by Adam Tooze
AIG’s troubles did not end there. It had made life much harder for itself by engaging in the securities lending business. A group within AIG specialized in pooling the high-quality Treasurys and other securities held by AIG’s insurance funds. It lent those assets to other investors in exchange for cash, a trade akin to a repo. AIG’s securities-lending business then looked to maximize returns by investing the cash it received from the securities loan in higher-yielding but more risky mortgage-backed securities. Perversely, the securities lending office of AIG began to take those risky bets in 2005 precisely at the moment that AIG’s own Financial Products division decided it was too risky to continue writing CDS on mortgage-backed securities. By the summer of 2007, AIG’s securities lending program had $45 billion invested in high-yield private label MBS. As the securitization business collapsed, those assets became virtually unsalable, leaving AIG scrambling to find funds with which to repay the securities borrowers who now wanted their cash back. In search of profit, a cash-rich insurance company sitting on a giant portfolio of high-quality securities had turned itself into a dangerously leveraged shadow bank with a serious maturity mismatch. And to make matters worse, it was dealing with some of the most heavy-hitting players in global finance.
Taking the lead in making collateral calls against AIG was Goldman Sachs.23 It was one of the sharpest operators in the market. But it was also an investment bank with no FDIC-insured deposit base. Like Bear, Lehman and Merrill, Goldman was acutely vulnerable to a loss of confidence. One of the plays that would see Goldman through the crisis was the big short position it had built, betting against mortgage-backed securities. A big piece of that bet was placed by buying CDS from AIG. Already by June 30, 2008, Goldman had called $7.5 billion in collateral. When AIG was downgraded on September 15, there was a new surge in margin calls. Of the total claim against AIG, which now topped $32 billion, Goldman Sachs and its partner Société Générale accounted for $19.8 billion.24 For AIG the consequences were drastic. It was scrambling for cash at the worst possible moment. With its rating on the downgrade it could not borrow tens of billions through ordinary channels. It could raise the funds only through fire sales, and that meant recognizing the losses on its balance sheet, which would make its position only even more precarious. By the morning of September 16, AIG was hours away from default.
With ABCP, repo and CDS having gone into crisis, the next link to snap in the shadow banking chain was the money market funds. On September 10, ahead of the Lehman failure, MMF collectively administered $3.58 trillion in savings and cash resources for individuals, pension funds and other investors.25 An essential part of their appeal was that while they offered better returns than ordinary savings accounts, they also promised that the principal invested was safe. They would return a dollar on the dollar whatever happened. The day after Lehman, on September 16, that illusion burst. The Reserve Primary Fund, one of the oldest and most respected in the business, with more than $62 billion under management, alerted the Fed that it was about to “break the buck.” It could no longer guarantee a payout of one dollar for every dollar invested. In August 2007 the Reserve Primary Fund had been under intense competitive pressure. To improve its yield and attract more investors it had committed 60 percent of its funds to buying ABCP just as other investors pulled out.26 The high yields on offer from desperate borrowers catapulted the fund from the bottom 20 percent to the top 10 percent in the performance league and doubled its assets under management in a single year. But it also exposed its investors to serious risks. In general its managers picked well. But 1.2 percent of its funds were invested in high-yielding Lehman ABCP, and by September those had plunged in value. The eventual losses at Reserve Primary were tiny. By 2014 the fund would pay out 99.1 cents on the dollar, but in the days following September 15, with investors no longer certain that they would get full reimbursement, half a trillion dollars fled out of exposed mutual funds looking for the safety of US Treasurys.27
The events of September 2008 brought the spectacular contraction of wholesale funding markets that had begun in August 2007 to crisis point. An index of haircuts on lower-quality collateral used in the biparty repo market surged from the elevated level of 25 percent it had reached over the summer of 2008 to 45 percent.28 This had the effect of doubling the amount of money an investment bank would have to mobilize to hold anything other than top-quality securities on its books. Even at Goldman Sachs, the strongest of the stand-alone investment banks, its vital liquidity reserve, which it had pumped from $60 billion in 2007 to $113 billion by the third quarter of 2008, plunged on September 18 to a nominal total of $66 billion.29 If that slide continued, the game would soon be up.
Meanwhile, the run for safety contracted balance sheets, which had the effect of withdrawing credit from the rest of the system. Loans by banks, investment banks, hedge funds and mutual funds to big businesses in the United States—so-called syndicated loans—fell from $702 billion in the second quarter of 2007 to as little as $150 billion in the fourth quarter of 2008. Interest rates demanded from high-yield, high-risk corporate borrowers surged to 23 percent, shutting out all but the most desperate borrowers.30 This put a huge squeeze on all business activities. At the same time, corporations that were finding it hard to gain credit elsewhere increased the draw down on their existing credit lines, putting further pressure on the banks.31
As money market mutual funds, repo, ABCP and AIG’s credit default swaps all came into question, the shock waves spread far beyond the United States. Among the investments most favored by the money market funds were European bank debts. They were a key source of dollar funding for the European megabanks.32 With the mutual funds pulling back, how were the European banks to fund their large books of dollar assets? With interbank lending shutting down, the European banks resorted to a variety of roundabout mechanisms to obtain dollar funding. A measure of their desperation was the price that they were willing to pay to borrow in euro, sterling, yen, Swiss francs and Australian dollars, and then to swap those loans into dollars. Normally, since these were close to risk-free transactions, the premium was zero. As dollar funding shut down, it soared to 2–3 percent. Applied to balance sheets running into the trillions of dollars, that spread was enough to threaten an avalanche. If the Europeans couldn’t fund their dollar portfolios at affordable rates, they would be forced to sell. But as the Paribas announcement had made clear already in August 2007, there simply was no market for assets, which once had been valued at hundreds of billions of dollars. On Tuesday, September 16, 2008, the day after Lehman, Europe’s funding issues were judged to be so serious that they were first order of business for the Fed’s Open Market Committee meeting, even before Bernanke and his colleagues turned to the problems of AIG.33
Nor was it just the Fed that was preparing for the end of the world. By conference call early in the morning on Saturday, September 13, Jamie Dimon of J.P. Morgan commanded his astonished senior staff to prepare for Armageddon. While J.P. Morgan would retreat to the safety of its legendary “fortress balance sheet,” they should brace for the bankruptcy of every investment bank on Wall Street, not just Lehman, but Merrill Lynch, Morgan Stanley and Goldman too.34 Meanwhile, on the other side of the Atlantic, the impact of the funding crisis on a string of big European lenders was devastating. HBOS and RBS in Britain, Fortis and Dexia in the Benelux, Hypo Real Estate in Munich, Anglo Irish Bank, UBS, Credit Suisse and dozens of others all faced failure. Given that there weren’t any deposits, no one needed to run. You just stopped transacting in money markets and pulled in your horns. The result of the collective flight to safety, not by households but by the largest actors in the global financial system, was a trillion-dollar disaster.
II
Beyond Manhattan and the City of London, the economic news was devastating. Real business activity was collapsing on both sides of the Atlantic. In Europe no less than in the United States it was the crisis of 2008, not the later eurozone debacle, that marked the decisive b
reak in investment, consumption and unemployment. From the second half of 2007, as banks great and small in Germany, France, Britain, Switzerland, and the Benelux began to acknowledge the scale of their losses, lending collapsed. The banking sector felt the pressure first because it was most dependent on the daily churn of vast volumes of credit. But soon the crunch extended to nonfinancial corporations and households too. In the eurozone, after running at between 10 and 15 percent, growth in new lending plummeted to zero. It wasn’t the sovereign debt crisis of 2010 that halted Europe’s growth, it was the transatlantic banking crisis of 2008.
Lending In Eurozone to Households and Businesses Other Than Banks, Year-on-Year Growth (%)
Source: http://macro-man.blogspot.co.uk/2016/06/a-broad-scan.html.
As new mortgage borrowing contracted, the slide in the housing market accelerated. Falling house prices and collapsing financial markets slashed personal wealth. In Spain net wealth per person fell by at least 10 percent between 2007 and 2009. Within five years personal wealth would plunge by 28 percent, or 1.4 trillion euros, more than a year’s worth of output.35 In the UK, as the stock market and house prices slumped, household wealth losses in 2008–2009 were estimated by the IMF at $1.5 trillion—50 percent of GDP in a matter of twelve months. Ten percent of home owners found themselves mired in negative equity.36 In Ireland, house prices, having quadrupled between 1994 and 2007, halved between 2008 and 2012, taking household wealth with them.37 These were severe shocks, but for sheer scale the US crisis trumped them all. An early IMF estimate in the summer of 2009 put US household wealth losses at $11 trillion.38 By 2012 the US Treasury would raise that to $19.2 trillion.39 Independent estimates put the figure closer to $21–22 trillion—$7 trillion from real estate, $11 trillion in the stock market and $3.4–4 trillion in retirement savings.40 From their peak in 2006, by 2009 US house prices had fallen by a third. At the worst point in the crisis, 10 percent of home loans across the United States would be seriously in arrears and 4.5 percent of all mortgages crashed into foreclosure. More than 9 million families would lose their homes. Millions more suffered years of anxiety as they struggled to make payments on homes that were no longer worth the mortgages secured on them. At the worst point in the crisis more than a quarter of US homes had negative equity.41
And the pain was compounded by the distribution of losses between wealthier and poorer households. Between 2007 and 2010 the mean wealth of American households fell from $563,000 to $463,000. But those figures are elevated by the huge fortunes of the very wealthy. If we look instead at the median household—the household that sits at the 50 percent mark in the wealth distribution—it saw its net worth halved from $107,000 to $57,800.42 And as bad as these figures are, the experience of America’s minority populations was worse. The median wealth of the Hispanic population, which had participated particularly actively in the housing boom, plunged by 86.3 percent between 2007 and 2010.43 The median African American household saw virtually its entire housing wealth wiped out, and African American home owners were twice as likely to suffer foreclosure as white borrowers.44 It did not produce the memorable imagery of the 1930s Dust Bowl, but the housing crisis that began in 2007 forced the largest mass movement of people in the United States since the Great Depression. And as minority home ownership collapsed, the result was resegregation along racial lines.45
With households suffering, in America’s economic downswing of 2008 it was consumption that led the way.46 As demand fell, so did production and employment. In the Central Valley in California, which witnessed a collapse of 50 percent in home values, consumption was cut by 30 percent.47 Every kind of expenditure that could be postponed was cut back. For America’s long-ailing motor vehicle industry it was the coup de grâce. Car and light vehicle sales plunged from an annual rate of 16 million units in 2007 to as few as 9 million per annum in 2009. By December 2008 it was clear that both Chrysler and General Motors would fail. In the early twenty-first century GM was no longer the national totem that it had once been. Its total worldwide employment in 2007 was 266,000, compared with a peak of 853,000 in 1979. But as 2008 began it was still the largest car company in the world. GM paid $476 million in salaries each month as well as the health-care and pension benefits for 493,000 retired workers. Its production operations generated $50 billion in orders for parts and services supplied by 11,500 vendors.48 In total, industry lobbyists claimed that c. 4.5 percent of all US jobs were supported by the auto industry, paying more than $500 billion annually in wages and generating more than $70 billion in tax revenues.49 On November 7, 2008, GM declared that, barring government aid, it would face insolvency by the summer of 2009.
The imminent failure of GM and Chrysler was an exclamation point on the long-running decline of the American auto industry. One version of the American Dream was dying. But Detroit’s crisis sent shock waves around the world. The future of GM’s long-established UK and German divisions, Vauxhall and Opel, was in doubt.50 So too were Detroit’s operations in Mexico. Under the NAFTA free trade system, interconnected production systems, known as value chains, had been stretched from one end of North America to the other. As a result, Mexico’s dependence on the United States was overwhelming. In 2007, 80 percent of Mexico’s exports were sent to the United States. As the American crisis hit, Mexico’s GDP fell by almost 7 percent, a worse contraction even than during the homegrown financial crisis of 1995—the so-called Tequila Crisis.51 Mexico’s nonoil exports fell by 28 percent between May 2008 and May 2009. Automotive exports fell by 50 percent.52 In the northern industrial cities of Ciudad Juárez and Tijuana, the great maquiladora export processing centers, employment in manufacturing fell by more than 20 percent. Together with the surging violence of the drug wars, the recession led more than 100,000 desperate workers and their families to abandon Juárez. As unemployment surged north of the border, remittances dried up and hundreds of thousands of migrants returned home, making the situation of the poorest Mexicans progressively more desperate. Meanwhile, the inflow of new foreign investment in Mexico halved and the peso plunged in value from 11 to 15 to the dollar, driving up the cost of living.
Nor was the pain confined to North America. For decades GM’s great global rival was Toyota, and 2008 would be the year in which Toyota claimed the title of the world’s leading car producer. It paid a heavy price. In 2009 Japan was rocked by a “Toyota shock” as its national champion reported its first loss in seventy years and cut global production by 22 percent.53 From a profit of $28 billion in 2007–2008, Toyota slid to a loss of $1.7 billion in 2008–2009. In the words of its president, Katsuaki Watanabe, “The change in the world economy is of a magnitude that comes once every hundred years. . . . We are facing an unprecedented emergency.”54 As inventories of unsold cars piled up in the United States and Europe, Japanese car exports fell by two-thirds.55 Japan’s investment industries stopped in their tracks. Hitachi, the giant producer of capital goods and electronics, was worst hit, facing a record loss for a Japanese industrial company of $7.87 billion.56 Consumer electronics icon Sony announced a loss of $2.6 billion. Toshiba expected to lose $2.8 billion, Panasonic $3.8 billion.57 All in all, in January 2009 Japan’s economy contracted at a rate of 20 percent per annum and exports by 50 percent year on year.58 The largest part of this was accounted for by a fall in exports to the United States, followed by Japan’s immediate Asian neighbors, China, Taiwan and Korea, all of which were plunged into recession.
As the shock of 2008 revealed, with supply chains synchronized to perfection, “factory Asia” responded within a matter of weeks to any hesitation of demand in Europe and America. Nor were they the only ones to be hit. Germany suffered a 34 percent fall in exports between the second quarter of 2008 and 2009, with its machinery and transport equipment sector taking a deep dive. It was the most severe economic shock suffered by the Federal Republic since its foundation in 1949. As one bank economist remarked: “One has to go back to the 1930s during the Great Depre
ssion to find comparably horrible figures.”59 Meanwhile, emerging markets were hit too. Turkey, which had joined the club of rapidly growing economies after its financial stabilization in 2004, suffered a sudden and jarring stop. By the first quarter of 2009, Turkey’s GDP was falling by 14.7 percent on an annualized basis. Unemployment rocketed from 8.6 percent in the summer of 2008 to 14.6 percent in the first winter of the crisis. It was the worst affected of any of the emerging markets outside Eastern Europe. Turkey had not seen a situation so bad as this since the disastrous financial crisis of 2001.60 Istanbul’s stock market plunged by 54 percent between December 2007 and November 2008.61
What made the collapse of 2008 so severe was its extraordinary global synchronization. Of the 104 countries for which the World Trade Organization collects data, every single one experienced a fall in both imports and exports between the second half of 2008 and the first half of 2009. Every country and every type of traded goods, without exception, experienced a decline.62
If in manufacturing the downturn was in the volume of trade—the number of cars shipped or the number of cell phones exported—in commodities the shock was to prices. In the worst six months of 2008, oil prices fell by more than 76 percent. That in turn wreaked havoc with the budgets of the petrostates. Saudi Arabia swung from a budget surplus of 23 percent of GDP in 2008 to a substantial deficit.63 Kuwait was rocked by the crisis at Gulf Bank, which faced losses on currency trades.64 But nowhere was worse affected than the boomtown of Dubai. Driven by surging commodity prices, heavily backed by international banks such as RBS and Standard Chartered, Dubai’s real estate sector had become the center of a global construction frenzy.65 By 2008 the city bristled with construction cranes. Its palatial malls boasted floor space four times the per capita level in the United States. In the autumn of 2008 the bubble burst. New credit was slashed. By February 2009 Dubai’s rip-roaring six-year construction boom had come to a halt. Half of a portfolio of $1.1 trillion in construction projects being undertaken in the Gulf Cooperation Council was canceled in a matter of months. Luxury cars were abandoned in droves as Western contract workers scuttled to the airport to escape debtor’s prison. An airlift of charter flights repatriated tens of thousands of migrant guest workers to India.66