debt crises of the 1990s and the early 21st century, the East Asian financial crisis of the 1990s, and the global financial crisis from 2007 to the present, the market was always filled with optimistic rhetoric of "this time is different." However, the harsh reality is that not long after, the aforementioned optimistic rhetoric was once again ruthlessly crushed by financial crises. As the authors point out, "Technology changes, human heights change, fashions change, but the ability of governments and investors to deceive themselves has not changed."
-
The authors mentioned in the preface that when a researcher observes a "once-in-a-century flood" with 25 years of data, there is only a 25% chance of occurrence, but if observed with 800 years of data, the chance increases eightfold. However, due to the vast amount of data and relatively obscure content, this best-selling academic work is still quite difficult to read. However, for those studying debt and interest rates, this book and "A History of Interest Rates" are essential readings. A complementary read to this book is "Money Nexus" (Weekly Book, Issue 10 (20131103): "Money Nexus—Money and Power in the Modern World").
The main structure of this book is as follows:
The first part is an introduction to financial crises, describing, discussing, defining, and delineating the types, definitions, and various basic data related to debt issues, proposing the establishment of a global financial crisis database based on a long-term perspective.
The second part begins to apply the dataset, extensively using charts and numbers to depict the history of debt defaults and financial crises, clearly showing the universality of defaults.
The third part describes the forgotten domestic debt and default situations (overall scale is large, especially during periods of external debt defaults and inflation), making an initial attempt to categorize publicly disclosed defaults and domestic debt restructuring events over the past century.
The fourth part expands the discussion to banking crises, currency crises, and inflation crises. I believe this is the most essential part of the book and is worth reading multiple times.
The fifth part is "The U.S. Subprime Crisis and the Second Great Contraction," which mainly includes cross-national historical comparisons, the consequences of financial crises, an international perspective on financial crises, and a comprehensive measure of financial crises, proposing the BDCI index to measure the probability of financial crises occurring in various countries, representing indices of banking crises (systemic), currency crises, debt crises, and inflation crises.
Finally, the last part is "What We Learned from Financial Crises," which includes the authors' thoughts on early warnings, national upgrades, policy responses to human weaknesses, and some ideas about academic research methods.
2. Detailed Insights:#
- Debt Intolerance: The authors reflect on why emerging market countries remain on the brink of default and construct quantitative indicators (the ratio of external debt to GNP or exports, which shows a significant statistical correlation with the sovereign rating IIR published by "International Investor") to measure the vulnerability caused by rising marginal debt. "Debt intolerance" refers to the immense constraints faced by many emerging market countries at certain levels of external debt, which are completely manageable in developed countries. This constraint often involves a vicious cycle among loss of market confidence, spiraling government external debt interest rates, and political resistance to repaying external debt.
Ultimately, when emerging market countries default, their debt levels (debt-to-GDP ratios) are usually far below the 60% threshold set by the Maastricht Treaty in Europe (which aims to protect the euro system from government defaults). The safe debt threshold largely depends on a country's historical record of defaults and inflation, and ignoring debt intolerance may underestimate the impact of unexpected shocks on market confidence or repayment willingness (the capital inflows into emerging markets are significantly pro-cyclical, and the entrenched view that their economic growth is hindered by limited access to international capital markets is not as persuasive as imagined), leading to another debt crisis. Debt intolerance has clear implications for sustainable debt management, especially regarding institutional considerations.
The authors point out that after the global financial crisis of the 21st century, countries facing debt intolerance will face the challenge of finding non-debt capital supplementation channels to prevent their countries from experiencing repeated defaults over the next century.
-
The severity of economic recessions related to banking crises: Banking crises tend to act more as amplifying mechanisms rather than as exogenous causal mechanisms. When a country experiences a negative shock, such as a decline in productivity, outbreak of war, or political and social turmoil, the default rate on bank loans will rise sharply, and banks will be severely impacted by loss of public confidence and runs. The decline in output and shrinkage of wealth lead to a series of loan defaults; even if bank failures do not occur, the deep reliance of modern economies on complex financial systems will lead to credit tightening, further declines in output, debt defaults, and a vicious cycle. The authors emphasize that systemic banking crises are accompanied by enormous recession costs, and their research indicates that banking crises pose equal threats to both developed and emerging market economies. Regarding the process of deciphering banking crises, the starting point is that the recessions accompanying banking crises are always extremely severe and share many commonalities (capital flows, asset price cycles, credit cycles, and overcapacity in the financial sector). Due to prolonged periods of calm in the banking sector, research on banking crises has remained at a clear dichotomy (the historical crises of developed countries and the contemporary crises of emerging market countries), and only the recent second contraction has rekindled interest in studying banking crises (but the social costs are too high), necessitating further research into the causal relationships involved and, more importantly, determining the priority of policy implementation.
-
The Greenspan Put: The "this time is different" characteristic of the U.S. subprime crisis is the blind trust in modern monetary policy institutions. The famous Greenspan Put is based on market confidence in the Federal Reserve (with empirical basis) that it will not raise interest rates during rapid asset price increases and will lower rates to rescue them during any sharp declines. Therefore, the market believes that the Federal Reserve provides investors with a one-way bet, and during market crashes, the Federal Reserve will take unconventional measures to rescue them. The independence of central banks, viewed from the perspective of moral hazard, is exaggerated; a monetary policy focused solely on inflation will only be effective in an environment where other regulations ensure that debt leverage is not excessively utilized.
-
Personal Understanding: I first learned about the authors of this book through the academic debate sparked by "Growth in a Time of Debt," which had a programming bug in its data processing. Professors Carmen Reinhart from Harvard Kennedy School and Kenneth Rogoff from Harvard University studied data from 44 countries over two centuries and found that:
- (1) When government debt exceeds 90% of GDP, the speed of economic growth (median) declines by one percentage point.
- (2) For emerging markets, external debt (public and private) exceeding 60% of GDP leads to a two percentage point decline in economic growth speed.
- (3) For developed economies, inflation does not have a significant relationship with public debt levels, but for emerging markets, rising debt levels lead to rising inflation. Once government debt levels exceed 90% of GDP, GDP growth slows. This number (90%) quickly became a hot topic in political debates about tightening. However, three economists from the University of Massachusetts, Herndon, Ash, and Pollin, published a working paper that examined the original electronic data tables of Reinhart and Rogoff's paper and found several serious calculation errors, including misuse of statistical programs and Excel coding errors. The average actual economic growth rate of countries with public debt exceeding 90% of GDP should be 2.2%, not the -0.1% claimed by Reinhart and Rogoff. In other words, the critical threshold (90%) that led to a sharp decline in economic growth does not exist. However, the authors believe that the programming errors do not affect qualitative results, and exceeding a certain threshold of debt ratios will certainly impact economic growth.
- If you are interested in summarizing the above academic debate, you can refer to the following link:
http://stock.sohu.com/20130705/n380849097.shtml
In the previous issue, I recorded Krugman's "The Return of Depression Economics," which mentioned that in dealing with depressions, one can "raise the expected inflation rate a bit" (using the baby-sitting cooperative story for extension, winter depressions need summer ticket depreciation to rescue, inflation will cause the actual value of money to depreciate over time), as well as "Ending the Depression Now," where "Krugman believes that the slowdown in economic growth has led to rising debt levels. If we view the world as a whole, one person's debt is another person's asset. Borrowing does not make society as a whole poorer. Using new debt to solve debt problems is possible, and perhaps necessary. If debtors significantly reduce spending when repaying debts, the consequences will not only be economic downturns, low income, and low inflation but also make it harder for debtors to repay their debts." These are standard Keynesian understandings and approaches to public debt, and the authors, including the two authors, also acknowledge that currency devaluation or inflation is a historically favored way to repay debts; the only question is how to grasp the scale.
- "Rolling Stones Gather No Moss": Based on historical data and experience, including analysis of data before and after the U.S. subprime crisis, debt is often only likely to continue to grow. The deep thought is how to replace one debt with another in a better, more efficient, reasonable, and moderate way (for example, using public debt at low cost to replace private sector debt during a crisis, such as replacing risky short-term debt with long-term debt, or allowing banks to use completed term, credit, and liquidity conversion asset securitization business to replace interbank, wealth management, non-standard high-risk off-balance sheet businesses). After all, the issue of debt indeed requires further research and will never go out of date. On this point, much can still be explored from Keynesian thought, including when the national team should enter, when to exit, and in what way is best; these are all questions that finance needs to consider.
- A month ago, written on August 20, it discussed the financial drivers of rising capital prices. Although financial markets are becoming increasingly complex, corporate debt financing tools are becoming increasingly rich, involving not only the previously dominant bank balance sheet loans but also bank off-balance sheet wealth management, trusts, securities, insurance, bonds, short-term notes, private lending, overseas financing, etc.
- Corporate liabilities have taken on many new forms and are becoming increasingly short-term. How companies respond to changes in monetary policy depends on how changes in overall demand significantly impact companies' expected sales and profits. In the context of high debt and economic downturn, the complex and diverse debt structure of companies makes it impossible to solve the problem of rising financing rates solely by loosening monetary policy. However, we must clarify that in the modern financial system, institutions with high leverage supported by short-term financing.
"This Time Is Different: Eight Centuries of Financial Folly" is a book co-authored by Carmen M. Reinhart and Kenneth S. Rogoff, which details the history of international financial crises over more than 800 years across 66 countries and regions. This book reveals the ups and downs of financial markets over centuries through detailed and in-depth analysis, using rich data to support its views.
The book not only reviews