Bill Totten's Weblog

Monday, July 12, 2010


by John Lanchester

London Review of Books (October 23 2008)

Byron wrote that 'I think it great affectation not to quote oneself'. On that basis, I'd like to quote what I wrote in a piece about the City of London, in the aftermath of the Northern Rock fiasco: 'If our laws are not extended to control the new kinds of super-powerful, super-complex and potentially super-risky investment vehicles, they will one day cause a financial disaster of global-systemic proportions' {1}.

The prediction was right, but the tense was wrong. The disaster had already happened, it just hadn't yet played itself out in the markets. It is doing so now, though. The recipe is starting to become well known, but perhaps it's worth spelling it out one more time. Financial institutions in the US lent money to people with poor credit histories. This wasn't a bad thing in itself, indeed it could be seen as an example of capitalism at its most beneficently creative - indigent housebuyers needing loans, financial institutions wanting high-interest-paying borrowers, and presto! a new class of homeowners coming into being. Unfortunately, a lot of the lending was reckless, verging on criminal; for a glimpse at how chaotic and wild-westish the process became, take a look at a book by a former Texas mortgage broker, Richard Bitner, called Confessions of a Sub-Prime Lender {2}.

The invention which made it possible for the lending to become so reckless was securitisation: the process by which loans were added together and sold on to other institutions as packages of debt. This had the effect of making the initial lender indifferent to whether or not the loan could be repaid - he'd already sold the debt to someone else, so he didn't need to care. These packages of debt were then sold on and resold in the form of horrendously complex and sophisticated financial instruments, and it is these which are the basis of the global jamming-up of capital markets. The interlinked and overlapping loans are so complicated that no one knows who owns what underlying debt, and furthermore, no one knows what these assets are worth. (If you own someone else's debt, it counts as an asset.) The normal mechanism for assessing the value of these assets is the market: they are worth what someone is prepared to pay. At the moment, because no one is buying, no one has a clue what they're worth, if anything. Because of an accountancy practice called 'mark to market', requiring that assets be listed at their current values, this fact had to be reflected in the companies' balance sheets - so these balance sheets suddenly looked disastrous. As a result, banks are reluctant to lend to each other, and the entire financial system has ground to a halt: such capital as is moving in the markets is supplied by the central banks, which have to date pumped in hundreds of billions of dollars to generate some liquidity.

The scorecard so far is impressive, and it began with Northern Rock, done in by Britain's first bank run in 150 years. The bank was a demutualised former mutual society. It had adopted a groovy, go-go financial strategy: only 27 per cent of its funds came from money deposited in its accounts by savers; the rest came from short-term borrowing, on an 'as and when needed' basis, from the international money markets. When those markets choked up the Rock sought emergency funding from the Bank of England, which acted too slowly and by doing so triggered the run on the Rock, which led, after a certain amount of governmental faffing about, to its nationalisation on 17 February.

Note that the Rock wasn't destroyed by risky lending. Some of its loans were risky: a banker contact of mine told me that there was trouble with a 'book' of mortgage loans for 120 per cent of the value of homes. (Why would any sane person want to borrow 120 per cent of the value of the thing they wanted to buy? I can just about answer that question: because they want to do the place up, or spend the extra on a new car, and because all parties involved are mortally certain that the price is going to go up. But it's still crazily reckless. Why would any sane lender lend the money? No idea.) But while loans like this did nothing to help the Rock, what ruined the bank was its exposure to the now malfunctioning money markets.

Next to go was the US investment bank Bear Stearns. This bank, super-bullish even by the standards of Wall Street, had too great an exposure to sub-prime debt; investors fled, the share price collapsed, and on 16 March the bank was bought by its competitor J P Morgan, its market value having declined from $20 billion to $236 million. The US government underwrote the purchase by providing a guarantee of $29 billion against the bank's mortgage liabilities - basically, the government took on the risk of the dodgy mortgages, in order to make the rest of the bank viable for purchase. They did so because they were worried about the risk to the rest of the banking system if Bear Stearns collapsed and a 'chaotic unwinding' of the financial system followed. 'Chaotic unwinding' - good phrase. It was coined by Ben Bernanke, chairman of the US Federal Reserve, and formerly an academic whose special subject of study, usefully, was the Great Depression.

Fannie Mae and Freddie Mac, on the other hand, were more directly done in by bad loans. These odd institutions are/were a hybrid, with capital drawn from shareholders but underwriting from the US government: their function was not to lend money to the public directly but to underwrite the mortgages given by other institutions, and to provide liquidity to the mortgage markets. They are Government Sponsored Enterprises whose deposits are not guaranteed by the government, a fact stated in the law founding them, on the securities themselves, and basically on every press release or document ever emanating from either GSE - and a fact nobody believed, since it was generally felt certain that if Fannie and Freddie ever got into trouble, the government would have no choice but to bail them out. That assumption turned out to be correct. After the collapse in US house prices and the soaring default rate of mortgages, Freddie and Fannie, with mortgage-backed securities worth, or maybe that should be 'worth', $5 trillion and debt of $1.6 trillion, were on the verge of going under, and they were taken into 'conservatorship' by the US government on 7 September.

The term 'conservatorship' fails to mask the fact that this was, by cash value, the biggest nationalisation in the history of the world. It was followed eight days later by the largest bankruptcy in the history of the world, when the investment bank Lehman Brothers went into Chapter 11, the American form of receivership. (Chapter 11 is a much more business-friendly form of bankruptcy than pertains in other countries, and has been compared to leaving the fox in charge of the henhouse.) Lehman had an impressive $613 billion of debt, but some parts of its various businesses were viable: it was the holding company that went broke, leaving the subsidiary businesses free to be sold off. The main one, the US investment banking arm, was bought by Barclays for $250 million, with another $1.5 billion for buildings and data centres. Oh, and an important part of the deal was the $2.5 billion in bonuses that would be paid for the bank's New York staff. The previous year, Lehman's bonuses were $5.7 billion.

If you are wondering how a total of $8,200,000,000 could be paid in bonuses over two years to the great minds whose company went bankrupt, well, what can I tell you? The bonus question is often seen as a tragicomic footnote to the business of banking, but it may be that it goes close to the heart of the problem of how we got to be in this place. Through history, the great fortunes have been made by people directly taking risks on their own account. Today, great fortunes are made by employees, doing nothing other than their jobs: jobs which, in the case of bankers, involve taking on risks, usually with other people's borrowed money. To make more money, and earn more bonuses (which are usually sixty per cent of an investment banker's pay), it's simple: you just take on more risk. The upside is the upside, and the downside - well, it increasingly seems that for the bankers themselves, certainly in the case of Lehman New York, there isn't one. This undermines the whole principle of 'moral hazard', which was the idea behind letting Lehman go under in the first place - the need for companies to face the consequences of their decisions. This principle obviously collapses if the individuals involved don't face any consequences.

There had been talk about the big banks being 'too big to fail', meaning that the risk of allowing them to go under was too great, but by allowing Lehman to go under the US Treasury seemed to be making the point that where possible it would allow the market to take its course. The markets reacted to this with horror. It is now received wisdom in the markets that it was the US government's willingness to let Lehman Brothers fail which triggered the meltdown, by causing fear to become panic. The day after the biggest bankruptcy in history saw the biggest bail-out of a private company in history, with the US government taking a 79.9 per cent share in the insurer AIG in return for a loan facility of $85 billion. AIG was exposed to a lot of bad loans, and it had emerged that it was valuing its mortgage securities at 1.7 to two times as much as Lehman had valued theirs. So if Lehman was broke, AIG was in an even worse position. The share price had collapsed by 95 per cent when the Federal Reserve was brought in to stage its rescue.

The suddenness of these implosions, and their spectacular scale, masked what would otherwise have been a gigantic story: Merrill Lynch, the bank whose symbol is the original Wall Street 'prancing bull', was taken over by the Bank of America on 14 September, after a year of huge losses linked to sub-prime mortgages and their derivatives. On 21 September, Goldman Sachs, the world's biggest investment bank, and Morgan Stanley converted their legal status from investment banks to holding banks, a change which allowed them access to help from the Federal Reserve in return for a greatly increased level of government supervision. Goldman had done all right in the initial phases of the credit crunch, because although it was exposed to mortgage-backed securities, it also made big bets that the securities would fall, thus offsetting its own losses. But the general turn against banking stocks nonetheless did for its status as an investment bank. That means that in the last months the five biggest investment banks in New York - Bear Stearns, Merrill Lynch, Lehman Brothers, Goldman Sachs and Morgan Stanley - have ceased to exist as investment banks. On 25 September came the largest bank failure in American history, as Washington Mutual went into receivership following a bank run during which its customers withdrew $16.7 billion in ten days.

Taking all these superlatives together, it's easy to see why the Federal Reserve and the US Treasury (run by Hank Paulson, former head of Goldman Sachs) decided to step in with their proposal to bail out the US banking system. The idea is to buy up the toxic assets which are poisoning the banking system, so that the banks can go back to lending money to each other again and the system can reboot itself. They must have known that the initial plan wouldn't pass unamended: it was only three pages long and the only power it didn't grant Paulson was the right to call himself God-King Hank the First. After being knocked back by the House of Representatives, it hit the floor of the Senate at 451 pages, passed, and then was passed in its amended form by the House. It is a strange document, the bill, crammed with tax cuts and pork and populist gestures but at its heart allowing Paulson to buy any 'troubled assets' he likes at any price he sees fit.

It's going to be interesting - to put it very, very mildly - to see if the bail-out works. The usual model for a crisis of this scale is for the state to take over the troubled institutions, then go through the books separating the good from the bad assets, and selling them off, part one and then part two. This is what was done in the 1980s, when the post-deregulation collapse of the US Savings and Loans (roughly like our old building societies) led to the creation of the Resolution Trust Corporation to sort out and flog off its assets - and as optimists are never slow to point out, the Resolution Trust ended by making a profit. The bail-out is an attempt to do part two of that without doing part one, no doubt because the scale of the problem is so big that part one would involve the nationalisation of the entire US banking system. The socialisation of US banking would be a hell of a punchline to decades of unfettered liberal capitalism. As it stands, the plan is socialism for the rich in as pure a form as has ever been seen.

The British and European scorecard seemed, at the start, less spectacular. On 18 September, news of the biggest bank merger - carefully not denominated a takeover - in British history: Lloyds was to buy HBOS, the largest mortgage lender in the UK, with twenty per cent of the market. That market share was precisely the problem: HBOS had expanded in recent years and taken on a disproportionate share of the newer, riskier mortgages, and also was only 58 per cent funded by depositors, the rest of its funds coming from the wholesale markets. That is a much, much safer ratio than the 27 per cent of depositor funding held by Northern Rock, but it was still enough for the share price to collapse and induce a takeover. The price offered by Lloyds was GBP 2.32 a share - this for a company which last October was trading for more than GBP 10. On 28 September, the Luxembourg, Belgian and Dutch governments nationalised the bank Fortis, the biggest private employer in Belgium, at a cost of 11.2 billion euros, after its share price collapsed. On 29 September, Bradford and Bingley (another demutualised former building society), which had the largest share of the buy-to-let market, was nationalised, at a cost of GBP 41.3 billion, and its branch network sold off to the Spanish bank Santander - the classic part one, part two model mentioned above. On 30 September, the Icelandic government nationalised the country's third largest bank, Giltnir, at a refreshingly modest cost of GBP 500 million. Iceland's second biggest bank, Landsbanki, followed on 7 October and its biggest, Kaupthing, on 9 October. The Icelandic government would not guarantee overseas depositors' money, including nearly GBP 1 billion of UK local government cash. This caused the British to use anti-terrorism legislation to freeze Landsbanki's assets in the UK. The German commercial property loan giant Hypo Real Estate was bailed out on 5 October at a cost of fifty billion euros. At the same time the German government blurted out that it was guaranteeing the deposits of all savers, a bizarre thing to do given that the previous day it had criticised the Irish government for doing the exact same thing. The German promise caused mayhem all round Europe. It became obvious that the absence of a European equivalent of the Fed - able to knock heads together and impose a consistent Eurozone policy - is a huge strategic problem for the EU.

The markets, which were already troubled, now went into freefall - especially banking shares. On 7 October, HBOS and Lloyds both lost forty per cent of their value. A total collapse seemed possible. In the early hours of 8 October, the British government announced that it was forcing the eight biggest banks to increase their levels of capitalisation, and offering to provide them the money to do that, in return for 'preference shares'. These are a last-in, first-out type of shareholding, without voting rights or a link to the share price. First, though, the object of the exercise is to prevent further systemic meltdown, and to that end the government offered to provide another GBP 200 billion of short-term loans: the kind of loan which the banks would once unthinkingly have made to each other, the kind of loan whose absence is at the heart of the whole current freeze-up. The government is also offering GBP 250 billion of loan guarantees to back loans between the banks. It is a partial form of nationalisation, and constitutes the biggest move to shore up the UK banking system that there has ever been. At the same time, six central banks - in the US, UK, EU, Sweden, Switzerland and Canada - cut interest rates by 0.5 per cent, and China by 0.27 per cent.

Will it work? Let's hope so. No other government has, at the time of writing, moved as systematically or boldly as the British, in simultaneously addressing capitalisation (how much money the banks have), liquidity (their ability and willingness to lend to each other) and interest rates (to help the economy in general). Quite a lot of detail is missing: the assurances about bankers' pay and suchlike are woolly. The Treasury and the government clearly hope that these huge new moves will bring the market to its senses, and allow us to have a good old-fashioned recession, rather than a full-scale depression.

One of the structural problems which brought us to this pass is that our big banks aren't just big, they're huge: the four biggest each have a capital value of more than a trillion pounds. Add the five biggest together, and the sum is four times the value of Britain's GDP. Our (remaining) banks have less exposure to the famous toxic debt than their US counterparts, but while the wholesale money markets aren't functioning, normal banking life is impossible. They are highly leveraged, too. It was this combination of size and leverage that did for Iceland's banks. The ratio of Barclays' assets to its equity in June hit 61.3 to 1. Imagine that for a moment translated to your own finances, so that you could stretch what you actually, unequivocally own to borrow more than sixty times the amount. (I'd have an island. What about you?) It sounds sensible to reduce that leverage, and indeed it is, except that the process of reducing it is the dreaded 'deleveraging' which is causing the banking system and the wider economy to grind to a halt. The scale of bank leveraging is one of the things that must be targeted by regulators if/when the crisis has passed; we can't let the banks get this far out of control ever again. For a start, there must be a tight limit on the relationship between banks' debt and their equity, and much greater transparency about the nature of banks' 'assets'.

So: a huge unregulated boom in which almost all the upside went directly into private hands, followed by a gigantic bust in which the losses were socialised. That is literally nobody's idea of how the financial system is supposed to work. It is just as much an abomination to the free marketeer as it is to the social democrat or outright leftist. But the models and alternatives don't seem to be forthcoming: there is an ideological and theoretical vacuum where the challenge from the left used to be. Capitalism no longer has a global antagonist, just at the moment when it has never needed one more - if only to clarify thinking and values, and to provide the chorus of jeering and Schadenfreude which at this moment is deeply appropriate. I would be providing it myself if I weren't so frightened.

Having fully indulged their greed on the way up, and created the risks, the bankers are now fully indulging their fear on the way down, and allowing the system to seize up. But it wasn't just the banks. One thing which has been lacking in public discourse about the crisis is someone to point out that we did this to ourselves, because we allowed our governments to do it, and because we were greedy and stupid. It's not just bankers who have been indulging in greed, short-termism and fantasy economics. In addition to our stretched mortgage borrowing, Britain has half of the total European credit-card debt. That is a horrible fact, and although it's nice to reserve the blame for banks who made lending too easy, the great British public is just as much to blame. We grew obsessed with the price of our houses, felt richer than we should, borrowed money we didn't have, spent it on tat, and now that the downturn has happened - as it was bound to do - we want someone else to blame. Well boo fucking hoo. Bankers are to blame, but we're to blame too. That's just as well, because we're the ones who are going to have to pay.

Other than that, it's too early to draw general conclusions from this amazing crisis. What will, what must, die is the mystical belief in the power of the markets that has dominated political and economic discourse in most of the Western world for the last several decades. The markets have so manifestly, so flagrantly malfunctioned that we can't go back to the idea of unfettered liberal capitalism as a talisman, template or magic wand. The unquestioned Cityphilia I wrote about earlier this year is gone, I hope for ever. Unfortunately, we have no current model of where to go from here, apart from a more heavily regulated form of growth-based liberal capitalism. There will be more intrusive regulation, more proactive interference. There may even be (there should be) a new Bretton Woods to control the global flow of capital. That doesn't seem enough, but in the absence of another set of ideas about how the world should work, it may turn out to be what we have to settle for. In the meantime, it's seatbelt sign on, sickbag to hand, and that deep, bitter, prayerful longing for smooth air.


{1} LRB, 3 January 2008.

{2} Wiley, 208 pages, GBP 10.99, August, 978 0 470 40219 1.

Bill Totten


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