Wolfgang Munchau is an associate editorof the Financial Times, where he writes aweekly column about the European Unionand the European economy. Between 1988and 1995 he held several posts at The Timesnewspaper, including Washington and Brusselscorrespondent. Wolfgang Munchau livesin Belgium.

THE MELTDOWN YEARS

THE UNFOLDING OF THE GLOBAL ECONOMIC CRISIS

By WOLFGANG M, #220;NCHAU

The McGraw-Hill Companies, Inc.

Copyright © 2010 Carl Hanser Verlag Mnchen
All rights reserved.
ISBN: 978-0-07-163478-6

Contents

PrologueChapter 1 BEFORE THE MELTDOWNChapter 2 THE MELTDOWNChapter 3 WHY DID IT HAPPEN, AND WHAT NOW?Epilogue: When The Crisis Is Over …Appendix: Bubbles of the PastGlossary and List of AbbreviationsResourcesIndex

Excerpt

CHAPTER 1

BEFORE THE MELTDOWN

In 2003, Robert Lucas, a Nobel Prize–winning economist teaching at theUniversity of Chicago, claimed the “central problem of depression-prevention hasbeen solved, for all practical purposes, and has in fact been solved for manydecades.” It was probably one of the biggest economic misjudgments of our time,but let there be no doubt: It was misjudgment, not stupidity, that gave rise tothis error. It reminds us of a similar misjudgment by another great economist.In 1929, just days before the stock market crash, Irving Fisher almost destroyedhis reputation when he said that “stock prices have reached what looks like apermanently high plateau.”

We should remember that both of these statements seemed obviously true to manypeople on the day they were made. Many economists agreed with Lucas back in2003, and they did so until the summer of 2008. Fisher merely said what manyothers were thinking at the time. But just as those statements appearedobviously true at the time, they suddenly appeared false, just as “obviously.”Looking at it with hindsight, everything is so easy, so obvious. It is theeternal delusion of the hindsight observer.

People always try to rationalize the bubble, to explain why house prices wouldcontinue to rise, even after they had trebled in value, or why the Dow JonesIndustrial Average would soon hit 36,000, as one unfortunate forecaster claimed.Nothing is more alienating than listening to what people used to say duringthose days, which is really not that long ago. But very few people at the timesounded the warning bells. Those who did were denounced as doom-mongers.Denouncing those doom-mongers was not even that difficult, because year afteryear they were proven wrong. This was the age of the optimist, the age of thegambler, who had no time for financial economics, of history, let alone doubt.It took a minimal understanding of history and economics to see this crisiscoming.

The British have a saying: “The past is a foreign country. They do thingsdifferently over there.” This is exactly how it feels when one looks at thisnot-too-distant past, if one listens to what people were saying then. And forthat reason we need to delve into history, when some of the seeds of the presentcrisis were planted. Our first chapter starts in a foreigncountry—literally, that is.

When Banks Go Bust

Finance was pretty stable in the 1950s and 1960s. This was an age ofextraordinary economic stability. Most exchange rates were tied to the dollar ina system known as Bretton Woods. The name comes from the system’s 1944birthplace in New Hampshire.

The 1950s and 1960s were also a period of extraordinary financial stability. Theworld still benefited from the many changes in economic policy that resultedfrom the Great Depression. The gold standard that was still in place during theDepression was one of the great global amplifiers of economic shocks in theearly 1930s. The new Bretton Woods was also a gold standard of sorts, but it wasmore flexible, as exchange rates were allowed to adjust from time to time. Thiswas still an age in which banking and investment banking were separate, whenfinancial innovation was slow, and regulation was tough. It appeared duringthose years that the world had solved the recurring problem of financialinstability for good. Bank runs were considered a disease of the past, much likesmallpox.

In the early 1970s, the illusion of eternal financial stability would endabruptly. One of the first modern crises took place in Great Britain, which hada large housing boom at the time—not as large as our recent one, but verylarge nevertheless. Banks had lent too much money to homeowners, as everybodybelieved that the house price boom of that period would last forever. Soundfamiliar? When house prices subsequently collapsed, the banks discovered thatthey had insufficient collateral. Some banks were technically insolvent. Bankingwas a lot simpler then than it is today. There was no subprime market, nosecuritization, none of the toolkits of modern finance. But other than that, thesituation was not that fundamentally different: Hubris about house prices leadsto excessive credit, which leads to more hubris. At one point this gamecollapses. Economists refer to this as a Ponzi game, named after Charles Ponzi,an American swindler who lived in the early part of the twentieth century, whoduped his victims with a mind-boggling pyramid scheme. Much of modern banking isin the same spirit. And the ghost of Ponzi fell over the city of London in theearly 1970s.

One of the biggest surprises one realizes when studying financial crises acrosscountries and across decades—even centuries—is how similar they allare. Most financial crises involve excessive lending secured on assets with fastcollapsing values. The British eventually resolved their first truly modernfinancial crisis through a bailout. The Bank of England, the central bank of theUnited Kingdom, rescued some 30 banks in the 1970s. Finance was not as big as itis today, and rescuing the banking sector was a smart thing to do. At the time,countries could actually afford it without getting into difficulty themselves.This is probably the main difference between the bailouts of 30 years ago andtoday.

The British central bank acted according to a doctrine created in the nineteenthcentury by Walter Bagehot, an editor of the Economist magazine, who saida central bank should never allow an important bank to go bust. It should alwaysbail it out, but do so at a punitive price to avoid what economists call “moralhazard.” It means: Do not create an incentive for others to misbehave as well,in the hope that they, too, will be bailed out. Bagehot’s famous doctrinesurvived for a long time, but for the current crisis the doctrine is much moredifficult to apply because the banking sector has become so big that countriesare no longer in the position to bail out every bank. Belgium’s largest bank,Fortis, had assets greater than the annual economic output of the entirecountry. In Iceland, the banking sector was almost nine times as large as thecountry’s annual economic output. So banks that were regarded as too big to failsuddenly became too big to save. It would have been easier for Fortis to bailout Belgium, and for Iceland’s banks to bail out Iceland, rather than the otherway around.

But that was not the case in the United Kingdom back in the early 1970s. Thecrisis ended with a bailout, in the tradition of Bagehot. All was well.

There was no such happy ending for Herstatt Bank in Cologne, Germany, a city notknown for its financial savvy, but for its magnificent cathedrals and its modernart markets. One morning in 1974, German bank regulators walked into the bankand closed it down after it had incurred serious losses in foreign exchangetransactions. Bagehot’s famous doctrine, to the extent that it was known inGermany, would not have applied here, since Herstatt was considered a relativelysmall and insignificant bank. This turned out to have been a big misjudgment.And as every reader knows today, it was not the last time that such amisjudgment would be made.

Herstatt was a private bank. Founded in the late eighteenth century, theHerstatt family sold the bank in the nineteenth century, and then bought it backagain in 1955. It was a tiny local bank at the time that specialized inproviding funding to small nonprofit societies, churches, newspapers, and evenbrothels—a rather unusual combination of customers. But something strangehappened during this period. Between 1955 and 1973 this little neighborhood bankwas able to raise its total assets from an equivalent of $1 million to almost $1billion, an increase by a factor of 1,000!

One of the reasons for this miraculous transition was a rogue trader by the nameof Dany Dattel, who was tremendously successful in his early days. Dattel washead of the bank’s small foreign exchange operations, which suddenly became alucrative business in the early 1970s when the Bretton Woods system ofsemi-fixed global exchange rates collapsed. The switch from fixed to floatingexchange rates offered an ideal source of activity for speculators like Dattel.But not only professionals took part in this speculation. The German newsmagazine Der Spiegel reported the story that a secretary won a six-figuresum in a single foreign exchange bet, and that a young trainee builderwas able to afford a Porsche car valued at several decades’ worth of his annualearnings. Exuberance bred further exuberance, and ordinary people became activeparticipants in the game.

In early 1974, the foreign exchange traders at Herstatt got it badly wrong. Theyspeculated on a rising dollar, but the opposite happened, and they lost some 1.4billion Deutsche Marks in the space of just four months. That sum exceeded thebank’s capital to a large extent. The following day, the investors lined upoutside, angrily demanding their money back, but the regulators had arrivedthere first.

It was the first notable bank failure of that time. But the reason it became sonotorious was a different one. The bank had also engaged in so-called currencyswap operations, which is normally a fairly riskless business. In thisparticular case, the bank exchanged dollars for Deutsche Marks (DM) at someagreed rate. But there is a time difference of six hours between EasternStandard Time in New York and Central European Time in Cologne. At the moment,when the regulators walked in, Herstatt had already received the dollars fromits U.S. counterparts, but had not yet paid the Deutsche Marks, which they couldonly have done after business started in New York several hours later. But bythe time New York had opened, Herstatt had already been shut down, and was notable to complete its part of the transaction. Within the same time zone, thatproblem could not have arisen. The two payments would have been swappedinstantaneously. The entire deal would either have gone through before the bankceased operations, or it would have failed. It was only because of the timedifference that Herstatt’s U.S. counterparts did not get their money back.

The risk encountered by the U.S. banks is known as settlement risk, subsequentlyknown as Herstatt risk. It could have produced a dangerous series of cascadingbank collapses. If the losses by the U.S. banks had been sufficiently large,they could have been technically insolvent as well. The principal reason whybanks are so vulnerable to a large loss in exchange rate speculation, as in thecase of Herstatt, or the exposure to settlement risk, is the fact that bankshave relatively little capital in relation to the enormous amounts of money theyplay with each day. Back at the time, there were no agreed international ruleshow much capital a bank should hold. The more capital, the more protected a bankis against shocks. Capital is the shock absorber for banks. If a bank makes aloss, for example, if loans do not get repaid, or if securities the bank ownssuddenly fall in value, the loss comes out of the bank’s capital. If the lossexceeds the capital, the bank is insolvent. But even if it does not, the bankcan still be in trouble if the ratio of capital to assets falls below a minimumthreshold.

The following discussion explains the basis of a bank balance sheet. It isprobably the single most important technical concept in this book.

When something goes wrong, it is very important to distinguish between a bankthat is insolvent, and one that has no liquidity. In the case of Herstatt, thesituation was evident. The bank lost more than it had. It was bankrupt, and thiswas immediately clear. But in our crisis, the situation was more opaque.

Insolvency is what happens when a bank’s capital falls toward zero. Illiquiditymeans that a bank does not have the cash to pay out a depositor who closes theaccount, or to repay a loan, for example, from another bank. In the past,illiquidity occurred frequently as a result of bank runs, usually triggered byfalse rumors. There were many such occurrences in the United States during thenineteenth century when the banking systems were still rudimentary. Investorswould seek to withdraw their money, only to find that their banks, which hadalready lent the money to borrowers, suddenly lacked sufficient liquidity to payback the investors. The banks, unable to obtain liquidity quickly enough, wereoften forced to close their doors. Anyone who saw the movie It’s a WonderfulLife knows exactly the importance of having enough cash in the till right upuntil the bank closes its door in the evening.

Back in the old days, after a bank run, a bank was often shut down, but theimportant thing to remember is that these banks were usually solvent. Theirbalance sheets were probably healthy in the sense that at any point in timethere was sufficient capital in relationship to assets. There was much bankscould do to protect themselves against insolvency—by maintaining anadequate ratio of capital to assets. But managing liquidity is more difficult.No bank in the world would be capable of surviving a bank run without externalhelp.

Basle

In the early 1970s, there was no formal regulation that imposed limits on thebanks’ leverage on a truly global scale. After the Herstatt crisis, governmentsagreed that what was needed was a global solution to ensure that all banks thatparticipated in worldwide transactions meet a minimum set of rules, to beenforced by domestic regulators. The Herstatt collapse gave rise to a long andarduous process, which resulted in a globally accepted system for capitaladequacy regulations. In the aftermath of the Herstatt collapse, a group ofregulators and central bankers met regularly in the Swiss city of Basle, home tothe Bank for International Settlements (BIS), an august institution that hasoften been referred to as the central bank for central banks. The purpose ofthese meetings was to structure a globally acceptable banking system.

The BIS was one of the institutions founded near the end of the Great Depressionto help prevent such calamities in the future. During the Bretton Woods regimeof semi-fixed exchange rates from 1944 until the early 1970s, there wererelatively few crises, and the BIS somewhat lost its sense of purpose. Manypeople began to question the usefulness of such an institution. TheInternational Monetary Fund (IMF) and the World Bank dealt with sudden crisesand development issues. The BIS was not a lender of last resort; to some it waslittle more than a central bankers’ think tank.

But the Herstatt collapse gave the BIS a new lease on life. The meeting ofregulators turned into a series of semipermanent political processes. The ideawas to make the incipient process of financial globalization shockproof againstthe kind of risks that were evident in the Herstatt collapse. One of those riskswas obviously the settlement risk, the Herstatt risk. But this was only arelatively minor technical issue that was resolved relatively quickly. It playsno part in our narrative. The real issue was capital adequacy—ensuringthat a bank had enough capital to withstand a serious shock.

It was a long and arduous process. The Basle Committee prepared a set of rulesthat were later known as “Basle I.” These rules gave a very clear and strictdefinition of how much capital a bank needs. The basic rule is that capital hasto be a minimum of 8 percent of risk-weighted assets. “Risk-weighted” means thatcertain assets, like a business loan, are considered risky; some are consideredless risky, as in the case of a mortgage; and others, such as government bondsand cash, carry no risk. It is a very crude mechanism. There were no ratings andno attempt at differentiating between different types of business loans. Thecrudeness, however, was not the main problem of the system. As long as banksplayed by the rules, the system would deliver a reasonable degree of stability.If the ratio of capital to assets was 8 percent, a simple calculation shows thatthe gearing of the bank could not exceed 12 at any time. This is a relativeconservative value. We should not forget that the Basle rules, too, were theresponse to a previous crisis. And however sharply we may criticize those rules,they were indeed drawn with the best of intentions, with the goal to providemore capital adequacy to the global system.

The problem with the Basle rules was not their crudeness, but that banks couldcircumvent them. Worse still, it was perfectly legal to do so. It was evenencouraged. Textbooks on banking and finance used the euphemism of regulatoryrelief. This was probably the biggest and costliest financial scam of thetwentieth century, and everybody was playing it.

The trick is off-balance sheet finance. Under accounting rules, a company orbank needs to consolidate everything it owns in its balance sheet. But this doesnot apply to companies in which the bank’s own shareholding is less than acertain percentage rate, often 50 percent. The precise rules may vary from onejurisdiction to another, but all countries allowed banks to push assets off itsbalance sheet, and park them in a subsidiary, or, as occurred in this crisis, toshift those assets to the bank’s parent group, which was not subject to theBasle rules. Remember, the Basle capital adequacy rules only applied to ordinarycommercial banks, or to the banking units of conglomerates, but not to theconglomerates themselves. The rules did not apply to investment banks, or hedgefunds, or other investment companies. Hedge funds were often geared 50 to 100times, while the maximum possible gearing for a bank, under the Basle rules, was12—or more realistically ten, since the banks needed some headroom. So thebanks would, for example, create special purpose vehicles (SPVs), in which theywould own a stake, but a stake below the ceiling, which would require the bankto consolidate the SPV into its accounts. The bank would then sell the assets,for example a pool of mortgages, to the SPV, in return for cash. How would theSPV obtain the cash? It would transform the mortgages into mortgage-backedsecurities (MBSs)—a process also known as securitization. We explain laterhow securitization works in all its gory detail. The mortgage-backed securitieswould be sold to investors. During the bubble, these securities were verypopular among some investors, since they carried a higher interest rate thangovernment bonds. And since investors mistakenly thought that real estate priceswould go up forever, they did not see the risk that borrowers would ever defaulton their mortgages. The actual return on these securities depended crucially onwhether borrowers would be able to service their loans. So these securitieswould be next to worthless once borrowers defaulted en masse.

(Continues…)
(Continues…)Excerpted from THE MELTDOWN YEARS by WOLFGANG M, *NULL* #220;NCHAU. Copyright © 2010 by Carl Hanser Verlag München. Excerpted by permission of The McGraw-Hill Companies, Inc..
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