A few generations ago, savers responded to financial panics with runs on banks, and even healthy institutions could fail if they could not raise enough cash quickly enough.
For a long time, that all seemed to be safely relegated to the past. But now the runs are back — and this time the targets are not banks but the securities that have replaced them as the prime generators of credit in the new financial system.
“Our current system of levered finance and its related structures may be critically flawed,” said William H. Gross, the chief investment officer of Pimco, a mutual fund company. “Nothing within it allows for the hedging of liquidity risk, and that is the problem at the moment.”
This problem has plagued the United States at regular intervals. The Panic of 1907 was halted only when the banker J. P. Morgan persuaded banks to stand together and halt the string of closings by lending money to threatened institutions. That led to the creation of the Federal Reserve, as Congress recoiled from the notion that the country’s financial health had relied on the wealth and wisdom of one private citizen.
Then the Depression, with a wave of bank failures, led to the establishment of deposit insurance. With that, savers became convinced that they need not worry about the health of their bank, and bank runs vanished.
But a new financial architecture emerged in the last decade — one that relied more on securities and less on banks as intermediaries. With the worth of those securities now being questioned — and no equivalent of deposit insurance — some who financed the securities want their money out, a fact that has created the 21st-century equivalent of a run on a bank.
Left to deal with the run are the institutions that were created to deal with the old system’s problems — notably the central banks like the Federal Reserve and the European Central Bank. But, in contrast to their close involvement with the banking system, these banks have little regulatory oversight of the securities that are in trouble and may not even know who is holding them.
At the heart of the new system was a decision to have loans financed directly by investors, rather than indirectly by bank depositors. Investors, ranging from hedge funds to wealthy individuals, had confidence in the arrangement because most of the securities were blessed as very safe by the bond rating agencies, like Moody’s and Standard & Poor’s.
The highly rated securities pay relatively low interest rates, but until now there were many willing to own them or to lend money to those who did own them. But there is no reason to hold them if there is any question about their safety — just as there was no reason to keep deposits in a bank that was facing a run amid rumors about its safety.
A result has been a freezing up of markets for many securities that, it turns out, were critical to the free flowing of credit. The problem first gained widespread attention when two hedge funds run by the brokerage firm Bear Stearns collapsed and a third Bear Stearns fund had to suspend redemptions as investors sought to get out even though there was no evidence that the fund was in trouble.
“The third Bear Stearns fund announcement was the key,” said Robert Barbera, the chief economist of ITG. “You have to believe that in the hedge fund and mutual fund complexes, there is a decision that is building that says, ‘I want to hold some Treasuries to have a cushion if I see redemptions.’ ”
The basis of the system was a belief that securities backed by bad credit could be very safe — so long as there were other securities that would suffer the first losses that came from defaults in pools of subprime mortgages or of loans to highly leveraged companies.
So far, none of those highly rated securities have failed to make their interest payments on time, but that fact is not enough to make anyone want to buy them. The rating agencies have downgraded some securities, and they are tightening their standards for new ratings.
Early this week, stock market investors around the world tried to reassure themselves that nothing was really wrong, and financial stocks bounced back after suffering sharp declines last week. Analysts argued that profits remained strong, as does world economic growth.
On Tuesday, the Fed declined to lower the federal funds rate, saying that despite financial market volatility and a decline in the housing market, “the economy seems likely to continue to expand at a moderate pace over coming quarters, supported by solid growth in employment and incomes and a robust global economy.”
But that comforting outlook did not help the credit markets recover, or persuade anyone to buy the newly questioned securities — at least at anything like the prices people had assumed. No one wants to sell the securities at very low prices — and in many cases they have borrowed heavily against them. So the markets have dried up.
Yesterday, BNP Paribas, a major French bank, said it could no longer value three investment funds that it managed, whose assets had been invested in highly rated securities that were backed by dubious mortgages.