The short answer is that Capitalism stopped for four days in 2008, from September 15 to September 18.
The long answer is more complex:
Governments in both the US and the UK allowed their financial sectors (particularly investment banking) to run virtually unchecked. And should we be surprised? In 2007, the financial services sector generated over 25% of all tax revenues for the government in the UK (I don't have access to US figures at my fingertips, but they are likely similar).
The Bank of England had been stripped of its regulatory role, and the FSA (Financial Services Authority) was created. On paper, the separation of monetary policy from marketplace regulation looks good, but the problem was that the FSA never established significant regulatory authority. In fact, Blair called for less regulation in 2007, citing the FSA as being seen
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to inhibit efficient business by respectable businessmen who never defrauded anyone.
Howard Davies (director of the LSE) sums the crisis up nicely with the acronym, "SLUMP":
S - subprime
L - liquidity
U - unravelling
M - meltdown
P - pumping
Subprime: There were huge profits to be made from mortgages, and banks began to rely on credit rating agencies, who were under pressure from the banks to be pretty free with their ratings, so that almost anyone could get a mortgage. Remember Greenspan:
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In a market economy based on property rights it is critical to have as broad a swathe of people as possible with a vested interest in making that system work.
Suddenly, NINJAS are getting mortgages (No Income, No Job, No Assets). So banks started taking the prudent step of offsetting their risk, by carving up and selling off their mortgage portfolios. These became assets as everybody bought up packages of everybody else's mortgage portfolios, and what do you do with assets? You leverage them (i.e. borrow against them). This is the stage where the Investment Banks come in.
These "Securitised Debt Arrangements" are dangerous. In a classic borrower-lender relationship, if the borrower defaults, the lender has to take the write off. But with SDA's suddenly the person taking the hit is the person who bought the mortgage asset from the lender. The lender faces no risk in issuing questionable debt, as long as he can find a willing buyer for it. This is all well and good when default is the exception. But with subprime mortgages coupled with a slump in housing prices, suddenly default rates climbed astronomically.
Just for reference, from 2003 to 2008, the credit default swaps in the UK financial services sector climbed from GBP 3trillion, to 63trillion. This leads us into phase 2:
Liquidity: Banks fail for one reason, and one reason only: they run out of cash. When banks stopped lending to other banks, then the failures started.
If you are looking only at your own portfolio, selling off mortgage assets (not all of which are sub-prime, mind you), looks like an intelligent strategy to maintain your liquidity. Essentially, the marketplace is issuing you an insurance policy. But if the marketplace is insuring everybody, and everybody's risk event happens at once, suddenly there isn't enough cash on hand anywhere. Suddenly there's no one in the marketplace willing to move liquidity from one bank to another. Every bank had run models on its own risk, but nobody had modelled a scenario where everybody was facing the same risk. This is where the the next part comes in:
Unravelling. In the UK, it started with Northern Rock. In the US it was Lehman Bros. Bad debt can be written off, losses can be offset--but when you are out of cash, you are out of business. And once one player in the market goes under, the risk starts to spread.
In the UK, the Bank of England stepped in to save Northern Rock, which was later nationalised. But the virus was already loose, and RBS, HBOS and Lloyds all had to come, cap in hand.
In the US, Lehman could have saved itself--it had an offer from Korea Development Bank, but they insisted on going to the Fed. The Fed had rescued FNMA and FDMC, and they couldn't let AIG go down (because of AIG's involvement in China). For some reason, the Fed decided to hold the line on Lehman's bankruptcy. And with the clarity of hindsight, it was a stupid decision, because that led us into:
Meltdown. This is what happens when you go beyond failures of private banks, whose risk only spreads to professional investors. The Fed probably thought that since Lehman was an investment bank, their would be no retail banking implications arising from their failure. But when Lehman collapsed, everyone shut up shop. Lehman went, then AIG and then HBOS was in trouble.
And suddenly the Treasury does an about face and we're into phase 5.
Pumping: The Fed's free market principles lasted precisely one day. They could have held off the storm with a few billion at the start of the week, and were facing 700 billion by the end of it.
So where does the fault lie? Well there's plenty of blame to go around, but there are a few key players:
1) US and UK financial regulators. Having blurred the line between retail banking and investment banking, the risk averse culture of the former was overtaken by the risk taking culture of the latter. Failure to regulate the derivatives market in mortgage securities was also a significant failure. Note the far less significant impact on the Canadian financial services sector, where the Government has routinely refused the pleas of the "Big 6" to further deregulate the sector. Not one Canadian financial institution has fallen as a result of the subprime market and its derivatives trade.
2) The Accounting profession. The valuation of derivative instruments allowed deceptive financial statements to go into the marketplace. While responsibility lies, ultimately, with the issuer, it is accountants and auditors that facilitate the deception.
3) The financial services sector: The failure to take a step back and look at the overall health and exposure of the investment banking sector was a fatal misstep. While some might argue that this is the responsibility of government, those who seek deregulation must be able to demonstrate that they can govern themselves better than government can.
The subprime fiasco is a harder one to parse. With hindsight, it is clear that the scale of subprime lending led to enormous overexposure. But banks had what they believed was a prudent strategy for risk mitigation. By allowing foreign investors to get a piece of the US housing boom, it was expected that there would be sufficient liquidity to offset the risk.
4) Consumers. Consumers have been sold a bill of goods by lenders. The prospect of home ownership and easy money lulled many into a false sense of financial security. But consumers, ultimately, face the responsibility of taking on more debt than they can repay. If you declare bankruptcy, and your credit card issuers get pennies on the dollar, and your mortgagors realize on a loss on your foreclosure, it's easy to think that they can afford it. But when it happens hundreds of thousands of times, and each bankruptcy involves tens or even hundreds of thousands of dollars in losses, then the whole system gets shaken.
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--James
04 Jun 2010, 8:26 pm
