The impact of liquidity in the financial crisis

Abstract

The financial crisis of 2008, was one of the most spectacular crashes in living memory. An event that was seen to be a black swan, was actually similar to many previous crises in its essence viz. asset speculation, exposure, information asymmetry on who is exposed and panic runs. A speculative housing market bubble that grew due to the largesses of securitization and speculation, burst when the prices fell. The shadow banking system, exposed to the housing market through sub prime mortgages, slowly began to seize. Liquidity dried up and lenders to these banks became wary, because nobody knew how much who was exposed. Interbank rates rose sharply, tightening liquidity. Bear Sterns, exposed due to multiple subprime mortgage exposed hedge funds, collapsed. As panic spread to the repo markets, the market experienced an ”old fashioned run” because of the depositors’ information asymmetry. As liquidity continually dried up, banks found it increasingly difficult to heed to margin calls. Soon, the insurer AIG alomst collapsed, before being saved by the Fed. The crescendo was reached in the collapse of Lehman Brothers, wiping out a $600 Bn storied investment bank from the financial landscape. An even larger collapse was prevented by the intervention of the Fed, but the after shocks of the crisis are still felt around the world.