This is an explanation of the cause of the financial crisis, though it’s too long at 17 pages. Here’s my dumbed down summary. Around the world there was a huge glut of cash, particularly in Asia. Individuals can put cash in FDIC secured savings account, but no such safe account exists for huge deposits. So where can money markets and hedge funds and Chinese banks put their money and guarantee it’s safe? They put it in the repo market.
A money market fund (MMF) has $1B in cash and no safe place to deposit it. The investment banks came up with an idea: give them $1B cash and they’ll give the MMF $1B in Aaa-rated Treasury bonds as collateral. But the MMF wants to be able to withdraw money at anytime, so the bank agrees to buy back those bonds the very next day. This is called a repurchase agreement and is the foundation of the repo market, worth over $12 trillion worldwide. From the MMF’s point of view, they earn interest on their cash and hold an equivalent amount of bonds just in case the bank fails. And they get their cash back every day, so they can withdraw what they need in the morning and sign another repo agreement for the next day. From the bank’s point of view, the repo market turns their vast holding of Aaa bonds (required for all sorts of purposes) into cash they can use to do more lucrative investments. Everyone is happy.
The problem lies in those Aaa-rated bonds. The repo market got super huge and there wasn’t enough high quality bonds to meet demand. Someone figured out how to turn consumer loans (home, credit cards, auto, school) into Aaa-rated bonds. The bank gives the MMF $1B in consumer loans, and AIG promises to make up any loss in those bonds. AIG did this because everyone agreed that consumer loans would never blow up, so they earned a small fee on every loan for doing nothing. AIG made tons of money. Everyone is happy.
In 2007 home values suddenly declined a bit for the first time ever. The MMF complains the $1B in mortgage bonds have lost value, so they want more bonds as collateral or their cash back. All the bank’s cash is tied up in other investments, so they have to sell some stuff to raise money for the MMF. But all the banks started selling the same securities, which sent prices down. The banks suffered losses and had to sell more securities to make up for their losses, which sent prices down again in a terrible cycle. This initiated the banking crisis around Sept. 2007. The global economy crumbles. Everyone is freaked out.
The paper says that this was a classic run on the bank; that is, suddenly everyone wanted their money back at the same time. FDIC insurance stopped bank runs by consumers, but the lack of insurance for large depositors means we’ll continue to have this same crisis in the near future. Somehow the banking system must be made more resilient to panics. I don’t know if this is a complete explanation of the financial crisis, but it does help to understand all this weird “parallel banking system”.