brunnermeier_2008 - NBER WORKING PAPER SERIES DECIPHERING...

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NBER WORKING PAPER SERIES DECIPHERING THE LIQUIDITY AND CREDIT CRUNCH 2007-08 Markus K. Brunnermeier Working Paper 14612 http://www.nber.org/papers/w14612 NATIONAL BUREAU OF ECONOMIC RESEARCH 1050 Massachusetts Avenue Cambridge, MA 02138 December 2008 My views were shaped by conversations with Viral Acharya, Tobias Adrian, Franklin Allen, Patrick Bolton, Michael Brennan, Smita Brunnermeier, Sylvain Champonnois, Ing-Haw Cheng, John Cochrane, Doug Diamond, Jacob Goldfield, Joel Hasbrouck, John Kambhu, Arvind Krishnamurthy, Augustin Landier, David Lando, Jamie McAndrews, Konstantin Milbradt, Stefan Nagel, Filippos Papakonstantinou, Lasse Pedersen, Lucas van Praag, Raghu Rajan, Ricardo Reis, José Scheinkman, Til Schuermann, Hyun Shin, James Vickery, Glen Weyl, Wei Xiong, and Moto Yogo. Special thanks go to the editors, James Hines, Andrei Shleifer, Jeremy Stein, and Timothy Taylor, and also to Martin Oehmke. Rachel Goodwin, Martin Schmalz, and Hao Wu provided excellent research assistance. I am grateful for financial support from the Alfred P. Sloan Foundation. The views expressed herein are those of the author(s) and do not necessarily reflect the views of the National Bureau of Economic Research. © 2008 by Markus K. Brunnermeier. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including © notice, is given to the source.
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Deciphering the Liquidity and Credit Crunch 2007-08 Markus K. Brunnermeier NBER Working Paper No. 14612 December 2008 JEL No. E4,E5,G2 ABSTRACT This paper summarizes and explains the main events of the liquidity and credit crunch in 2007-08. Starting with the trends leading up to the crisis, I explain how these events unfolded and how four different amplification mechanisms magnified losses in the mortgage market into large dislocations and turmoil in financial markets. Markus K. Brunnermeier Princeton University Department of Economics Bendheim Center for Finance Princeton, NJ 08540 and NBER [email protected]
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2 The financial market turmoil in 2007 and 2008 has led to the most severe financial crisis since the Great Depression and threatens to have large repercussions on the real economy. The bursting of the housing bubble forced banks to write down several hundred billion dollars in bad loans caused by mortgage delinquencies. At the same time, the stock market capitalization of the major banks declined by more than twice as much. While the overall mortgage losses are large on an absolute scale, they are still relatively modest compared to the $8 trillion of U.S. stock market wealth lost between October 2007, when the stock market reached an all-time high, and October 2008. This paper attempts to explain the economic mechanisms that caused losses in the mortgage market to amplify into such large dislocations and turmoil in the financial markets, and describes common economic threads that explain the plethora of market declines, liquidity dry-ups, defaults and bailouts that occurred after the crisis broke in summer 2007.
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