by Adam Tooze
Chapter 3
TRANSATLANTIC FINANCE
Americans liked to think of their problems as American and outsiders were only too happy to concur. As the mortgage meltdown spread like a lethal virus across urban America in 2007–2008, European commentators took up the narrative of an American national crisis. “Feral” financial capitalism, like the Iraq war and climate change denial, was part of a toxic Anglo-American variant on modernity.1 When the storm broke in 2008, the Schadenfreude among European politicians was palpable. The polite phrases at the UN only scratched the surface. On September 16, 2008, as Wall Street unraveled, Peer Steinbrück, Germany’s tough-talking SPD finance minister, went before the Bundestag to announce that the global financial system faced a crisis originating in America from which Germany had so far been spared. “America’s laissez-faire ideology,” as practiced during the subprime crisis, “was as simplistic as it was dangerous,” he later told Germany’s parliamentarians. He confidently expected that America would soon forfeit its role as financial superpower.2 French president Sarkozy chirped along with him. Just returned from New York on September 25, Sarkozy, who had formerly been regarded as a true disciple of Atlantic capitalism, told a crowd in Toulon that “the idea that the markets were always right was mad . . . laissez-faire is finished. The all-powerful market that always knows best is finished.”3 And just in case anyone wondered where the home of that mad idea was, Giulio Tremonti, Silvio Berlusconi’s outspoken finance minister, boasted that Italy’s banking system would be fine because “it did not speak English.”4 It was convenient, but it was a self-deception. America’s securitized mortgage system had been designed from the outset to suck foreign capital into US financial markets and foreign banks had not been slow to see the opportunity.
I
Since the 1980s Americans had grown used to the idea that Asians—first the Japanese, now the Chinese—owned their government debt. That was the anxiety that haunted the Hamilton Project. What they did not reckon with was that foreigners owned a large portion of America’s houses. By 2008 roughly a quarter of all securitized mortgages were held by foreign investors. Fannie Mae and Freddie Mac funded $1.7 trillion of their portfolio of $5.4 trillion in mortgage-backed securities by selling securities to foreigners. China was by far the biggest foreign investor in these “Agency bonds,” with holdings estimated at $500–600 billion.5 But in the riskier segment of the securitized mortgage business it was Europeans, not Asians, who led the way.6
For nonconforming high-risk MBS, those not backed by Fannie Mae or Freddie Mac, the share held by European investors was in the order of 29 percent.7 In 2006, at the height of the US mortgage securitization boom, a third of newly issued private label MBS were backed by British or European banks.8 The segment of the securitization chain in which European banks were of truly crucial importance was also the weakest link in the chain, ABCP. In the summer of 2007, though it was Citigroup that had the largest off balance sheet SIV exposure, it was European banks that dominated the market. Overall, two thirds of the commercial paper issued had European sponsors, including 57 percent of the dollar-denominated commercial paper. Europe’s banks had good standing with the ratings agencies, but they did not have large dollar-denominated depositor bases. If they wanted to get in on the MBS boom, they needed to go to the wholesale market.
Among the European sponsors, German financial institutions were particularly prominent, and what was remarkable was the kind of German bank that was involved. Germany’s giant, Deutsche Bank, was a leading player on Wall Street. It is not for nothing that it featured as prominently as it did in Michael Lewis’s bestselling narrative of the crisis, The Big Short, or in the subsequent Senate investigation.9 Dresdner Bank, Germany’s number two, was also heavily involved in the United States. But it was Germany’s smaller regional banks, the Landesbanken, that threw themselves head over heels into the American adventure. In the early 2000s, at the insistence of Brussels, the Landesbanken were stripped of the local state guarantees that lowered their funding costs. They responded by taking a punt on adventurous financial engineering. Banks from the former industrial heartland of Germany, such as Sachsen-Finanzgruppe, WestLB and IKB of Düsseldorf, took huge gambles on real estate investments in the United States. At least four German sponsors—Sachsen, WestLB, IKB and Dresdner—had ABCP exposure large enough to wipe out their equity capital several times over.
ABCP Sponsor Location and Funding Currency (in $ millions)
Currency / Sponsor location
US dollars
Euro
Yen
Other
Total
Belgium
30,473
4,729
0
0
35,202
Denmark
1,796
0
0
0
1,796
France
51,237
23,670
228
557
75,692
Germany
139,068
62,885
0
2,566
204,519
Italy
1,365
0
0
0
1,365
Japan
18,107
0
22,713
0
40,820
Netherlands
56,790
65,859
0
3,116
125,765
Sweden
1,719
0
0
0
1,719
Switzerland
13,082
0
0
0
13,082
United Kingdom
92,842
62,298
0
3,209
158,349
United States
302,054
0
0
2,996
305,050
Total
714,871
219,441
22,941
12,444
969,697
Source: Viral V. Acharya and Philipp Sc
hnabl, “Do Global Banks Spread Global Imbalances? Asset-Backed Commercial Paper During the Financial Crisis of 2007–09,” IMF Economic Review 58, no. 1 (2010): 37–73, figure 15. Based on data from Moody’s.
Nor did European banks confine themselves to dealing in the securities. The Europeans went native, joining their American counterparts in integrating down the supply chain so as to control mortgage origination itself. After all, if a Wall Street investment bank could do it, why not a European bank with some experience in retail banking? From the mid-1990s banks like Britain’s HSBC aggressively bought into the American mortgage market. By 2005 HSBC could boast of having serviced 450,000 mortgages to a total value of $70 billion.10 Credit Suisse built an American mortgage-servicing department that fed one of the largest ABS CDO operations of the early 2000s.11 Deutsche Bank had close relationships with the giant mortgage-generating machines at Countrywide and AmeriQuest. In 2006 the German bank bought the subprime specialists MortgageIT Holdings and Chapel Funding LLC. As a Deutsche Bank press release glowed, ownership of these operations at the bottom of the US credit pyramid would “provide significant competitive advantages, such as access to a steady source of product for distribution into the mortgage capital markets.”12 From the point of view of generating high-yielding CDOs, it was precisely the bottom of the mortgage barrel that was most attractive.
II
How was this possible? It was easy enough to understand how China acquired claims on the United States. It had a gigantic trade surplus, the dollar proceeds of which were bought up by its financial authorities and invested in US Treasurys, giving rise to Larry Summers’s scenario of a “balance of financial terror.” But among those who worried about global macroeconomic imbalances, Europe was rarely mentioned. The EU current account surplus with the United States was modest compared with that of China. With the world as a whole, Europe’s current account was in modest deficit. The Europeans did not peg their currencies against the dollar. There was no agency in Brussels accumulating foreign assets as part of a currency stabilization effort, no German sovereign wealth funds. So how did European banks end up owning such a large slice of American mortgage debt?
The answer is that European banks operated just like their adventurous American counterparts. They borrowed dollars to lend dollars. And the scale of this activity is revealed if we look not at the net flow of capital in and out of the United States (inflows minus outflows), which has its counterpart in the trade deficit or surplus, but at the gross flows, which record how many assets were bought and sold in each direction. As the gross inflow data show, by far the largest purchasers of US assets, by far the largest foreign lenders to the United States prior to the crisis, were not Asian but European. Indeed, in 2007, roughly twice as much money flowed from the UK to the United States as from China.
Gross Capital Flows to the US by Region (% US GDB)
Source: Claudio Borio and Piti Disyatat, “Global Imbalances and the Financial Crisis: Link or No Link?,” BIS Working Paper 346 (2011), graph 6.
Before 2008 the net financial flow from Asia to the United States could reasonably be construed as the financial counterpart to America’s trade deficit with Asia. By contrast, the financial flows between Europe and the United States made up a financial circulatory system quite independent of the trade connections between the two. Across the Pacific, from Asia to the United States, money flowed one way. In the North Atlantic financial system it flowed both ways, both in and out of the United States. This was in the logic of the market-based banking model. Europe’s banks did not have branches spread across the United States. But a Wall Street firm like Lehman didn’t either. This was the beauty of the market-based model of banking. You borrowed the dollars on Wall Street to fund your holdings of mortgages from all over the United States.
The ABCP market was a showcase for this transatlantic system. The ABCP conduits organized bundles of securitized assets from the United States and Europe.13 With those securities as collateral they then issued short-term commercial paper, which was bought by the managers of cash pools in the United States. In 2008, $1 trillion, or half of the prime nongovernment money market funds in the United States, were invested in the debt and commercial paper of European banks and their vehicles.14 A large portion of this simply moved from one office on Wall Street to another, with one address being adorned with the name of a European bank. But hundreds of billions of dollars took a more circuitous route. They flowed out of the United States from the branches of foreign banks in New York to the head offices of European banks, from which they returned for investment in the United States, sometimes by way of an offshore tax haven such as Dublin or the Cayman Islands.15 It was the spinning motion of this transatlantic financial axis that impelled the surge in financial globalization in the early twenty-first century.
In managing these flows, the multicurrency balance sheets of European banks played a crucial role. To understand the nature of these flows, take the example of a German bank keen to participate in the lucrative American mortgage business. The bank did not have an existing depositor base in dollars. Its existing liabilities—deposits, bonds issued and short-term borrowing—were in euros. This meant that the German bank had a funding problem if it wanted to lend in dollars. But in that respect it was no different from a Wall Street investment bank. To participate in the profitable American securitization wave, European banks exchanged part of their euro funding for dollars (option 1), holding a long dollar position or hedging by way of swap agreements (option 2). Or the German bank could borrow directly in the United States (option 3), for instance from an American money market fund eager to earn slightly more than the returns offered by Treasurys, now that the Chinese were buying them. The result would be a German bank with a balance sheet that featured liabilities and assets of different maturities and denominated in a variety of currencies. And its counterparts would include a bank or other business that had lent dollars in exchange for euros (if it had chosen funding options 1 or 2), or an American money market fund holding dollar-denominated debt issued by a German bank (option 3). In the national balance of payments statistics one would see both borrowing from and lending to America happening within the accounts of the same bank. One could net the flows out to identify how much, on balance, flowed one way rather than the other, but that would give no idea of the scale of the commitments on each side. It would be akin to noting that two elephants on either end of a circus seesaw leave a net balance of zero. It would be true, but it would not be a very adequate description of the forces in play.
Financial Globaliszation Revolves Around Europe: Cross-Border Bank Claims (in $ billions)
Note: The thickness of the arrows indicates the size of the outstanding stock of claims. The direction of the arrows indicates the direction of the claims: Arrows directed from region A to region B indicate lending from banks located in region A to borrowers located in region B.
Source: Stefan Avdjiev, Robert N. McCauley and Hyun Song Shin, “Breaking Free of the Triple Coincidence in International Finance,” Economic Policy 31, no. 87 (2016): 409–451, graph 6.
The rise of China dominated contemporary perceptions of early twenty-first-century globalization. And the axis of imbalance that attracted most attention was that between China and the United States. Worries about geopolitics, Larry Summers’s balance of financial terror, Ben Bernanke’s savings glut, all pointed the finger in that direction. But if we map not annual flows but cross-border banking claims, this gives further proof of how one-sided the Sino-American view of the buildup to the crisis was. The central axis of world finance was not Asian-American but Euro-American. Indeed, of the six most significant pairwise linkages in the network of cross-border bank claims, five involved Europe.
European banking claims on the United States were the largest link in the system, followed by Asian claims on Europe and American claims on Europe. European claims on Asia exceeded the much commented u
pon Asian-American connections. Indeed, West European claims on emerging Eastern Europe alone were more than three times the size of American claims on Asia. It was also noticeable that oil- and gas-rich Middle Eastern investors preferred to channel their funds through Europe rather than directly to the United States. This was a pattern already established in the 1970s and only reinforced by the aggressive politics of Bush’s “War on Terror.” The European financial centers offered a safe channel through which funds from Asia and the Middle East were then sluiced into more speculative investments in the United States. It was not for nothing that China preferred to channel many of its claims on the United States through Belgium. In the process, the European financial system came to function, in the words of Fed analysts, as a “global hedge fund,” borrowing short and lending long.16