This time, zombie borrowing

The 2008 financial crisis has been characterized with subprime mortgages. The current phenomenon is zombie borrowing.

Fragile loans once again undermine the financial system in the COVID-19 downturn.

This time, central banks pumped unlimited liquidity to all types of markets and borrowers. The lender of last resort mechanism has saturated the markets with liquidity.

Surging commercial defaults will introduce the insolvency phase of the crisis.

Asset-backed commercial paper (ABCP)

The 2008 financial crisis has been characterized with subprime mortgages. Risky loans once again undermine the financial system in the COVID-19 downturn. This time, the triggering dynamic is not subprime mortgages, nevertheless. Consumer borrowing has strictly been constrained all over the world. Debt-to-income and value-to-loan tools have significantly constrained consumer leveraging. It is not too complicated to predict how the next financial crisis would erupt. Expectedly, subprime business loans are the current phenomenon. How do insolvent firms become a threat for the financial system? Asset-backed commercial paper (ABCP) market is the key to comprehend commercial borrowing.

An asset-backed commercial paper (ABCP) is a financial instrument that resembles mortgage-backed security. However, it has one major difference in terms of maturity transformation. ABCPs fund long-term assets with short-term liabilities. Therefore, ABCPs need to be rolled over as they become mature.

As banks fund long-term assets with short-term deposits, ABCPs perform a similar function. Nonetheless, ABCPs are not insured by the government but are backed by collateral. Therefore, contemporary financial crises do not lead to a run from traditional banks but a run from security markets. Such a run crashes initially ABCP issuers and later the entire economy.

In the ABCP framework, the most qualified long-term assets of the borrower serve as the collateral of the debt. Thus, once a borrower cannot serve debt, lenders are able to liquidate the reserved high quality assets and get their money back.

The maturity mismatch between borrowers and lenders prevails for the corporate security market as well. Businesses issue long-term debt while lenders demand short-term. A nonbank financial agency transforms maturity by buying long-term securities of businesses and selling short-term ABCPs backed by long-term securities. Non-bank institutions, thus, make money via bearing the maturity risk (Armour, 1999).

Banks have a stake in the ABCP market as well. They provide short-term liquidity for the ABCPs market. Non-banks borrow from banks against ABCPs. Since asset backed commercial papers (ABCP) have maturities below 90 days, banks play a crucial role in keeping the ABCP market liquid.

What happens to the ABCP market in a crisis?

The 2008 financial crisis began with the collapse of the subprime mortgage market. One of the profound reflections of the mortgage collapse was observed in the ABCP market. ABCPs were partly backed by the subprime mortgages. However, it was not easy to analyse the individual exposures of each ABCP. Instead of making deep analysis of each paper, investors ran away from all ABCPs just as in the old days. Consequently, ABCP balance fell from 1.2 trillion dollars to under 1 trillion dollars just in a month, in August 2007 (Covitz, 2013).

At this point, ABCP manufacturers needed the liquidity support of the traditional banks. Nonetheless, traditional banks were also in liquidity shortage due to the losses in the subprime mortgage market. As a result, ABCP issuers could not fulfill their liabilities in the absence of the access to the lender of last resort mechanism.

Once the revolving feature of the ABCPs was broken, besides financial sector, commercial entities were trapped in the liquidity shortage as well (Covitz, 2013). Businesses could not fund themselves as easy as in the pre-crisis period. The transfer of crisis from the financial sector to the real sector further worsened credibility of other financial institutions which guaranteed ABCPs. The rising concerns about the guarantees further deterred lenders from lending to the financial sector as a whole. As a result, over night interest rates soared (Covitz, 2013).

In 2020, this scenario is not put on the scene because central banks have learnt their lessons from 2008. This time, central banks pumped unlimited liquidity to all types of markets and borrowers. The lender of last resort mechanism has filled the liquidity gap. The US Treasury has created a fund that will compensate losses of defaulting commercial papers in the Fed's portfolio.

Yet, the next phase will be more problematic. As unemployment surges, aggregate expenditure will remain low. Rising number of companies will not be able to fulfill their obligations. Surging commercial defaults will introduce the insolvency phase of the crisis.

References

Armour, John, Dan Awrey, Paul Davies, Luca En riques, Jeffrey Gordon, Colin Mayer and Jennifer Payne, 1999, Principles of Financial Regulation (Oxford: Oxford Universit. Press), pp. 275-289.

Bernanke, Ben S., The Subprime Mortgage Market, Speech at the Federal Reserve Bank of Chicago’s 43rd Annual Conference on Bank Structure and Competition, Chicago, Illinois, May 17, 2007.

Covitz, Daniel, Nellie Liang, and Gustavo A Suarez, 2013, The evolution of a financial crisis: Collapse of the asset ‐ backed commercial paper market, The Journal of Finance 68, 815 - 848.

Mayer, Christopher, Karen Pence, and Shane M Sherlund, 2009, The rise in mortgage defaults, The Journal of Economic Perspectives 23, 27 - 50

References

Armour, John, Dan Awrey, Paul Davies, Luca En riques, Jeffrey Gordon, Colin Mayer and Jennifer Payne, 1999, Principles of Financial Regulation (Oxford: Oxford Universit. Press), pp. 275-289.

Bernanke, Ben S., The Subprime Mortgage Market, Speech at the Federal Reserve Bank of Chicago’s 43rd Annual Conference on Bank Structure and Competition, Chicago, Illinois, May 17, 2007.

Covitz, Daniel, Nellie Liang, and Gustavo A Suarez, 2013, The evolution of a financial crisis: Collapse of the asset ‐ backed commercial paper market, The Journal of Finance 68, 815 - 848.

Mayer, Christopher, Karen Pence, and Shane M Sherlund, 2009, The rise in mortgage defaults, The Journal of Economic Perspectives 23, 27 - 50