Causes of a Financial Crisis

• The Global Credit Crisis of 2008 caused institutional investors to fear that the commercial and investment banks, where they normally invested their money, might become insolvent overnight. This actually happens. When institutional investors are concerned about the financial strength of a bank, they don't invest their tens of millions of dollars in that bank. Suddenly the bank experiences a huge outflow of money as their regular institutional depositors stop their new deposits and withdraw money already on deposit. Such an outflow of cash can destroy a bank, so the bank goes to the Federal Reserve and borrows enough cash to stay in business. Lehman Brothers went out of business because institutional clients became concerned about its financial strength and stopped doing business with the firm.
  
  

Results of a Crisis

• Once institutions become fearful of credit weakness in financial institutions, those financial institutions can't raise enough money to continue to fund loans to small companies and consumers. They start to call in any loans that are slow paying and cancel consumer credit lines. Businesses fail to pay for inventory and salaries because they can no longer obtain financing, and they begin to lay-off employees. Those employees fail to pay their mortgages and auto loans and soon lose their cars and homes.
  
  

Flight to Quality

• On Wednesday, September 17, 2008, the yield on U.S. Treasury bills fell to 0.02 percent, the lowest yield since 1940 on the three-month bill. On Friday, September 12, it had yielded 1.47 percent. This drop in yield was the result of panic investing by institutions afraid to deposit money in banks. The were content to receive such a low interest rate just to keep their principal safe. Such activity is known as a flight-to-quality, and it happens every time there is a financial crisis.
  
  

What You Should Do

• During any financial crisis, keep your money in very short-term investments such as U.S. Treasury bills, deposits at FDIC member banks and money market mutual funds that invest only in government guaranteed securities. As the crisis lessens, you can move to longer maturities, but keep the credit quality high. Don't seek the highest interest rates. Unfortunately, during financial crisis times, the safety of your money comes at a high price, which is low interest rates.