Financial Alchemy in Crisis

The Great Liquidity Illusion

By Anastasia Nesvetailova

Pluto Press

Copyright © 2010 Anastasia Nesvetailova
All rights reserved.
ISBN: 978-0-7453-2877-5

Contents

Abbreviations, ix,
Acknowledgements, x,
Introduction: The End of a Great Illusion, 1,
1. The Stages of the Meltdown, 24,
2. The Tale of Northern Rock: Between Financial Innovation and Fraud, 40,
3. How the Crisis has been Understood, 62,
4. Some Uncomfortable Puzzles of the Credit Crunch, 90,
5. 2002–7: The Three Pillars of the Liquidity Illusion, 113,
6. After the Meltdown: Rewriting the Rules of Global Finance?, 143,
Conclusion: A Very Mundane Crisis, 172,
Notes, 177,
Bibliography, 184,
Index, 197,

CHAPTER 1

The Stages of the Meltdown

Since it began in the summer of 2007, the global credit crunch has gone through three distinct stages. It began with paralysis in the international financial markets, commonly dubbed a 'liquidity crunch'. A year later, the meltdown turned into a cross-border banking crisis which threatened the very viability of the financial services in key economies. Gradually, the financial malaise spread to the real economy, causing a chain of bankruptcies and job losses in manufacturing and the services sector. By the summer of 2009, the financial meltdown had matured into one of the deepest recessions recorded in the postwar history of capitalism. To date, the credit crunch has had no lack of chronologies: every major media outlet and financial institution updates the timeline of key events and figures. Rather than replicate these detailed records, this chapter uses the records of the crisis and traces the evolution of the global meltdown through its three distinct stages.

The Prelude: The American Sub-Prime Crisis

Most records of the global credit crunch start at 9 August 2007. However, the meltdown goes back earlier than that. In the United States, which has been the epicentre of the global malaise, the prelude to the global financial meltdown unfolded in late 2006/early 2007.

It all started with a boom. Between 2002 and 2007, housing markets in the Anglo-Saxon economies were booming at unprecedented levels. The great housing boom was supported by cheap and plentiful credit and the widely held belief that house prices would continue to rise. In the US in particular a whole new segment of housing finance – sub-prime mortgages – provided a major motor for the credit boom and the expanding financial system. 'Sub-prime' designates a category of borrowers who otherwise would be considered 'high-risk' clients: they had poor or no credit histories. But in the booming housing market, supported by opportunities to manage the high risks that the new financial system offered, these clients were now granted access to credit and could own a house on what appeared – initially at least – to be favourable and affordable rates. The expansion of the mortgage-backed securities (MBSs) market drew investors into some of the more risky tranches of MBS debt. In 2006, the US sub-prime market was worth $600bn, or 20 per cent of the $3 trillion mortgage market. In 2001, sub-prime loans made up just 5.6 per cent of mortgage dollars. In global terms, American MBSs became the largest component of the global fixed income market, accounting for a fifth of its value.

Yet it was as early as 2006 that the price increases in the American housing market slowed down, and the first wave of mortgage delinquencies started to spread. The trigger to the rising number of defaults was the increase in the interest rate, which climbed to 5.35 per cent in 2006, from 1 per cent in 2004. Also, crucially, in 2006 the structure of US sub-prime mortgages shifted many borrowers out of their initial (presumably favourable) fixed-rate terms, thereby increasing the interest payment on the loans. Observers offered different readings of this trend: some argued that despite the notable increase in bankruptcies, the trend historically was insignificant (IMF 2007: 5). Others began to anticipate a bigger wave of defaults and bankruptcies: most 2006 borrowers were still in the 'teaser rate' period of their mortgages. According to the structure of sub-prime loans, their repayments were due to rise in a year or two. Some sceptics warned that against this background a default of one or two financial companies could well spark a worldwide financial crisis. The words of reassurance, for those who needed them, came from the architect of mortgage-backed finance himself, Lewie Ranieri, who said: 'I think [the risk] is containable ... I don't think this is going to be a cataclysm' (in Kratz 2007).

The sceptics were proven right. Homeowners, many of whom could barely afford their mortgage payments when interest rates were low, began to default on their mortgages and defaults on sub-prime loans rose to record levels. By the end of 2006, sub-prime delinquencies more than 60 days late jumped to almost 13 per cent, compared to 8 per cent in 2005. Commentators explained this by the fact that in 2006 some of the more neglected sub-prime loans had reached their refinancing limits, and borrowers could no longer afford to pay the mortgage on a new, and higher, interest rate. The number of bankruptcies and foreclosures also rose: according to Moody's, in 2006 it reached almost 4 per cent, compared to 2.2 per cent for a similar type of loan originated in 2004. The impact of these defaults was felt throughout the financial system as many of the mortgages had been bundled up and sold on to banks and investors (BBC 2009). Eventually, the housing boom stalled and, through the complex web of mortgage-backed finance, started to affect the financial and banking system more generally.

The winter of 2006–7 brought the first signs of the real magnitude of the coming meltdown. On 22 February 2007 HSBC, the largest sub-prime lender in the US and a leading investment bank globally, announced a $10.5bn loss in its mortgage finance subsidiary, HSBC Finance. Market sceptics immediately read this as a sign of a greater trouble ahead: HSBC's total annual profits were around $15bn. Many smaller sub-prime lenders were already facing bankruptcy.

At the time, a giant like HSBC could write off the $10bn loss and escape relatively unscathed from the mounting market distress. Smaller sub-prime lenders operating on the American markets were in a less healthy position. In March 2007, news of heavy losses from the ailing sub-prime market hit American building companies. This fuelled fears of bankruptcy in several sub-prime lenders, most notably New Century Finance Corporation, at the time the largest American independent sub-prime mortgage lender. In just a few weeks, on 2 April 2007, New Century Financial Corporation filed for Chapter 11 bankruptcy. The fall of the company marks the point when tensions in the sub-prime mortgage markets started to affect Wall Street directly.

Interestingly, even as the prospects for the housing market and financial boom darkened, commentary at the time viewed the unfolding downturn as no more than a cyclical adjustment to the otherwise normal trend of rising house prices, rather than as a systemic breakdown in finance and the economy. The IMF, for instance, explained the downturn as a combination of regional economic factors and a shift in the US mortgage market. Specifically, the weaker mortgage collateral was partly associated with adverse trends in employment and income in specific American states rather than with escalating housing markets (IMF 2007: 7). According to the BIS, this reflected a 'seemingly orderly re-pricing of credit risk', conditioned by changing economic and policy factors in the US economy (Borio 2008: 5).

From Sub-Prime Crisis to the Global Credit Crunch

Notwithstanding the optimism in the markets, over the following few months the sub-prime crisis escalated as more and more high-ranking companies, including UBS and the investment bank Bear Stearns, announced write-downs. In July 2007, Bear Stearns told investors they would get little, if any, of the money invested in two of its hedge funds after rival banks refused to help it bail them out. Federal Reserve chairman Ben Bernanke estimated that the sub-prime crisis could cost up to $100bn.

As large financial houses were calculating their losses from sub-prime loans, the credit ratings agencies were downgrading asset-backed securities (ABSs), subprime-backed bonds and collateralised debt obligations (CDOs). By early August 2007, the list of casualties of the implosion included the hedge fund run by Bear Stearns, Countrywide Financial, a US home loan lender, American Home Mortgage Investment Corporation, and the German bank IKB.

The fateful date 9 August 2007 became the official anniversary of the global credit crunch. On that day, the largest French bank, BNP Paribas, announced that it was unable to value three investment funds in the volatile market context and informed investors that they could no longer withdraw money from these facilities. Reacting to the news, the world's financial indices went into free-fall and pretty much remained there over the following months. Central banks around the world immediately offered liquidity support in an attempt to stem the panic. On 9 August 2007, the European Central Bank (ECB) injected &8364;95bn into the overnight markets and the Federal Reserve injected $38bn; other central banks followed with similar actions over the following weeks. In the space of just a few days in mid-August 2007, the world's central banks pumped an extraordinary $240bn into the ailing markets. Aside from liquidity injections, other emergency policy measures employed over the next few months included repeated cuts in interest rates and coordinated international monetary interventions in the credit markets.

Despite these collective and unprecedented efforts to restore optimism in the markets, the first stage of the global meltdown – the sub-prime crisis in the US – had not been brought under control. Through its effects on the financial markets worldwide and, in particular, by harming those financial institutions that relied heavily on wholesale credit markets, it was transformed from a crisis in one segment of the market into an international banking crisis and global credit crunch. The best known of the casualties during this second phase was the British bank Northern Rock, which went bankrupt in August–September 2007 and had to be nationalised.

Northern Rock

Just days into the unfolding malaise in the financial markets, on 13 August 2007, the Financial Services Authority (FSA), the UK financial watchdog, was reportedly informed that the country's fifth largest mortgage lender, Northern Rock, might be facing a liquidity crisis. With this, the first run on a bank in the UK for a century, and a subsequent political scandal, started to unfold.

In 2006–early 2007, Northern Rock had a portfolio of loans and assets of £113bn, but a small customer deposit pool of only £24bn (Wood and Milne 2008). During the years of the credit boom, this 'aggressive' business strategy had paid off handsomely. But fortunes turned against the bank in the summer of 2007. As credit dried up, it could no longer tap the international financial markets for financing, while the deposits it had on its books were simply not sufficient to cover its outstanding obligations. Between 10 August and mid-September 2007, Northern Rock and the UK tripartite authorities (the Bank of England, the Financial Services Authority and the Treasury) debated how best to extricate the bank from its difficulties. As Wood and Milne document, three scenarios of crisis management were discussed: a market solution (Northern Rock would try to obtain the necessary funding by itself); a takeover by another major bank; and cash support from the Bank of England guaranteed by the government (ibid.).

As the crisis in the international financial markets deepened and credit flows froze up, the first two options became unfeasible. On 13 September 2007, the Bank of England provided Northern Rock with emergency liquidity support. At the time, the amount of money used to save the bank was not disclosed, but it would later emerge that the UK authorities spent around £50bn of taxpayers' money rescuing the bank. Granting the cash, the authorities also commented that funding problems at Northern Rock were of a temporary (liquidity) nature, linked to the exceptional market conditions, rather than a serious structural problem. Despite government support, however, customers launched an old-fashioned run on Northern Rock – on Friday 14 September they withdrew £1bn in what was the biggest run on a British bank for more than a century. This continued until the government stepped in to guarantee depositors' savings (BBC 2009).

Meanwhile the crisis intensified, entering the year 2008 in the gloom of foundering housing markets, panic in the financial markets and more losses being revealed by banks and other companies. After a failed attempt by the Virgin group to buy Northern Rock, the bank was nationalised in February 2008. By March 2008 things had become darker still. On 17 March 2008, Wall Street's fifth largest bank, Bear Stearns, was acquired by its larger rival, JP Morgan Chase, for $240m in a deal backed by $30bn of central bank loans. The collapse of the bank and general market downturn prompted the authorities in the US and the EU to draft the first regulatory policy responses reflecting the unfolding malaise.

Despite these measures, credit markets remained frozen. As banks were increasingly reluctant to lend to each other, the IMF estimated that total losses from the sub-prime crisis could reach $1 trillion. Sceptics warned that the true costs would be much higher still. In the midst of gloomy macroeconomic data now coming from economies around the world and debates about the imminent recession and, potentially, depression, the crisis continued to accelerate into the summer and autumn of 2008.

The next dark moment in the crisis chain came in mid-summer 2008. On 14 July, the two largest lenders in the US – Fannie Mae and Freddie Mac – appealed for help from the US government. They had been the drivers of the mortgage securities markets, owning or guaranteeing $5 trillion worth of home loans, or nearly half of the US's $12 trillion mortgage market. On the other side of the Atlantic, signs of recession were becoming more visible. In late August 2008, the UK Chancellor, Alistair Darling, warned that the economy was facing its worst crisis in 60 years and added that the downturn would be more 'profound and long-lasting' than most had feared.

From Global Credit Crunch to Global Recession

The week of 7–15 September 2008 was the darkest to date in the history of the credit crunch. On 7 September, Fannie Mae and Freddie Mac were taken over by the US government in one of the largest bailouts in US financial history. The pressure, according to market consensus and common sense, came from China, the largest holder of US debt. Although the Chinese government made no official comment at the time, it was clear that the fall of the two institutions would harm the value of the dollar and thus affect all holdings of US debt held by foreign creditors around the world.

Three days later, Lehman Brothers – one of the largest Wall Street banks – posted a loss of $3.9bn for the three months to August 2008. On 15 September 2008, after several futile attempts to find a buyer or secure governmental rescue, Lehman Brothers filed for bankruptcy protection under Chapter 11. The collapse of the global bank was a major shock to the international financial system and marked the transformation of a market liquidity crunch into an international banking and credit meltdown. Alan Greenspan described the fall of Lehmans as 'probably a once in a century type of event'. Markets went into free-fall for weeks in a row, representing the biggest erosion of financial wealth since the 1930s. Direct comparisons with the 1930s crisis and projections of a global depression became commonplace. The situation worsened as another high-profile US bank, Merrill Lynch, agreed to be taken over by Bank of America for $50bn (BBC 2009).

The second half of September 2008 witnessed several attempts by governments to tame the panic in the markets and save individual institutions from bankruptcy. In the US, the Federal Reserve authorised an $85bn rescue package for the country's biggest insurance firm, AIG, in return for an 80 per cent stake in the company. Several months later, it would emerge that having received the bailout, AIG paid out hundreds of millions of dollars in bonuses to its senior executives. Under pressure from an angry Congress, AIG eventually had to list the firms to which the money was actually paid. These included top US firms Goldman Sachs ($12.9bn), Merrill Lynch ($6.8bn), Bank of America ($5.2bn), Citigroup ($2.3bn) and Wachovia ($1.5bn). The major foreign banks included Société Générale and Deutsche Bank (nearly $12bn each); Barclays ($8.5bn) and UBS ($5bn). In total, AIG named nearly 80 companies and municipalities that benefited most from the Fed rescue, though many more receiving smaller payments were unnamed (Williams Walsh 2009). In the UK at around that time, HBOS, the country's biggest mortgage lender, was facing bankruptcy. Lloyds TSB took over the ailing bank in what would soon prove to be an unwise £12bn deal. On 25 September, US mortgage lender Washington Mutual (whose assets were valued at $307bn), was closed down and sold off to JP Morgan Chase.

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