This is the second entry in my series of diaries on what actually happened in the Fall of 2008 and winter of 2009, and why the global economic system almost completely collapsed. As I said in my first entry, it's really difficult to talk about anything having to do with what happened in banking and the real economy back during that crisis without talking about everything, and the only way to do so is to break up this historical analysis into chunks. So although I invite everyone to read this episode, I would ask that if you haven't read the first entry, please do so, because this one won't make sense without that introduction.
If you think the introduction in part 1 is long winded (well, you're right), then please just scroll to near the end and read the sections after the heading, "We Almost Needed Gold to Buy Groceries," here:
http://www.dailykos.com/...
At the end of that diary, I tried to explain why, in mid September 2008, the system almost collapsed to the point that you wouldn't have been able to deposit a paycheck drawn from a bank other than yours, or use an ATM or credit card. In fact, for a few hours, this actually seemed to be happening.
At the end of part 1, I also quoted an exchange that took place between Amy Goodman, host of DemocracyNow, and the progressive economist, Dean Baker, on September 22, 2008. Goodman was skeptical about claims that the system was collapsing, and although Baker was extremely critical of how the outgoing Bush administration was handling the crisis, he told Goodman that the crisis was real -- so real, that the week before, we had come close to a situation in which we would have to have something like gold to buy groceries:
AMY GOODMAN: Dean Baker, you’re the head of Center for Economic and Policy Research. It’s based in Washington, D.C. The climate right now? I mean, watching the Sunday talk shows, there was this clear sense that if this is not accomplished in the next few days, that—you know, it’s like before the invasion of Iraq. We can be hit by a weapon of mass destruction, is basically the idea. And this is about not saving Wall Street, but saving the American people. That was the message that was put out immediately yesterday.
DEAN BAKER: Well, I’m going to walk a line here. I mean, there is a point. The system of payments stopped working last week. If that happened, we would have to, like, go to buy our groceries with gold. We had a serious situation. Now, on the other hand, the Fed and Treasury were able to deal with it. They are able to deal with it; they have the resources to deal with that. But that is a very serious situation. So they aren’t talking about total nonsense in that. Now, they’re trying to scare Congress to death, because it’s not as though we have to do it today or tomorrow. And, you know, what I would say is we do have to keep the system operating, but it should be punitive.
AMY GOODMAN: But they’re saying by Thursday or Friday.
DEAN BAKER: I keep emphasizing punitive.
AMY GOODMAN: They’re saying by Thursday or Friday.
DEAN BAKER: Thursday—we could probably wait a week. We could probably wait two weeks.
Actually, if what happened in places like Argentina and post Soviet Russia were the precedent, you probably wouldn't need gold, but you would have had to barter something useful. In mid September 2008, the banking system came to a near complete collapse, and as Baker points out, the part that would have prevented you from cashing your check or using your ATM was the "system of payments" which almost ended.
Baker is referring to an extremely complex system of settlements between banks. On many levels, that system ceased to function. If that system had permanently ceased to function, you would not have been able to use the banking system, right down to the consumer banking level of withdrawing $20. Here's why.
The banking system makes it appear to the consumer that when he or she deposits, say, a $1,000 paycheck, the money in the bank on which the check is drawn (the employer's bank) is transferred to the bank in which the check is deposited (the employee's bank). Or that when you use an ATM card issued by, say, Citibank, where you have your account, at an ATM owned by Chase, that Citibank sends the money electronically to the Chase ATM so you can get your money.
This is not what happens.
A better way to understand it is that when you deposit your paycheck, and your bank credits your account with $1,000, your bank makes a loan to your employer's bank.
When you use a Citibank ATM card at a Chase ATM, when it dispenses cash, Chase makes a loan to Citibank. More specifically, it makes an "overnight loan". It's a bit more complicated than that, which I'll get to below.
The point, though, is that if Chase is not willing to make a loan to Citibank, then Chase can't dispense cash drawn on Citibank accounts. And if your bank is not willing to make a loan to your employer's bank, then your bank cannot accept your employer's check for deposit.
This is what happened in September 2008. When Lehman collapsed -- after a long summer of collapse after collapse of financial giants -- banks realized that even the most short term overnight loans between banks might not be paid back, and they briefly and intermittently stopped making them, or would only make them at interest rates that were not feasible for the borrowing banks, or requiring collateral that no banks had.
This is why the Fed and Treasury officials, and the pundits who were trying to report their panic, kept saying, "we've got to get banks lending again." They didn't mean at that point, "we've got to get banks lending again to businesses and consumers"; they meant "we've got to get banks lending again to each other."
If inter-bank lending had stayed frozen, then the entire system of paying bills, paying invoices, cashing checks, writing paychecks, using ATMs, transferring funds electronically, funding big business deals, and on and on and on, would have ceased, permanently.
This is what the Fed and TARP prevented. So when I argue that the Fed and TARP prevented economic catastrophe, I recognize that it did not prevent the worst recession since the Great Depression, and it did not prevent 10% unemployment and 20% structural unemployment. But it did prevent the end of us being able to use checks and ATMs, and all that this would have meant for a modern global economy.
Why this happened, and how it happened is a really complicated story. For those of you interested in the inner guts of the banking system, here's how they system works and what went wrong.
Before I tell you how it works today, with our computers, bank networks, electronic funds transfers, and so on, I'd like to explain how it worked in the olden days. The reason is that it's really difficult to understand the complex world of modern banking. But one of the very odd things about the financial sector is that it is based on extremely, extremely old fashioned systems. Shipping finance is still modeled on the system developed by merchants, sailing ship captains and bankers sitting around in cafes in English ports. Light speed electronic funds transfers are still somewhat modeled on how things worked when people wrote checks that bankers gathered into boxes that looked like shoe boxes.
So it's much easier to explain the new system by explaining the old system, and then just adding the electronic aspect to the description.
Let's say we are in small town America circa 1965 and there are two banks in town, Planters Bank and Mechanics Bank. Joe works for Acme Bolts, which has an account at Mechanics Bank, but Joe has an account at Planters Bank. When he gets his paycheck, for $200, he deposits it in Planters Bank. Planters Bank credits his account. Needless to say, this does not mean that a messenger runs money in the amount of $200 from Mechanics Bank to Planters Bank.
Theoretically, Mechanics Bank owes Planters Bank $200.
Smith works for the Grain Elevator. It has an account at Planters Bank, and Smith has an account at Mechanics Bank. When he gets his paycheck of $250, he deposits it in Mechanics Bank, and Mechanics Bank credits Smith's account.
Theoretically Planters Bank owes Mechanics Bank $250.
If these were the only two transactions in town that day then at the end of the day, the bankers would "net" the two checks against each other. Rather than Mechanics paying Planters $200, and then Planters turning around and paying Mechanics $250, they "net" the checks against each other, and Planters Bank now owes Mechanics Bank $50 ($250 - $200).
Even then, more likely, Planters Bank is not going to transfer $50 to Mechanics Bank. Tomorrow, the situation might be reverse. So to avoid moving cash, Mechanics Bank makes a loan to Planters Bank -- a very short term loan, in fact over night. And since the bankers trust each other, Planters Bank doesn't even have to put up collateral.
This is why it is often said that banking (at least between bankers) is based on trust and confidence.
Of course, there never were just 2 transactions -- even in small towns there were hundreds of them. But at the end of the day, most of the transactions "netted" each other out, and fairly small overnight loans were required.
When I was blogging about the collapse as it happened in 2008, a very nice lady, an old timer who worked in banking long before my time, posted this reminiscence of how banking was done in a small town when she was young and worked in a bank:
In the WAAAAY back olden days.. officials from banks would actually file checks in long skinny cardboard boxes, labeled with the other banks names in town, and they MET late at night in the Planter's state Bank parking lot.. traded back each other's "paper", then met at the A & G Cafe for coffee. they sat at the long table in the back, and tallied up their balance sheets..and traded local gossip
So the cliche that bankers worked short hours, from 8 AM to 3 PM so they could be on the golf course by 4 PM wasn't true. Banks historically closed early because the process of counting up the checks and netting each other's checks went on late into the night, until an overnight loan could be arranged.
This all important process is called settlement.
This also is why one of the most important international benchmark lending rates is called "LIBOR." It stands for "London Inter-Bank Offered Rate." It is the interest rate that banks offer each other for large overnight loans in the London financial markets.
Getting back to my small town example, you can see how if Planters Bank is shaky, Mechanics Bank isn't going to give them an overnight loan -- at least not without Planters Bank putting up some collateral -- some property in the form of a financial asset, that Mechanics Bank can keep if the loan isn't repaid. One form of collateral that would have been used back then would have been a mortgage that Planters Bank had made to some farmer or homeowner, or it could be a bond.
In the modern era, since the 1980s up until 2008, that collateral would have been a mortgage backed security.
I also like to compare banking to banking in the movies. One of the best movies ever made about small town banking is the Christmas classic, "It's a Wonderful Life," starring Jimmy Stewart. Surprisingly, that Christmas fantasy story also had a lot of interesting accurate information about small town banking before the creation of mortgage backed securities, something I'll come back to from time to time in this series.
But for now, I want to point out one of the more surprising facts about banking that the movie showed, and that was central to the story. That fact is that our hero, the struggling, community oriented savings and loan banker, George Baily, although he ran a bank of sorts actually made deposits in the town's big commercial bank, owned by the evil Mr. Potter. And when George's senile Uncle Billy loses $8,000 he is supposed to deposit in Mr. Potter's bank (it's actually stolen by Potter), Potter claims to have "lost confidence" in Baily Savings and Loan. The crisis in George's bank is of course the plot point that leads to the sad and funny heart of the movie in which George finds out what his town would be like if he had never lived and never run Baily Savings and Loans.
OK, what on earth does this have to do with what happened in 2008?
Multiply these small time transactions by millions of transactions per day and billions of dollars flowing through modern bank accounts. For a prolonged period, leading up to September 2008, banks became increasingly worried that overnight loans to other banks would not be paid back. In fact, when Lehman collapsed, many of its overnight loans were not paid back, and this hit Japan particularly hard.
In early 2009, Bank of Japan looked back at what had happened to their payment and settlement system after the collapse of Lehman:
The collapse of LBJ <Lehman> has tested the effectiveness of risk management measures that had been developed by payment and settlement systems over the years.
It is estimated that JGB {Japanese Government Bonds} and other financial transactions worth several trillion yen were suspended from settlement as a result of LBJ’s {Lehman's} bankruptcy. The counterparties to LBJ {Lehman}, both market players and securities clearing houses, liquidated their unsettled positions through close-out netting and other measures and acquired securities and funds they could not receive from LBJ {Lehman}. The amount of funds financed by LBJ’s {Lehman's} counterparties were huge, but thanks to the massive liquidity injected by the Bank {i.e., Bank of Japan}, cash funding operations were carried out without difficulty and LBJ’s {Lehman's} failure did not trigger a train of defaults among market participants.
On the other hand, it took several days to acquire securities and the outstanding amount of settlement fails surged temporarily. This accumulation of settlement fails was gradually resolved as LBJ’s {Lehman's} counterparties acquired and delivered securities to cover their failed positions.
In layman's terms, overnight money that was expected from Lehman didn't materialize and trillions of yen weren't paid to financial institutions expecting and needing that money in the morning, risking that they themselves would go under.
Just as small town bankers sat down with cardboard boxes full of checks to carry out settlement, today's mega banks, mid sized banks and small banks still carry out settlement. Most of it is done by computers. But if banks are not willing to lend each other money overnight, then the settlement process grinds to a halt. At first, in 2008, banks began to require collateral in the form of mortgage backed securities.
But by mid 2008, as the sub prime mortgage crisis spread, and some mortgage backed securities (MBS) began to default, and worse, no banks knew which MBS were good and which were bad, even loans with collateral couldn't be had.
Working backwards, or trickling down, if banks couldn't trust each other to make overnight loans without collateral, and if even when some banks would make loans based on collateral, but all the collateral was bad, then banks simply ceased to make overnight loans.
If they couldn't make overnight loans then they couldn't complete settlements.
And if they couldn't make settlements, then they couldn't accept checks from other banks.
You would think that with electronic funds transfers, the instaneous transfer of money, say from your bank to the ATM you are using, inter bank loans would be irrelevant.
But despite the use of computers and electronic funds transfers, much of our high tech banking is still based to some extent on the model I sketched out in the small town setting. For example, when you use an ATM owned by one bank, and your account is with another bank, the ATM electronically asks your bank if there are funds in your account. Your banks sends a message back saying there is money in your account, and go ahead dispense the $20.
This is sometimes described as an electronic transfer of money from your bank to the ATM.
It isn't.
This is where it gets weird and abstract.
What has been transferred from your bank to the ATM bank isn't money; it's information. Electronic funds transfers generally are not transfers of funds; they are transfers of numbers. The money does not pass through the wires. The funds transfers happen later during settlement, after they have been "netted" against millions of other ATM, check and electronic funds transfer transactions. Not in all cases but in many.
There are two kinds of electronic settlement systems. I won't bore you with the details and exact names, but they can be called, "Net" and "Real Time Gross".
Real Time Gross means that the money actually moves when the transaction occurs in real time.
Net means that many, many transactions are added up and netted against each other, and only the net amounts lent or transferred from one bank to another. Even more old fashioned, Net electronic settlement systems have to, just like the old time bankers in the parking lot with their card board boxes, choose an exact moment of time each day when the net is deemed to have occurred.
So, in Net systems, all day long, banks accumulate debts to each other to be "netted" at, say, midnight, and covered by overnight inter-bank loans. In September 2008, banks realized that they couldn't take the risk of accumulating debts from other banks.
So they were really, really close to not accepting checks. This is what Dean Baker meant when he said the system of payments stopped.
Fortunately, the Fed and Treasury had certain tools to deal with this issue, and it has to do with how banks actually settle.
Remember "It's a Wonderful Life"? In that world, Uncle Billy "settles" by taking $8,000 in cash over to Mr. Potter.
In our world, how and when does real money move? As I said earlier, so-called "electronic funds transfer" often transfer information, not money. When is "real" money transferred from one bank to another?
Just as Baily Savings and Loans had an account at Potter's bank, big depository banks must have accounts with the Fed. So while an electronic funds transfer looks like a transfer of money, but is a transfer of information, the money is actually transferred after settlement, after the millions of transactions are netted, and when the Fed credits one big banks account while making a corresponding debit to the account of its counterparty.
Taking advantage of their central role in settement, the Fed, Bank of England, and Bank of Japan were able to "inject liquidity." The Fed and Bank of England also told banks that they would guarantee overnight inter-bank loans.
The system of settlement began to recover.
Unfortunately, the prospect of the shut down of all checking, ATMs, and electronic funds transfers was only one part of the crisis of 2008.
Something much bigger, something more horrific was happening -- if that's possible to imagine.
To put it in perspective, all the Treasury and Fed and FDIC bailouts and takeovers came to commitments of (my guestimate) between $4 and $5 trillion over several years. Most of that was guarantees, loans and investments that weren't used or were paid back -- which is why overall they ended up not costing as much as expected. The big actual outlays were from GM, the FDIC shutting down and resolving banks and deposits, and AIG.
But for a few hours, the Fed and Treasury were staring down the face of a monster so huge that it had devoured $500 billion in a few hours and was predicted to be able to devour $5.5 trillion by 2:00 PM on the afternoon of the same day it had appeared -- money that even the Treasury and Fed didn't have.
As a result, much of the United States economy was about to be unable to meet payroll, and the financial sector was about to experience something analogous to, what in the nuclear power industry is called a complete runaway meltdown.
That was the monster that prompted Henry Paulson and Ben Bernanke to predict that if they couldn't contain it, if the monster continued to go on the rampage, then the government would eventually have to impose martial law to contain the social chaos the monster was about to unleash.
UPDATE: A couple of people have asked for links, so I'll update this diary from time to time by going back and finding the links it was based on. You already have the link to Dean Baker's interview in Part 1. Here is the link to the Bank of Japan's "Settlement Report 2009," which explains the impact Lehman's collapse had on settlements in Japan:
www.boj.or.jp/en/type/ronbun/psr/psr2009.pdf