Storm, The (6 page)
The immediate source of turbulence, and the trigger for the current global financial crisis, was the US mortgage market. As
the economy recovered from the downturn of 2000–1 on the back of low interest rates, a veritable army of American Adam Applegarths
pumped out enormous numbers of mortgages, often
aimed at poorer families or those with a poor credit history. So-called ‘ninja’ loans – to people with no incomes, no job
and no assets – look in retrospect to have been criminally irresponsible. But at the time it seemed a worthy idea, as in the
UK, to spread the fruits of home ownership from the middle class to poor Americans, often recent immigrants or poor black
people, as part of a process of empowerment and liberation from the ghetto or from poor-quality public housing. And, as in
Britain, property seemed self-evidently a good investment, as house prices doubled in value from the late 1990s to the peak
in 2006, outperforming the stock exchange by a considerable distance over that period.
More-cynical observers might ask why bankers suddenly became so enthusiastic about poor people whom they otherwise wouldn’t
have touched with a financial bargepole, and certainly wouldn’t want in their golf clubs. Philanthropy can be discounted.
Poor people have one great attraction. Because they are poor, and have a poor credit history, they can be charged relatively
high interest rates. Of course, this was not obvious to the borrowers, who were offered low-interest ‘teaser rates’, which
would then be refinanced later at a higher rate. For banks looking for new business with a high yield the attractions were
obvious, especially if they could find a way of spreading the (higher) risk. An instrument to achieve just that was at hand
in the form of collateralized debt obligations (CDOs), or packages of debt paying interest rates that varied according to
the risk. These could be sold as bonds in international markets. Soon, mortgage-backed securities accounted for a third of
the whole US $27 trillion bond market – and of this, at the end of 2007, $1.3 trillion was sub-prime. The concept of ‘sub-prime’
is an elastic one, but the USA, unlike the UK, has a formal definition based on the multiple of borrower’s income and loan
value relative to house acquisition price.
So far, so good. Lots of poor people (and others) were able to buy their homes for the first time when interest rates were
low and house prices were rising. Lots of happy bankers and brokers were
paid bonuses for successfully closing deals. Lots of pensioners and other investors across the world were enjoying a higher
yield on the securities that made up the assets of the institutions to which they had entrusted their money.
What burst the bubble of US property values was rising interest rates. The US equivalent of the bank rate rose from 1 per
cent to over 5 per cent in early 2006. Large numbers of borrowers could no longer afford to pay. Many of the sub-prime borrowers
gave up when their ‘teaser’ loans at low interest were refinanced at the new, higher rate. Large numbers simply handed over
their keys to their bank and disappeared, not waiting to be repossessed. The market fell sharply, with distress-selling as
the bubble burst. Prices fell on average by 25 per cent from the peak in July 2006 to the financial crisis in the autumn of
2008, and subsequently fell another 10 per cent before apparently stabilizing. The number of potential repossessions has been
variously estimated at 2 million on the conservative side to as many as 6.5 million by Credit Suisse – as many as one in ten
mortgages.
Whilst this story has been distressing for those American families, it is not immediately obvious why their problems should
have reverberated around the world. To understand this, I need to explain how the US mortgage market works and how its risks
are transmitted to wider financial markets. The total US mortgage market was worth roughly $12 trillion in July 2008. This
sum compared then with a UK mortgage market of $2.5 trillion (or £1.2 trillion) – five times smaller. US mortgage lenders,
who are far more numerous than in the UK, raise money for new loans by selling on their debt to other institutions. Of the
total $12 trillion, $5.2 trillion was acquired, and effectively guaranteed (or so it was assumed at the time), by two state-backed
but privately owned agencies, the Federal Home Loan Mortgage Corporation, known as ‘Freddie Mac’, and the Federal National
Mortgage Association, known as ‘Fannie Mae’. Fannie Mae had been created during the New Deal as a way of stimulating, while
also stabilizing, mortgage lending and, thereby, the housing industry. In 1968 it was
privatized, to help finance the Vietnam War, and its explicit guarantee was dropped, while Freddie Mac was set up as a competitor.
These two agencies became the stalwarts of the Middle American mortgage market, buying and selling mortgages below a certain
size (just over $400,000), but not the riskier sub-prime mortgages. Those were left to the (fully) private-sector banks, which
advanced a mixture of high-grade, high-value and sub-prime mortgages. While Fannie Mae and Freddie Mac did not support sub-prime
lending directly – though they had a lot of marginally prime loans – they did, however, hold large amounts of securities backed
by sub-prime mortgages, so they were, indirectly, highly exposed to that market.
Freddie Mac and Fannie Mae, and the banks, then sought to sell on the mortgage debt they had acquired in the form of mortgage-backed
securities. This process of securitization broadened out into a slicing and dicing of the risks, through an exotic proliferation
of new instruments, including the aforementioned CDOs and SIVs (structured investment vehicles). By repackaging the mortgage
debt through more and more complex vehicles, securitization made it possible to dilute and spread the risk, gain access to
a wider pool of capital, and thus reduce the cost of borrowing. At the same time, securitization provided investors with new
products to invest in at a competitive yield.
This relatively small amount of debt was leveraged with much larger amounts of debt. In practice, each transaction could generate
a margin of profit from which the managers of the institutions and their shareholders, brokers, dealers, rating agencies,
designers of asset packages, sales staff and lawyers could all take their cut. The degree of leverage involved also amplified
the debt, sometimes to astronomical proportions. In effect, institutions borrowed money in order to buy debt, which was the
security for the borrowing, and the money they borrowed was in turn borrowed, sometimes through several institutions. In addition,
debt default could be insured against, but the insurers depended in turn on borrowed capital. Derivatives markets also
made it possible to hedge (or speculate) against the risk of default. The credit default swap market, for example, which grew
on the back of the growth of these debt instruments, achieved a notional value of over $60 trillion. This, in turn, represented
about one tenth of the overall size of derivatives markets, which Warren Buffet warned us was the H-bomb to follow the sub-prime
A-bomb.
How has the downturn in the US housing market, and increase in mortgage default, had such a profound impact on financial markets,
triggering panic among the sophisticated financiers who thought they had diluted the toxicity of sub-prime loans to harmless
levels? At first sight, the sums of money involved in sub-prime losses simply do not justify the collapse of confidence that
has occurred. Let us assume, for the sake of illustration, that roughly one third of the total US sub-prime debt eventually
has to be written off by the financial institutions that hold it: that is, around $400 billion. Perhaps this overstates the
problem, since the earlier sub-prime loans, before 2005, seem to have held up well. The sum is less than the losses in the
1980s savings and loans crisis, even in nominal terms. It represents only 3 per cent of total mortgage debt. In fact, when
the IMF made its estimate of total US financial sector losses in its Global Financial Stability Report, it estimated that,
of total losses of $1.4 trillion ($1400 billion), only around $150 billion could be traced to mortgages, and only a fraction
of that to sub-prime mortgages. So much for the idea that US sub-prime lending caused the crisis. It was merely the fuse that
lit the bomb. The explosive was non-traditional lending outside the banking system, centring on securitization. Through securitization,
loans once held on the books of banks were repackaged and sold. The scale and complexity of this repackaging increased many
times in the rapidly growing pool of debt-based products created by investment banks.
The genius of securitization is also its central weakness. Debt is so widely and skilfully diffused that it becomes impossible
to trace it. No one really owns the loans. So institutions have
struggled to identify how much their own financial assets, backed by sub-prime mortgages, are actually worth, and how much
should be written down. A yet more serious problem is what are called ‘amplifiers’, multiplying losses (and gains) and adding
to uncertainty. Amplification of losses has come from several sources, the most important being excessive leverage. Banks,
and particularly investment banks, increased borrowing relative to equity (share capital) in order to achieve higher returns
for shareholders’ equity when the value of assets was rising. In a world where investors were seeking higher returns on their
assets, one recourse, which occurred here on a grand scale, was to assume more and more debt in order to buy assets, thus
pushing up their value further, but increasing risk in the process.
The investment banks were at the heart of this process of increasing leverage. Leverage of 30:1 was not uncommon. The bankers
were able, for a while, to make large profits from a big expansion of business on small underlying assets, with each financial
instrument created becoming collateral for yet more complex instruments. Furthermore, some of the debt instruments, such as
CDOs, produced substantial profits from small increases in asset values – but, conversely, multiplied losses once asset values
fell.
Other amplifiers have included derivatives, which involve contracts at one stage removed from the original transaction. In
some form they have been around since organized commerce began, and they perform the useful function of enabling traders to
cover themselves against future changes in prices (and financiers to make money by selling that cover). For those owning a
derivative, the contract creates exposure to risk, even if the underlying assets are not actually owned. Derivatives have
grown at a staggering rate in today’s sophisticated markets, to an estimated notional value of outstanding contracts of $600
trillion (from $15 trillion a decade earlier) at the end of 2007 – over ten times world output. One particular kind of derivative,
credit default swaps (CDS), which allow investors to separate out – and pay for – the risk that a borrower
will not repay, have been crucial to the growth of financial leverage. This $60 trillion market (which has grown from virtually
zero in a little over five years) permits, in effect, gambling at very long odds that banks and other institutions, including
governments, will not fail. Bookies at the racecourse carefully adjust the odds in order to ensure that they reflect the backing
of different horses. They, like casino owners, know from experience and intuitive maths not to put their firm or their house
at risk. But the novelty and complex maths of the CDS market has meant that large bets have been advanced – usually in borrowed
money – which are cumulatively so vast that there is no underlying capacity to pay out in the event of their being called
in. And that is the weakness that was exposed when a large bank such as Lehman Brothers did indeed default on its debts.
These complex products depended ultimately on market confidence that those who manufactured and sold them knew what they were
doing, and that what markets were being offered was healthy cooking oil rather than snake oil. Confidence and trust are essential
to any functioning market, and the reputation and sophistication of the main investment banks which dominated the industry
was underscored by the ratings agencies. Supposedly (but not actually) independent of their clients, agencies such as Moody’s
and Standard and Poor offered a quality guarantee. If they rated a product or institution AAA, who was going to question that
judgement? Like driving examiners, they might make individual mistakes, but the system depends on a belief in their overall
objectivity and confidence that they will not allow incompetent and dangerous drivers on to the public roads. But extremely
dangerous financial drivers were being passed with flying colours.
This combination of an apparently strong, yet fragile, business depending on confidence is captured in a metaphor used by
the
Financial Times
journalist Gillian Tett, whose book,
Fool’s Gold
, is one of the most insightful accounts of the crisis. She likens financial systems, and specifically the investment banks,
to giant
sausage factories. Clever manufacturers secure low-quality meat from a variety of abattoirs, which in turn source it from
a large number of farms. Mixed with preservatives and stuffing, the meat is covered in skin and marketed through numerous
supermarkets under famous brand names. A lot of money is made by the sausage makers, and consumers enjoy a cheap, tasty product.
Until the food inspectors withdraw their certificate of approval. The cry goes up: ‘BSE. Panic.’ The meat from the mad cows
cannot be traced. Collapse of market. Sausage factory goes bust and appeals for government support. The metaphor is not exact,
but it captures the way in which an industry is as strong or as weak as each of the parts of its supply chain, and how it
ultimately depends on confidence.
A succession of events occurred in the early months of 2007 that, to the acute observer at the time, and more clearly in retrospect,
could be seen as the early warnings of the crisis to come. In February, specialist US sub-prime lenders were reporting losses
on the back of defaults, and the second-largest, New Century, was suspended and then filed for bankruptcy. Then, in May, UBS
was forced to take over its in-house hedge fund, Dillon Read, which had run up heavy losses in sub-prime investment, and shortly
afterwards UBS’s chief executive was fired. In June, two hedge funds run by Bear Stearns were reputed to be in serious trouble,
despite having supposedly very safe investments, because they were exposed to bonds backed by sub-prime mortgage debt.