My Colleague Peter Bell Pointed Me to This Analysis by Robin Blackburn

THE SUBPRIME CRISIS

In the summer of 2007 many leading banks in the US and Europe were hit by a collapse in the value of mortgage-backed securities which they had themselves been responsible for packaging. [*] To the surprise of many, the poisonous securities turned out to constitute a major portion of their ultimate asset base. The defaults fostered a credit crunch as all financial institutions hoarded cash and required ever widening premiums before lending to one another. The Wall Street investment banks and brokerages haemorrhaged $175 billion of capital in the period July 2007 to March 2008, and Bear Stearns, the fifth largest, was ‘rescued’ in March, at a fire-sale price, by JP Morgan Chase with the help of $29 billion of guarantees from the Federal Reserve. Many of the rest only survived by selling huge chunks of preferred stock, with guaranteed premium rates of return, to a string of ‘sovereign funds’, owned by the governments of Abu Dhabi, Singapore, South Korea and China, among others.

By the end of January 2008, $75 billion of new capital had been injected into the banks, but it was not enough. In the UK the sharply rising cost of liquidity destroyed the business model of a large mortgage house, leading to the first bank run in the UK for 150 years and obliging the British Chancellor first to extend nearly £60 billion in loans and guarantees to its depositors and then to take the concern, Northern Rock, into public ownership. In late January Société Générale, famous for its skill at financial engineering—indeed the winner that month of the coveted ‘Derivatives Bank of the Year Award’ from Risk magazine—reported that a 31-year-old rogue trader had lost the bank over $7 billion. The SocGen management began unwinding the terrible positions taken by this trader on 21 January, contributing to a share rout on the exchanges and, it seems, to an emergency decision by the Federal Reserve the next day to drop its interest rate by 75 basis points.

The management of risk—especially systemic risk—in the financial world was evidently deeply flawed. An important part of the problem was that core financial institutions had used a shadowy secondary banking system to hide much of their exposure. Citigroup, Merrill Lynch, HSBC, Barclays Capital and Deutsche Bank had taken on a lot of debt and lent other people’s money against desperately poor collateral. Prior to theUS deregulation and UK privatizations of the 1990s, US investment banks would have been barred by the Glass–Steagall Act of 1933 from dabbling in retail finance, and Northern Rock would have remained a solid, and very boring, building society.

The trigger for the credit crunch was rising defaults among US holders of subprime mortgages in the last quarter of 2006 and early 2007, as interest rates were inched up to protect the falling dollar. This led to the failure of several large mortgage brokers in February–March 2007, but the true scope of the problem only began to register in the late summer. Interestingly, the first bank to report a problem was Deutsche Bank, which was forced to bail out two property-based funds in July. In October the US Treasury encouraged three of Wall Street’s largest banks—Merrill Lynch, Morgan Stanley and Bank of America—to set up a $70 billion fund to establish a clear value for threatened assets. This did not work. Analysts complained: ‘The path they have taken of skimming off the cream from the top doesn’t resolve the fact that there is poison at the bottom’. [1]

At the end of 2007, with the credit crisis still as bad as ever, the world’s central banks tried to pump vast amounts of liquidity into the global financial system, but the impact was temporary, and the banks remained unwilling to lend to one another. Lawrence Summers, the former US Treasury Secretary, warned of a looming ‘major credit crunch’—as if six months’ paralysis had been a mere bagatelle; this danger stemmed from the ‘impaired’ asset base of major banks if more capital was not injected. [2] The subprime debacle and the drying up of credit, themselves the consequences of deteriorating conditions, were hastening the slide to recession in the US and global economy. On 10 February US Treasury Secretary Henry Paulson confirmed that credit problems were still ‘serious and persisting’, with more expected. [3]On 29 February two senior investment bankers—David Greenlaw (Morgan Stanley) and Jan Hatzius (Goldman Sachs)—and two economists—Anil K. Kashyap (Chicago) and Hyun Song Shin (Princeton)—published a study entitled ‘Leveraged Losses’ which cautiously estimated that losses from the subprime crisis were likely to total around $400 billion and cause a drop in GDP of between 1 and 1.5 per cent. [4]You might think the title mainly referred to the plight of millions of mortgaged homeowners but, as we will see, the destructive logic of over-leveraged assets was also at work in scores of financial concerns.

The US President and Congress swiftly agreed a stimulus package of $150 billion, and on 11 March the world’s central banks clubbed together to offer the banks $200 billion on easy conditions. But these supposed masters of the universe seemed caught in celestial machinery they did not control. On 16 March the US Federal Reserve intervened to avert the collapse of Bear Stearns and arrange for its purchase by JP Morgan Chase at a small fraction of its earlier price. The remaining investment banks were offered, for the first time, direct loans at low rates, against the flimsiest collateral and in confidence.

The credit crunch came as the climax of a long period of gravity-defying global imbalances and asset bubbles. Fear of recession had prompted the US Federal Reserve to keep interest rates low in 2001–06, and this in turn set the scene for cheap and easy loans. The world’s financiers and business leaders looked to US householders, the ‘consumers of last resort’, to keep the global boom going. Robert Brenner gave an arresting account of the structural flaws and systemic turbulence in the global economy in NLR in 1998. In a substantial Afterword to The Economics of Global Turbulence in 2006, he stressed that a contrived ‘consumption-led’ boom in 2002–06 had failed to overcome weak profitability and investment. While labour productivity rose in these years, real employee compensation did not. The maintenance of the boom was made a little easier by cheap Chinese imports, but the vital ingredient in consumer buoyancy was a build-up of personal debt. Brenner characterized the demand-stimulating policies of the Fed and US Treasury as ‘market Keynesianism’. [5] While Andrew Glyn and Giovanni Arrighi offered extra considerations, they too recognized that the bubble economics of 1995–2007 was not under control and that finance had escaped the reach of the regulators. [6]

According to the Federal Reserve’s Flow of Funds data, total debt in the US economy rose from 255.3 per cent of GDP in 1997 to 352.6 per cent of GDP in 2007. Debt growth was strongest in the household and financial sectors. Household debt grew from 66.1 per cent of GDP to 99.9 per cent of GDP over the decade to 2007. But the most rapid growth was in the debt taken on by banks and other financial entities which grew from 63.8 per cent of GDP in 1997 to 113.8 per cent of GDP in 2007. [7] A succession of asset bubbles fuelled this growth in debt.

Notwithstanding his famous remark about ‘irrational exuberance’ in 1996, Alan Greenspan, the Federal Reserve Chairman, took no stern measures to dampen the share bubble of the late 1990s. Robert Rubin and Lawrence Summers at the Treasury did even less, with Summers insisting that ballooning share prices should be viewed as an increase in US saving. [8] In the early 2000s Washington found compelling reasons to pursue a cheaper money policy—it wished both to devise a ‘soft landing’ from the share bubble and to demonstrate that the US powerhouse was unscathed by terrorism. It became a national security priority to inflate the purchasing power of US consumers. In the aftermath of 9/11 Americans had a patriotic duty to take on more debt in order to keep consumption rising, and banks and regulators to make this possible.

Banks were drawn to consumer debt because of a decline in their traditional role as custodians of savings and deposits, as this was increasingly assumed by pension funds and mutual funds, and also by a drop in the share of their earnings coming from traditional corporate finance. Between 1997 and 2007, the share of total financial sector assets accounted for by the assets of depository institutions plummeted from 56.3 per cent to just 23.7 per cent, while the share of pension funds and mutual funds rose from 21 per cent to 37.8 per cent. Freed by deregulation, the banks found new business by converting consumer debt into tradeable securities and then selling those securities to the funds (or other banks). In order to finance this operation the banks themselves took on more debt, blithely assuming that the return on the securities would be comfortably above their cost of borrowing, and that they would anyway soon sell on the securities to someone else, in what was known as the ‘originate and distribute’ model. It was difficult for anybody to know what was going on, or how justified these assumptions might be, because much of the action was registered only on the banks’ ‘invisible balance sheet’ in a ‘shadow banking system’. [9] Jane D’Arista argues that these trends also conspired to undermine traditional policy tools, since the latter, especially interest rate changes and great dollops of extra liquidity, work in and through their impact on banks as depository institutions. [10]

In what follows I interpret the credit crunch as a crisis of financialization—otherwise put, as a crisis of that venturesome ‘new world’ of leverage, deregulation and ‘financial innovation’ which Alan Greenspan celebrates in his recent memoir. I show how the pursuit of a market in almost everything led to a banker’s nightmare in which key assets could not be valued. I urge that attention be paid to the ideas of Fischer Black, the improbable inventor of structured finance, who warned against ‘loading up on risk’ when declining to become a founder member of Long Term Capital Management. I evoke both the New Deal response to financial failure and the rise of consumer finance in the postwar world, before considering, in conclusion, what can be done today.

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