Storm, The (7 page)

It was becoming clear, in mid-2007, that serious losses were accruing from the sub-prime market and the wider fall in house
prices, and that these losses were being transmitted through the system. There was a loss of confidence, initially centred
on the ‘shadow banking system’ that had grown up in the previous two decades, comprising broker-dealers, hedge funds, and
conduits or structured investment vehicles (SIVs), supported by credit lines from banks or affiliated to banks but independent
of them and off their balance sheets. More than the banks themselves,
these were highly leveraged, lending long-term but ultimately becoming very short-term. When questions were raised about the
toxicity of their investments, short-term funding suddenly dried up and in due course the run spread to the banks themselves.

Banks became nervous about the underlying value of their assets. They therefore hoarded cash and cut back drastically on their
lending. Moreover, banks could no longer attract funding from money markets worried about the underlying health of their borrowers.
Liquidity dried up. There was a crisis of confidence in complex securities run by BNP–Paribas, and a bail-out by the banks
of a German bank, IKB. Then came the run on Northern Rock. But even banks with adequate liquidity gradually had to acknowledge
that many of their assets were of diminished value. Citigroup wrote down $41 billion in the period from January 2007 to the
end of June 2008; UBS, a Swiss-owned global giant, and Merrill Lynch each wrote down almost $40 billion, and the UK’s Royal
Bank of Scotland $16 billion. Share values of the world’s largest banks, UBS and Citicorp, fell 50 per cent in the year up
to May 2008.

The impact of these changes on the world outside banking was felt through the slow, quiet strangulation of bank lending to
those institutions or markets that were now seen as excessively risky. In the UK, for example, 40 per cent of new mortgages
depended, until the credit crunch, on international credit markets, which effectively closed. It could be argued that such
a radical reassessment of risk is, on balance, healthy. Too much money was flowing into mortgages, especially but not only
sub-prime mortgages, driving up house prices to a level that represented an artificially inflated bubble. And it is sensible
that this process should go into reverse, even if the contraction has been painful. A more realistic pricing of risk should,
in principle, still leave plenty of opportunities for good companies and households to borrow. The worry is,
however, that even such healthy lending has been choked off, and that the process of adjustment to more-prudent lending is
happening so rapidly and brutally that it is causing severe economic contraction and much harm to good as well as to high-risk
borrowers.

Several events reinforced the pessimistic view that the process of deleveraging from excessive debt was so painful and difficult
that it could no longer be left to the financial markets to sort it out. On Friday, 14 March 2008, the Federal Reserve, with
the support of the federal government, rescued Bear Stearns from bankruptcy. Bear Stearns, as a broker-dealer, had seriously
over-extended itself in risky securitized markets and was on the brink of collapse. The judgement was made that its collapse
would have widespread systemic impact, dragging down other institutions. In particular, Bear Stearns was counter-party to
a staggering $10 trillion of swaps through its derivatives activities. Were these claims to escalate from the hypothetical
to the actual there would have been a further draining of liquidity and large balance-sheet losses, threatening insolvency
to institutions holding the now devalued paper. The Fed acted as ‘lender of last resort’. This was the first time that an
investment bank had been treated in this way, reflecting the fact that investment banks are no longer specialist, niche institutions
but have become integral to the financial system. Bear Stearns’s shareholders were hit badly during the rescue operation,
but salvaged $1 billion, a tenth of the bank’s value prior to the collapse. Taxpayers assumed responsibility in the form of
a $29 billion credit line to support a bundle of (the worst) mortgage assets, enabling a takeover of Bear Stearns by J P Morgan
Chase to go ahead at a knock-down price.

Problems followed elsewhere on an almost daily basis. Two large US banks, Washington Mutual and Wachovia, sacked their top
management as reports spread that they were in difficulties. Another class of institutions – the ‘monolines’, which give insurance
for credit – were in difficulties, as MBIA and Ambac had their ratings downgraded. The intervention to rescue Bear Stearns
had
initially reduced the perceived risk of credit default of major banks and therefore the risk of insuring against default.
But subsequently the cost of insurance rose again sharply, hitting the monolines. The problems of the insurers fed into Freddie
Mac and Fannie Mae, which relied on a healthy insurance industry to cover their own losses.

Then, on 7 July 2008, it was reported that Fannie Mae and Freddie Mac would have to raise an extra $75 billion to cover losses
on their sub-prime-backed securities and dodgier loans. Shares in the two companies fell heavily as doubts spread as to who
would cover these losses, and how. Since the companies were highly leveraged with vast debt and little equity, there was little
reserve capital within the institutions themselves. These institutions mattered enormously, since, following the impact of
the credit crunch on the banks, they were almost the only bodies providing credit to the US mortgage market, where they already
provided most of the mortgage finance to middle-class Americans, albeit at a subsidy. Their debts were also massive: $5.3
trillion in debt and credit obligations, equivalent to the entire publicly held debt of the US government. This fitted the
description of ‘too big to fail’.

The federal government therefore decided that it had no alternative but to support the beleaguered companies, and offered
what amounted to unlimited loans. The government provided an explicit guarantee instead of an implicit one, worth between
$122 and $182 billion on one estimate. Then, on 11 July, another substantial bank, Indy Mac Bankcorp, had its assets taken
over by the bank regulator when its depositors panicked and started queuing for cash. Two weeks later, two regional banks,
from Nevada and California, were taken over.

A downward spiral, or ‘toxic loop’, was setting in. Anxiety about the banks meant that their costs for borrowing became higher
than for non-financial companies, making bank lending unprofitable. Then, banks were obliged to take back on to their balance
sheets previous securitizations from insurance companies and pension funds, some with big losses. Furthermore, as they tried
to raise capital in order to meet their reserve requirements, they were forced to sell assets, thus driving down their prices,
especially as it became difficult to raise more capital from shareholders, who had become thoroughly scared. And as the economic
downturn intensified, with more defaults in mortgages, there were more losses and more pain, and confidence ebbed further.
In the quarter to the end of June 2008, US bank loans were contracting at an annual rate of 8 per cent. A similar process
was taking place in the UK.

These events were, however, merely the eddies that preceded the eye of the storm that hit Wall Street in the second week of
September. The explicit guarantees to Fannie Mae and Freddie Mac proved inadequate to prevent a loss of confidence, reflected
in collapsing share values. The two institutions, which provide 80 per cent of US mortgages, were deemed too big to fail and
were nationalized. The US state formally acquired institutions with assets of $1.8 trillion, wiping out their shareholders.
Nationalization formalized de facto state control. This was a striking event for an administration with an evangelical belief
in private-enterprise capitalism.

Then there was a collapse of confidence in Lehman Brothers, a venerable 158-year-old institution and the fourth-largest investment
bank in the USA. The US administration made the crucial decision to let it go bankrupt and not to help Barclays take it over
as a going concern. After rescuing Bear Stearns several months earlier, the decision was a carefully – if rapidly – calculated
gamble that the bank was insolvent and not merely illiquid, and that the failure of the bank would not result in widespread
systemic failure. The risk was a big one, since Lehman’s had a major role as counter-party in the credit derivatives market,
and critics have argued ever since that it should have been rescued (or nationalized). After the powerful signal that the
government would not automatically bail out investment banks, Merrill Lynch, which
was also in trouble, sold out to the Bank of America for $50 billion, a tiny fraction of its pre-crisis value.

An even more dramatic intervention led to the state take over of the world’s largest insurer, AIG, with an $85 billion loan.
A small section of AIG had, independently, and perhaps without the knowledge of the insurance managers, succeeded in taking
on $450 billion of credit default swaps. Had the company been allowed to collapse, it would not only have dragged down large
chunks of the global insurance markets – grounding a high proportion of the world’s commercial aircraft – but would have had
a massive impact on banks and investment funds. Nationalization was seen as a lesser evil than letting AIG collapse.

It soon became clear that financial markets were in a state of blind, uncontrolled panic. Contagion could be seen in many
areas: a collapse in bank shares, allegedly fuelled by short-selling (that is, speculation by means of selling borrowed shares);
a leap in the cost of insuring against bank default; and the growing cost of borrowing because of an increase in the cost
of banks lending to one another. There was a flight to safe assets, notably government bonds, reflected in negative interest
rates on US Treasury Bills (that is, investors were willing to lose money on lending to the government rather than lend to
commercial money markets or banks). The panic was spreading well beyond the USA. In the UK, Bradford & Bingley collapsed and
was nationalized. Halifax–Bank of Scotland (HBOS) was heading the same way, had Lloyds TSB not launched a $22 billion takeover,
encouraged by the British government.

The crisis was reaching a critical stage. The situation was deteriorating by the day and was approaching the point at which
investors were no longer willing to trust banks overnight. At this point the whole financial system was close to total collapse
– leading, potentially, to an economy dependent on barter. The Governor of the Bank of England has said that the UK was literally
24 hours from such a collapse. In previous generations that crisis point would have led to a run on the banks by depositors;
but, apart from a nervy weekend when Ireland offered all its depositors unconditional guarantees, there was a common-sense
understanding (helped by earlier interventions, such as the nationalization of Northern Rock in the UK and AIG in the USA)
that, whatever happened, depositors would be protected. It was clear, though, that piecemeal action was no longer enough and
that a comprehensive, and coordinated, approach was required.