By Frances Coppola
The seeds of that financial crisis were sown in the first half of the 2000s as global finance began to increasingly rely on so-called “safe assets” produced by banks and other financial firms and denominated in safe haven currencies, especially the U.S. dollar. But as the mortgages on which these private sector “safe assets” were based started to default, they were revealed as highly risky, rather than safe. The shock caused markets to freeze and banks to fail, rippling out around the world and eventually calling into question the safety not only of private sector but also public sector “safe assets.”
Remarkably, the dollar exchange rate remained firm throughout the global financial crisis. But as the financial crisis led into the European sovereign debt crisis, there was a warning that even the dollar’s safe haven currency status might not be wholly immune from the failure of safe assets.
Here’s how it all happened.
During the U.S housing boom of 2002-6, banks created exotic products derived from mortgages—most notable, Collateralized Debt Obligations (CDOs). In CDOs, pools of subprime mortgages were sliced into “tranches” ranked like a corporate structure: the top slice was known as “senior” or even “supersenior,” while the bottom slice was known as the “equity” slice. Cash flows from mortgages underlying CDOs were paid out in order of seniority. If cash flows started to fail because people weren’t making mortgage payments, the first slice to default would be the equity slice, and the last would be the supersenior.
Senior tranches of CDOs were considered so unlikely to default that they typically carried a triple-A credit rating. The world regarded them as essentially risk-free. Banks and financial institutions invested in them, and international markets relied on them as collateral for cash borrowing. With CDOs, the private sector helped to close the gap between the world’s demand for safe assets denominated in the safe haven currency of USD, and the U.S. government’s ability to produce them.
But in 2006, the U.S. housing market crashed. By mid-2007, as mortgage defaults mounted, the value of residential mortgage-backed securities (RMBS), was falling rapidly. In July 2007, ratings agencies downgraded many of the RMBS underlying the CDOs, in effect saying that they were no longer safe assets.1 In August 2007, the French bank BNP Paribas closed three of its funds, saying that it could not value the mortgage-backed securities on their books.
This event is often described as the start of the global financial crisis.2 International financial markets froze, depriving banks and other financial institutions of essential funding. In December 2007, as banks reported growing losses on RBMS and CDOs,3 the Federal Reserve established the Term Auction Facility to provide liquidity to distressed banks.4 U.S. Treasury (UST) bond prices rose and yields fell as investors abandoned private-sector safe assets in favor of U.S. government debt.
By the end of 2007, private-sector safe assets had effectively disappeared.5 But despite falling UST yields, the dollar’s exchange rate actually fell during this time, since investors remained concerned about rising U.S. government debt and a widening current account deficit.
Over the next few months, as subprime mortgage defaults escalated, the value of securities derived from them fell to virtually nothing. In March 2008 the investment bank Bear Sterns collapsed as its asset base evaporated.6 For the first half of the year, the dollar exchange rate continued to fall, as investors remained concerned about the U.S.’s twin deficits. But in July, as the crisis worsened in other countries, notably the U.K. and Europe, the dollar re-asserted its safe haven currency status—it stopped falling and started to rise.
On September 6, 2008, the government-sponsored agencies FNMA (“Fannie Mae”) and FHLMC (“Freddie Mac”) failed and were taken into federal conservatorship. Fannie Mae and Freddie Mac were key “safe asset” providers, hoovering up prime mortgages from their originators and converting them into RBMS. But the two agencies had become increasingly exposed to subprime loans. As subprime mortgages defaulted, losses rebounded to Fannie and Freddie.7
The failure of the agencies ratcheted up the safe asset crisis. Suddenly, even securities issued by government-sponsored agencies were no longer “safe.”8 The dollar’s exchange rate rose sharply as investors fled to cash.
Less than two weeks later, the global financial system went into meltdown. On September 16, 2008, the investment bank Lehman Brothers filed for Chapter 11 bankruptcy. The following day, the Fed bailed out the insurance company AIG. But the safe asset crisis worsened sharply when the money market fund (MMF) Reserve Primary “broke the buck.” MMFs had always guaranteed to return people’s investments at par, at least. Now, for the first time, an MMF had failed to honor this guarantee. Investors pulled their funds from MMFs, causing markets to freeze.
As the crisis spread out across the world, there were bank failures in the U.K. and Europe, and “sudden stops” in developing countries as investors moved their money to safe haven currencies, notably the U.S. dollar. Thus, the failure of dollar-denominated safe assets in the global financial crisis did not cause a U.S. sudden stop, as many had feared. Capital fled into, not out of, the U.S., causing the dollar exchange rate to soar and UST yields to fall.
At the height of the financial crisis, the euro crashed as European banks failed and money flowed back to the U.S.’s safe haven currency. It recovered, for a time, regaining most of its value by November 2009.9 But in early 2010, it emerged that Greece’s debts were far greater than previously reported. As concern grew that not only Greece, but other countries too would default on their debts and leave the euro, the euro’s exchange rate fell sharply and yields on bonds issued by those countries spiked. Suddenly, safe assets issued by developed countries, and believed to be guaranteed by the European Central Bank (ECB), were no longer safe.10
In July 2012, the president of the ECB, Mario Draghi, said that the ECB would do “whatever it takes” to preserve the euro.11 The announcement reassured investors, and the euro’s exchange rate started to recover.12 However, some economists say that the euro crisis has damaged the euro’s credibility as a safe haven competitor to the dollar in international markets.13
It is not just the euro’s exchange rate that is affected by rising risk of sovereign default. In the middle of the euro crisis, the U.S. dollar’s exchange rate suddenly fell in mid 2011 as Congress argued over President Obama’s budget, raising fears that the U.S. might default on its debt.14 Eventually, Congress relented and raised the debt ceiling, and the dollar’s exchange rate rose again.15 But fear of U.S. default due to disagreements over spending plans has resurfaced at intervals since, most recently in 2018.16
In the global financial crisis, the failure of dollar-denominated safe haven currency assets caused the dollar’s exchange rate to rise as investors turned to cash and government securities. Failure of government safe assets in the Eurozone crisis also helped to establish the U.S. as the primary supplier of safe assets to the world, strengthening the dollar’s exchange rate. But the 2011 debt ceiling argument showed that the U.S. is not wholly immune from currency crisis. If the U.S. were to default on its public sector debt, the U.S. dollar might no longer be a safe haven currency in a global financial crisis.
With 17 years experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.
1. “Moody’s Downgrades Residential Mortgage-Backed Securities,” CNBC; https://www.cnbc.com/id/19698687
2. “Looking Back: The Financial Crisis Began 10 Years Ago This Week,” Money & Banking; https://www.moneyandbanking.com/commentary/2017/8/6/looking-back-the-financial-crisis-began-10-years-ago-this-week
3. “Table: Subprime-related losses at major banks,” Financial Times; https://www.ft.com/content/9622326c-d5b8-11dc-8b56-0000779fd2ac
4. “Term Auction Facility (TAF),” Federal Reserve; https://www.federalreserve.gov/regreform/reform-taf.htm
5. “The Decline of Safe Assets,” FT Alphaville; https://ftalphaville.ft.com/2011/12/05/778301/the-decline-of-safe-assets/
6. “Bear Sterns Collapses, Sold to J.P. Morgan,” History; https://www.history.com/this-day-in-history/bear-stearns-sold-to-j-p-morgan-chase
7. “The Rescues of Fannie and Freddie,” New York Federal Reserve; https://www.newyorkfed.org/medialibrary/media/research/staff_reports/sr719.pdf
8. “The Decline of Safe Assets,” FT Alphaville; https://ftalphaville.ft.com/2011/12/05/778301/the-decline-of-safe-assets/
9. “U.S./Euro Foreign Exchange Rate,” FRED Economic Data; https://fred.stlouisfed.org/series/DEXUSEU
10. “The Decline of Safe Assets,” FT Alphaville; https://ftalphaville.ft.com/2011/12/05/778301/the-decline-of-safe-assets/
11. “Verbatim of the remarks made by Mario Draghi,” European Central Bank; https://www.ecb.europa.eu/press/key/date/2012/html/sp120726.en.html
12. “U.S./Euro Foreign Exchange Rate,” FRED Economic Data; https://fred.stlouisfed.org/series/DEXUSEU
13. “The Rise of the Dollar and Fall of the Euro as International Currencies,” Maggiori, Neiman & Schreger https://scholar.harvard.edu/files/maggiori/files/mns_pandp.pdf
14. “2011 U.S. Debt Ceiling Crisis,” Investopedia https://www.investopedia.com/terms/1/2011-debt-ceiling-crisis.asp
15. “U.S./Euro Foreign Exchange Rate,” FRED Economic Data; https://fred.stlouisfed.org/series/DEXUSEU
16. “Is the U.S. Headed for a Public Debt Crisis?” Gavyn Davies https://www.ft.com/content/f4fbdc02-4254-11e8-803a-295c97e6fd0b