Why You Will Be Blindsided By The Next Financial Crisis

“The global financial crisis that began in the United States in the summer of 2007 was triggered by a bank run, just like those of 1837, 1857, 1873, 1893, 1907 and 1933.”  That’s the theme of Yale economist Gary Gorton’s Misunderstanding Financial Crises, Why We Don’t See Them Coming, published last year by Oxford University Press. Students of financial crises will tell you that Gorton’s theme is highly relevant to the next meltdown we could face someday soon.

The last crisis five years ago was a systemic one “triggered by a run on repos and on asset-backed commercial paper,” says Gorton.  Frightened players in financial markets who had lent vast sums of money short-term, desperately wanted to retrieve their money pronto from the banks to whom they had lent it.

What transpired in 2007-08 “resembled the bank runs of the pre-Federal Reserve era. These were primitive expressions of panic by people trying desperately to sell assets, driving the price of those assets down, and causing other people to panic as well and try to get out at the same time. The panic spread from short-term instruments like repos and commercial paper to bonds and stocks and commodities and real estate.  The wave of fear sweeps from short-term investments to longer term obligations.

The playbook in the next crisis will be the same as it was in past crises from 2008 to 1987, 1929, 1907, 1893, 1857 and so on.  The run on the banks becomes systemic as no one institution is spared. Credit markets freeze, the economy goes south, millions lose their jobs, and other millions have their savings decimated. It happened time and time again in the 19th century before there was a central bank, and panics didn’t stop after the Fed appeared in 1913.

Expect it to happen again. Gorton warns clearly that “there is no mechanism for determining when there actually is a crisis.” In fact, there was no panic by depositors in Citibank, BankAmerica, Wells Fargo that would have alerted the nation. It required the Fed to realize how over-leveraged, under-capitalized and insolvent major banks had become before it acted to rescue them with huge monetary bailouts.

The 2007-8 crisis was experienced in the stock market when it was realized the entire money center banking community did not have the resources to absorb the “run.” Their funding markets were suffering from a complete lack of confidence– and only the late bold move by the Fed and the Treasury to guarantee the commercial paper market, to guarantee bank deposits up to $250,000, to inject tens of billions of capital saved the nation from catastrophe.

Full article: Why You Will Be Blindsided By The Next Financial Crisis (Forbes)

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