Figure 3.1 US and UK total government expenditure, 1970–2008
Source: OECD (2011).
Understanding the crisis
The concurring and dissenting opinions of the US Financial Crisis Inquiry Commission (FCIC) illustrate that there is little consensus on the causes of the crisis (see FCIC, 2011). The following analysis focuses predominantly on the US, the epicenter of the meltdown. On one level this is all very simple: asset market crises are common in capitalist economies and in 2008 the US housing market bubble burst (Reinhart and Rogoff, 2009). Yet the near collapse of the international financial system and the deepest recession since the Great Depression is well beyond common. Why was this crisis so much worse? How did the collapse in house prices in the US lead to an international financial crisis? Finally, were the sources of the crisis the same in the UK as in the US?
Macro-economic conditions created the conditions for a crisis, specifically the expansionary monetary policies of Federal Reserve Chairman Alan Greenspan and his successor Ben Bernanke. To keep the economy growing after the dot.com bust and 9/11, the Federal Reserve kept interest rates low: 2001–04 was the longest sustained expansionary monetary policy since the early 1950s (Gjerstad and Smith, 2009, p. 277). The federal funds rate fell from just under 6 percent in 2001 to 1 percent by mid 2003, not rising again for another year. The widely used ‘Taylor Rule’1 suggested that rates should have ascended starting in 2001 (Taylor, 2009, pp. 2–3). The steady flow of easy money encouraged institutions and individuals to take on riskier credit, including subprime mortgages, and fed the housing bubble. The Case-Schiller National House Price Index doubled from 2000 to its peak in the second quarter of 2006. Yet the Fed did not see the danger early enough. Greenspan expressed concern about house prices in mid 2005, but suggested it was ‘froth’ in the market rather than a bubble (New York Times (online edition), 21 May 2005), a position reinforced by Bernanke later that year (Posner, 2009, p. 90). Even in August 2007, the Federal Reserve’s Open Market Committee, responsible for setting interest rates, expressed greater concern with economic overheating and inflation than a collapse in asset prices (ibid., p. 121).
Nor was the regulatory structure attuned to identify systemic problems. Both the UK and the US systematically deregulated financial transactions, the ‘Big Bang’ deregulation of the City in 1986 and the repeal of Glass-Steagall in 1999 under President Clinton (which separated commercial and investment banking) being the major milestones along the way. On both sides of the Atlantic policy-makers believed innovation and growth were nurtured through minimal regulation. Nor was this only a right-wing policy. New Labour bragged of their ‘light touch’ regulation of the City, whose place as an international financial center was a pillar of economic policy. Gordon Brown claimed the era of boom and bust was over because of the sophistication and flexibility of finance (Gamble, 2009b, p. 454). Clinton’s Treasury Secretary Lawrence Summers, in agreement with Greenspan, spiked a plan to regulate credit default swaps in the late 1990s (Friedman, 2009, p. 158). The conventional wisdom was that ‘private regulation’ of financial markets was optimal (Greenspan, 1997). Financial firms pursuing imprudent strategies would be punished by the market, providing a warning to others. The speed of financial innovation, moreover, meant that regulators would always be ‘behind the market’. Markets were best left to correct themselves.
The organization of regulatory institutions exacerbated matters. The UK was governed under a ‘tripartite system’ wherein the Bank of England, the Financial Services Authority (FSA), and the Treasury were all responsible for financial stability. The FSA regulated individual banks while the Bank of England monitored the system as a whole, but communication and coordination between them was wanting. US regulation was even more divided:
The existence of multiple federal financial regulatory bodies – including the Federal Reserve, the Federal Deposit Insurance Corporation, the Securities Investor Protection Corporation, the Securities and Exchange Commission, the Commodity Futures Trading Commission, the Federal Housing Authority, the Federal Housing and Finance Administration, the Office of Housing Enterprise Oversight, the National Credit Union Administration, the Treasury Department and its agencies, such as the Comptroller of the Currency and the Office of Thrift Supervision – and fifty state banking and insurance commissioners – has led to a fragmentation of regulatory authority, a lack of coordination, turf wars, yawning regulatory gaps with respect to hedge funds, bank substitutes, and novel financial instruments, and an inability to aggregate and analyze information about emerging problems in financial markets. (Posner, 2009, pp. 289–90)
The most obvious failing in both systems is that no single entity had the responsibility, authority, or powers to monitor the system as a whole, spot destabilizing trends, and take preventive action in response (HM Treasury, 2010a, p. 4).
Financial deregulation is seen by many as the primary culprit in this crisis. Yet a note of caution is warranted. Firms unquestionably took on excessive risk without regulatory interference. Policy-makers had tools available to them, however, not the least of which was tightening monetary policy, to constrain market behavior if they chose to do so. They fully expected that markets would correct themselves, precluding any systemic crisis. Deregulatory ideology was thus more significant than the legal incidence of deregulation. Secondly, the impetus for bad behavior derived not only from the lack of regulation, but also from the perverse incentives created by (some) regulations.
Cheap credit and light touch regulation were necessary, but insufficient, conditions to produce an explosion in subprime lending. Further impetus came from the two government-sponsored enterprises (GSEs): Fannie Mae (formally the Federal National Mortgage Association, founded during the Great Depression) and Freddie Mac (Federal Home Loan Mortgage Corporation, created in 1970). Fannie and Freddie operated in the secondary mortgage market, buying mortgages from banks so as to encouraging more lending. The initial push for greater subprime lending came from the Community Reinvestment Act’s (CRA’s) (1977) goal of increasing affordable housing for poorer, often minority, homeowners. Following a Boston Federal Reserve Bank study on discrimination in mortgage lending, the Clinton Administration tightened the CRA so that banks would be evaluated on performance rather than the standards they used in lending. Extending loans to those otherwise unqualified for a standard (prime) mortgage meant reducing lending standards; hence ‘subprime loans’.2 Banks might have balked had not Fannie and Freddie loosened their underwriting standards to buy up these loans. Private sector actors looking to expand profits during an unprecedented housing boom pushed the growth of subprime lending, but their ability to do so was facilitated by the GSEs. By 2009, Fannie and Freddie had guaranteed $1.6 trillion in subprime and Alt-A3 loans, about 40 percent of all outstanding value (Wallison, 2009a, p. 370). Attempts were made during the Bush years to rein in the GSEs, but all were blocked in Congress, including by key Democrats who would later lead the charge on financial reform – Barney Frank (D-MA) and Chris Dodd (D-CT). That being said, government policies to boost homeownership, including the activities of the GSEs, received strong, bipartisan support for decades.
Asset bubbles popping, even the stock market crash of 1929, are not in themselves sufficient to engender systemic financial crisis (Friedman, 2009, p. 162). What transformed the housing collapse into a financial crisis was the securitization of subprime mortgages. Securitization is when assets are bundled into various types of financial instruments and sold to other actors; in this case, mortgage-backed securities (MBSs). Ironically, the rationale for securitization is to reduce risk through diversification. By bundling mortgages from different regions, you reduce the risk that a housing downturn in one area will wipe out your investment. Risk can be further reduced through credit default swaps (CDSs), a form of insurance transferring the risk of default to a third party for a premium (see Wallison, 2009b). Securitization decreases banks’ incentives to properly scrutinize loans, however, pursuing instead an ‘or
iginate and distribute’ strategy (Coates, 2010, p. 21). Big institutional investors should have been sufficiently savvy to avoid such a ‘sucker’s bet’. In reality, the major banks were heavily invested in subprime MBSs. Rather than diversifying risk, securitization served to concentrated it. Why did the proliferation of MBSs backfire so spectacularly?
This occurred, perversely, because of financial market regulations, specifically the capital-adequacy guidelines under the Basel Accords. With banks regulated nationally, the Bank of International Settlement’s Basel Committee on Banking Supervision’s job is to establish common guidelines across national regulatory structures. Under the Basel rules a bank was ‘well capitalized’ if it maintained 8 percent capital against assets (Jablecki and Machaj, 2009, p. 305). The rules also gave different risk weights to different classes of assets. Commercial loans received a 100 percent risk weight; government bonds were zero. Mortgages fell right in the middle at 50 percent. Securities issued by government-sponsored entities, including Fannie Mae and Freddie Mac, received a 20 percent risk weighting,4 as did asset-backed securities, including MBSs with an AAA or AA rating (Friedman, 2009, pp. 143–4). Shifting into MBSs meant decreasing capital minima and increasing profitable investment potential. Banks did not plunge into MBSs in order to diversify risk, they did so to make an end-run around capital adequacy requirements, increase their leverage and boost profits (Acharya and Richardson, 2009, p. 197). Bear Stearns’ borrowed to equity capital ratio was 35 to 1 before they collapsed; UBS’s was 50 to 1 (Posner, 2009, p. 221). Fannie Mae and Freddie Mac had a whopping 75 to 1 ratio in 2007 (FCIC, 2011, p. xx). Not all banks were so imprudent. JP Morgan, Capital One, and Wells Fargo, for example, did not get overly leveraged (Friedman, 2009, p. 153). Mortgage-backed securities were paying very favorable returns, so for many companies leveraging into MBSs made good business sense. Even when bankers recognized they were riding a housing bubble, competition created an incentive to stay with the crowd, hoping to jump at the right time. Citigroup’s CEO Charles Prince famously told the Financial Times in July 2007, ‘As long as the music is playing, you’ve got to get up and dance.’ That executives like Prince were handsomely compensated based on short-term profits rather than long-term solvency further encouraged this behavior.
Leveraging required highly rated (AAA or AA) securities. How did subprime MBSs, by definition high-risk investments, end up with AAA ratings? Partly it was the nature of the rating system. Beginning in the Depression era, banks are prohibited from investing in speculative securities (below a BBB rating), as determined by recognized rating manuals. Bankers had to rely on third-party risk assessment, whose pronouncements now attained the force of law. In 1975 the Securities and Exchange Commission (SEC) solidified this by declaring that securities firms could only use the ratings of ‘nationally recognized statistical rating organizations’. By the late 1990s this meant Moody’s, Standard & Poor’s, and Fitch, giving them a government sanctioned oligopoly over securities ratings (White, 2009, pp. 390–2). In addition, they operated an ‘issuer pays’ business model – the company for whom they issued the bond rating paid the fees. This created a conflict of interest; securities firms that did not like the rating of their bonds could take their business to one of the other three. Rather than serving as neutral arbiters of the quality of the securities, these firms worked with companies to reconfigure their offerings so that they could receive a favorable rating (White, 2009, p. 394).
The financial alchemy of transforming subprime mortgages into AAA securities occurred by dividing these securities into segments, or ‘tranches’. Investors in each tranche received dividends from the repayments of the mortgages from the entire MBS. Purchasers of junior tranches (rated BB and lower) received a higher payoff, but were first to lose their money if the mortgages went under. Senior tranche purchasers only saw a loss after all of the junior tranches were wiped out. The rating agencies, using probability formulas, deemed the likelihood of all the mortgages in these securities going under to be very low. Since the risk of senior tranche investments was low, they were given a AAA rating – even though all of the mortgages in the MBSs may be subprime (Friedman, 2009, pp. 136–8). Add to this that many subprime mortgage-backed investments were held in structured investment vehicles (SIVs) – informal entities connected to the banks through lines of credit. This ‘shadow banking system’ was not subject to the capital requirements and other regulations of their parent banks. Thus MBS purchases by SIVs entailed zero capital requirements, allowing the parent bank’s capital minima to be reduced even further. If the major banks had just passed these shabby investments on to others, they might be more hated, yet still solvent. In fact, the major purchasers of MBSs were the banks that issued them or the SIVs they sponsored (Acharya and Richardson, 2009, p. 200). Rather than diversifying risk as is intended, securitization served to concentrate a huge amount of risk right back on the balance sheet of major financial institutions. All was well, of course, as long as the value of the underlying assets continued to grow. When the US housing market collapsed, they were seriously overexposed.
Across the Atlantic, the crisis was both homegrown and imported. The financial sector plays an even larger role in the British economy than in America. Financial intermediation accounted for five percent of gross value added (GVA) in 1970. By 2008 it accounted for 8 percent of GVA and 15 percent of whole economy profits (Haldane, 2010, p. 4). From 1987 to 2007, the UK financial services sector grew at 4.7 percent per annum while the whole economy grew at 2.6 percent (Weale, 2009, p. 4). As a global financial hub, the performance of the City was intimately linked to trends in wider financial markets, including the US. Many British firms, moreover, pursued strategies similar to their American counterparts, starting with Northern Rock, the first major British bank to collapse. Nor was this merely a banking problem. The entire British economy became overleveraged during the 2000s, with a massive increase in private debt, much of it tied to a booming housing market. Average total household debt increased from 105 percent of income in 2000 to 160 percent in 2008 (McKinsey, 2010, p. 24). This was matched by a sharp rise in public debt. The reputation for economic prudence developed by Gordon Brown in the first Blair government was thrown aside after 2001, when the spending taps were turned wide open for the next five years. As revenue slowed, net public debt rose from 30.7 percent of gross domestic product (GDP) in 2000 to 36.5 percent in 2007 (HM Treasury, 2010b). Taken together, the UK experienced the largest rise of total debt to GDP of any of the major economies, from just over triple GDP in 2000 to 469 percent in 2008, before having to deal with the fallout of the crisis (McKinsey, 2010, p. 18). The crisis in America was entirely homegrown. The UK imported much of it, but once the contagion hit the British shores, it found an agreeable host.
Responses to the crisis
US housing prices peaked in late 2006 and deflated throughout 2007. As they did, the structure of securities and the interconnections between financial firms that relied upon their value began to unravel also. Northern Rock was nationalized, Bear Stearns was taken over, and Fannie Mae and Freddie Mac were formally absorbed by the US government. If there is a culminating point in the events of the crisis it was the collapse of Lehman Brothers on 14 September 2008, when it became clear to all that disaster loomed. London and Washington intervened in unprecedented ways to avert systemic collapse, provided economic stimulus to revive growth, and implemented regulatory reforms to prevent future catastrophes. Policy also influenced politics, and both countries have seen a change of government since the crisis hit. Cumulatively, these policies may have staved off depression, but both economies continue to struggle well into 2011.
After Lehman’s collapse, the global financial system seized up entirely. The British and American governments then ignored the boundaries of free market ideology altogether. In October 2008, Congress approved the Emergency Economic Stabilization Act establishing the Troubled Asset Relief Program (TARP) authorizing the Treasury to spend up to $700 billion dollars t
o purchase the ‘toxic assets’ of failing banks. The original plan was to then sell these assets at some form of auction, an idea which quickly proved a non-starter. The complexity and opacity of these instruments made it difficult to determine any meaningful values (Posner, 2009, p. 61). Plus the market for these assets had dried up. The Treasury thus shifted from asset purchases to capital injections, purchasing $205 billion in preferred stock from 707 financial institutions (CBO, 2010a, p. 2). Three institutions received the lion’s share of the funding. Citigroup and Bank of America (having swallowed up Merrill Lynch) each received $40 billion with Citigroup receiving an additional $5 billion in guarantees against losses. AIG got $70 billion – $40 billion in stock purchases and a $30 billion line of credit (CBO, 2010a, p. 4). President Bush also invoked his executive authority in December 2008 to extend TARP funds to automakers Chrysler, GM, including GM’s financing arm, GMAC. The program was expanded by the incoming Obama administration to $82 billion all told, giving the government majority ownership in GM and a substantial minority stake in Chrysler. TARP also established a $50 billion program to help homeowners avoid foreclosure through mortgage modifications and created a Special Master to review the executive compensation for companies receiving substantial bailouts. By early 2009, the US government owned stakes in major banks, was the majority owner of America’s largest automaker, was modifying mortgages, and was rendering judgement on executive salaries.
The Legacy of the Crash Page 7