The first signs that something was seriously wrong in the world of finance began in August 2007 with the French Bank, BNP Paribas, freezing several of its funds as it acknowledged that it was unable to accurately assess the collateralized debt obligations underpinning them. Further indication that this was not just a one off problem with one bank came just a month later with Northern Rock, a British bank, which was unable to sell its securitized mortgages on the markets. The resulting bank run involving vast lines of customers trying to withdraw their money was all too reminiscent of the Great Depression (indeed, the bank was only saved from collapse by its nationalization). In the spring of 2008, the full force of the crisis hit the shores of America with the buy-out of Bear Stearns by J. P. Morgan. But worse was to come in September with the collapse of Lehmann Brothers after it became clear that no bank was willing to take it over and the Federal Reserve refused to bail it out.1
The ensuing crisis led to $3 trillion worth of write-downs in the banking sector and a halving in value of the Dow Jones in just 18 months. With the possibility of meltdown staring them in the face, political leaders once again embraced Keynes (The Economist 16â22 May 2009, p. 13). Nationalization/bail-outs of financial institutions on both sides of the Atlantic looked like a roll call of the great and the good: Freddie Mac and Fannie Mae, Citigroup, American International Group in the US; Northern Rock, Bradford and Bingley, Royal Bank of Scotland, Lloyds Banking Group in the UK; Hypo-Real Estate in Germany; Glitmir, Landsbanki, Kaupthing in Iceland; Dexia was rescued by Belgium, France and Luxembourg; and Ireland saved its banks by guaranteeing the payment of any banksâ liabilities if need be. As the effects rippled throughout the global economy, the highly industrialized countries went into recession with the majority experiencing sustained negative economic growth. Indeed, most of Europe then experienced a double dip recession with dire consequences with regard to unemployment and welfare of their populations. Greece and Spain were the hardest hit with total unemployment levels reaching 25% and youth unemployment totalling a previously inconceivable level of 50%.
At the heart of the crisis was the drive for ever-increasing profits via various financial innovations that facilitated vast increases in financial leverage. The challenge was how to increase the amount of credit available to consumers within the parameters of the regulatory framework that was supposed to limit the risk of financial collapse while at the same time ensuring a level playing field for competition within the financial world. The solution to this conundrum came in several forms, but the result was essentially the sameâthe displacement of risk away from the banksâ balance sheets to other investors and âoff-bookâ accounts in special purpose vehicles (SPVs) which were all too often located offshore.
Asset-backed securities (ABSs) (and especially the sub-category mortgage-backed securities [MBS]) appeared to provide the ideal answer to the problem of having to maintain certain capital adequacy ratios by facilitating a move away from the âoriginate and holdâ model that pertained to loans towards an âoriginate and distribute modelâ (Augar 2009, p. 12). Financial institutions were able to create a package of claims giving the right to âthe lender to receive regular interest and capital from their borrowersâ on the open market (Arnold 1998, pp. 484â5). The future repayment of debt became a commodity in its own right, bought and sold in the open market converting âexpected cash flow, wherever and whenever it might occur, into instant spending powerâ producing liquidity from what would otherwise be âa relatively illiquid assetâ (Hoogvelt 2001, p. 82; Best 2010, p. 34). Essentially, this enabled financial institutions to receive income immediately, allowing them either to lend to an even greater number of clients or to diversify and invest the money in other financial instruments.
These securities became valid commodities precisely because it was believed that by their very nature the risk-spread was such that even in the direst of economic circumstances they would remain relatively stable forms of investment. However, these claims began to be sliced up into tranches according to their risk ratings. The claims on securities were split into three tranches or notes (senior, mezzanine and junior) with a different level of risk pertaining to each note. In the case that some borrowers in a security defaulted, then the losses would be borne, in the first instance, by those holding junior notes, then mezzanine and finally, in the unlikely event (at least at that time it was deemed improbable) that an unprecedented number defaulted, the holders of senior notes would incur losses. Of course, the tranches with the highest risk also attracted the highest returns.
At the same time, the development of the credit default swap enabled actual loans and the risk of the borrower defaulting on that loan to be separated. When making a loan, financial institutions covered themselves by paying an annual fee to another company insuring itself against the risk of default, thus keeping the claim but transferring the risk associated with such credit lines. In other words, âcredit-default swaps enabled them to convert risky assets, which demand a lot of capital, into supposedly safe ones, which do notâ (The Economist 11â17 October 2008, p. 10). Moreover, they bundled these credit default swaps together thus reducing the risk for the insurers because it was believed that the likelihood of a string of borrowers defaulting was less probable. Despite initial reticence, regulators agreed that the capital reserves for this type of loan could be reduced.2 They thus hit upon the financial worldâs equivalent of El Dorado, âreleasing banks from age-old constraints and freeing up vast amounts of capital, turbocharging not only banking but the whole economyâ (Tett 2009, p. 36). As one J. P. Morgan employee who attended the 1994 away day from which the widespread use of this innovation arose commented, âIâve known people who worked on the Manhattan Projectâfor those of us on that trip, there was the same kind of feeling of being present at the creation of something incredibly importantâ (Tett 2009, p. 24 and pp. 159â60).3 Little did he realize how accurate his description would turn out to be.
Connected to these innovations was the development of bank subsidiaries or SPVs which were often set up in offshore jurisdictions by these financial institutions (Tett 2009, p. 63). These SPVs enabled the financial institutions to offload their loans which the offshore entities would structure into âplain vanillaâ MBS, collateralized debt obligations or more complex derivatives and then sell them on to investors. The benefits of establishing this shadow banking system were obvious, it took many of the loans off the books and these subsidiaries were offshore in tax havens. Moreover, the parent bank lent money to these SPVs on a short-term basis (364 days or less). This meant that such loans would not affect the amount of capital reserves they held because the Basel Accord did not require such reserves for short-term lending (Tett 2009, p. 114).
Such activities made for a perfect storm. Although the banks were formally complying with the capital adequacy requirements of the Basle Accords, the low risk ratings of certain CDO tranches alongside the extensive use of offshore SPVs meant that in reality the banks were dangerously over-leveraged. As interest rates began to rise, so did delinquency and default rates on mortgages and loans to the extent that investors lost faith in the new financial alchemy of collateralized debt obligations, credit default swaps, CDOs squared and so on. It was also patently clear from BNP Paribasâ freezing of certain funds that the complexity inherent within such financial instruments had also produced a high degree of uncertainty with regard to risk exposure. Suddenly, the marketâs appetite for ABSs disappeared . Banks found themselves facing the possibility of not having enough reserves to cover non-performing loans. This situation was greatly exacerbated by the fact that the offshore SPVs that the banks set up were financing much of their long-term loans through the issuance of short-term asset-backed commercial paperâbut they found themselves unable to refinance their operations in the repo market as trust in ABSs dwindled . The resulting âGreat Freezeâ where banks struggled to even obtain overnight lending at reasonable rates and the unwillingness to buy out collapsing banks for fear of the unknown almost led to the collapse of the financial...