Transition 3: Crisis

Mary Mellor

The Crisis Unfurls

• Speculative Boom• Subprime Crisis• Credit Crunch• Banking/Financial Crisis• Economic Crisis• Sovereign Debt Crisis• Austerity

Meltdown

• September 2007 Credit Crunch and run on Northern Rock

• September 2008 Lehman fails - global banking crisis

• May 2010 Greek bailout (Ireland, Portugal) leading to euro crisis

• August 2011 US loses AAA rating• Still no end in sight

The Boom

• House price boom• ‘Equity release’ rapidly expanded money

supply• Cheap consumer goods (China)• Easy credit conditions – low interest rates• Lax bank regulation - bonus culture• Optimism and exuberance

Subprime Lending

• De-regulation of mortgage lending • Liar loans – NINJA (no income, no job, no

assets) • Teaser rates – people used to fixed rate• Originate to Distribute (loans sold on, so less

attention to risk of default)• All forms of debt expanded

Levels of Debt (% GDP)

• US Financial sector 1981 (22%) 2008 (117%)• US Household 1997 (66%) 2007 (100%) • US All sectors 1980 (160%) 2008 (350%)• UK All sectors 1987 (200%) 2009 (540%) • UK household debt peaked at 150% GDP

Where did the money go?

• UK money supply doubled 2003-2009 • 75% of loans linked to property • 30% of loans issued to the financial sector• 20% to manufacturing/nonfinancial sector

Trading in Debt

• Traditionally most house lending through specialised sectors e.g. Building Societies

• Latter part of C20th banks more involved• Debts (e.g. mortgages) seen as a financial

asset - investors could ‘buy’ a mortgage as an investment (mortgage-backed security)

Securitisation

• Securitisation is a paper ownership of an asset which can be bought and sold

• Share certificates are securities – the share can be sold without selling the factory

• Various forms of debt (consumer, student, mortgages etc.) were bundled up and sold as Collatoralised Debt Obligations (CDOs)

Slicing and Dicing

• The CDOs were sold in ‘tranches’ with higher interest for higher risk

• The first ‘tranches’ were rated AAA by the rating agencies (employed by the issuing bank) –this was essential to attract pension funds

• The AAA tranche would pay out first in case of default

Credit Derivatives

• Investors in credit insure against default • These insurances became investments in

themselves and were traded over-the-counter (i.e. not through regulated exchanges) as Credit Default Swaps (CDSs) between banks and other financial institutions

• Made insurances companies such as AIG very vulnerable ($180 billion bailout)

Credit Derivatives

• Derivatives do not need any direct connection with the product (debt) so large numbers of ‘naked’ CDSs were taken out e.g. on Greek default while holding no Greek debt

• Default will mean multiple pay out with no ‘hair cut’ (unlike actual owners of the debt)

• Credit derivatives grew from $108bn in 1995 to $1.23 trillion in 2006 and $45.5 trillion in 2007 (nearly equivalent to world GDP)

Shadow Banking

• There was so much profit to be made in the new securitisation that that banks started to outstrip their capital adequacy ratios

• Banks are supposed to have sufficient bank capital to allow for some losses on assets (e.g. loan defaults)

• Bank capital is made up of retained profits and any money raised by selling shares (equity)

Shadow Banking

• Banks solved their ‘balance sheet’ problem by ‘shadow banking’ holding the securitised loans ‘off balance sheet’ in SIVs Special Investment Vehicles which only needed 3% external ownership

• Real capital ratios fell almost to nothing • Total bank balance sheets grew bigger than

GDP (Iceland 10X, UK 5X, Ireland 8X)

Growth of Financial Sector

• US manufacturing % GDP• 1950 29.3% 2005 12.0% • US Financial services % GDP• 1950 10.9% 2005 20.4%. (but only 8% if

exclude real estate/mortgages)• 40% of GDP growth during boom

What went wrong?

• High levels of debt default (rare before)• The bundles of debt-based securities not

carefully screened for risk - all securities became suspect

• Financial institutions (insurance companies, pension funds) could not buy them

• Banks left holding unsold bundles of debt

What went wrong?

• As defaults occurred the flow of debts and investments stalled

• Credit crunch put most institutions on the edge of bankruptcy as their assets could not be valued i.e. they were ‘toxic’

• All types of bank affected• States had to step in

State Responses

• Guaranteeing bank deposits (Ireland 2XGDP)• Central banks issued cheap money• Nationalisation or capital injection • Toxic Asset purchase or insurance• State expanded money: quantitative easing• Supporting banks and the wider economy

transferred the debts to state budgets – leading to sovereign debt crisis

Why did the Crisis happen?

• Financial innovations such as securitisation• High levels of ‘leverage’ (borrowing)• Bonus culture encouraged risk and rapid

turnover• Lax regulation- regulators didn’t see the risk• Could not isolate parts of the system (Lehman

collapse)• Banks too big to fail (and too big to save?)

Forms of Leverage

• Reducing the ratio of capital available to meet immediate liabilities relative to the size of the firm’s assets

• Borrowing money to enhance the profit on original money invested

• Buying ‘on the margin’ – making a large ‘bet’ with a small initial outlay e.g. putting a ‘deposit’ on share trade

Leverage Gamblers

• Hedge funds – use borrowing to enhance clients’ money in short term trades – often relying on computer-based trading (rocket scientists)

• Already seen failure: Long Term Capital Management 1998 and ENRON 2001

• Private Equity Companies : used borrowed money to buy up companies: AA, Boots, Debenhams, EMI - aim to sell at a profit

Disembedded Finance

• Financial investment became detached from any interest in accumulating capital through productive activities

• Confusion of money speculation with wealth-creation – impact on productive investment

• Speculative investment in financial assets themselves e.g. stock, shares, bonds, derivatives, mergers and acquisitions – worth 10X world GDP

Credit and Investment Treadmill

• Speculative investment can only realise a profit if the asset is sold on

• Needs new money coming into the market from leverage (debt) or recycled wealth

• Boom cycles reinforce speculation• Effectively a chain letter system or pyramid

scheme – no consumption as in production• Vast room for fraud and deception (Madoff)

The Banks’ Problem

• Savings and mutual systems replaced by personal investment and privatisation e.g. personal pension plans - huge amounts of money looking for profitable investment

• Obligation to shareholders (e.g. pension funds) prioritised high share price

• High risk financial trading more profitable than productive investments in short run. US Banks bought CDOs because they paid 1% more than Treasuries (government debt)

Credit crunch

• Most banks and financial institutions were highly leveraged (30 – 100 %)

• Banks had built themselves into highly interconnected global networks

• The ‘money market’ had become a key part of the financial system (large scale borrowing)

• Susceptible to a credit crunch if any link in the chain broke

The wider context

• Growing inequality• Globalisation: low rates of profit in productive

sector of old economies, shift of production to low wage economies led to global imbalance

• Stagnant wages and high levels of consumer debt

• Privatisation of money issue as bank debt – rapid increase in money supply

Inequality

• 19,000:1 US highest earners:average wage• 2011 median salary of UK investment banker

£350,000 - total bonuses £7.5 billion• In UK over last 30 years: Bottom 50% wage

earners share of GDP fell by 25%• Top 1% of wage earners share rose 50%• 2011 of each £100 of GDP bottom 50% of

wage earners get £12 the top 1% get £3(Report of ‘Missing Out’ Resolution Foundation July 2011)

Globalisation of Production

• Exporting countries (China, Japan, Germany) low consumption/high savings – leads to balance of payments problems

• Importing countries high consumption/low savings and high debt

• Export earnings are lent back to the importing country (70% of dollars exported return to US financial sector – mainly government debt)

Globalisation of Production

• Germany does the same in the eurozone – earns money from the periphery and lends it back to them thus increasing their indebtedness

• Global money and trading needs a mechanism to maintain balance – major concern of Keynes

Why Public Rescue?

• Banks are a system of trust that have no means of withstanding a ‘run’ - reserve notion is meaningless in a crisis

• The financial sector has required periodic rescue since stockmarkets/banking emerged.

• Banks underpinned by state authority• People demand state recompense e.g.

Northern Rock, Icesave

Privatised Money - Public Responsibility

• As the national money supply is now based on bank issued debt it is subject to crisis

• State responsibility for the integrity of its national money means it has to continually bail out the privatised money system

• States now have to take on ‘sovereign debt’ to rescue private debt - borrowed from the self-same banks and ‘money markets’

Finance is not Private

• The financial system is not private• It administers a public resource – money as

legal tender • Late C20th 97% of all money has been issued

as bank debt• The final resource of the money system is the

taxation/money issue capacity of states

State and the Banking System

• Viability of money system rests on the capacity of the state to tax (viz Greece, Argentina) or the consent of the taxed (Iceland)

• Yet tax avoidance/off-shoring is rife even given the excessive remuneration

• States can also create new money if hold own currency (quantitative easing)

Sovereign Debt Crisis

• Most increased sovereign debt caused by the crisis: banks (US, UK, Ireland), speculative housing debts (Spain), GDP fall (Italy)

• A serious problem in the eurozone (Greece, Portugal, Spain, Ireland, Italy)

• Problem of Maastricht rules and limited powers of European Central Bank to issue new money or lend to states

Sovereign Debt

• Less problematic if the country has its own currency and borrows internally

• e.g. Japan national debt is 200% of GDP, Greece 150% (95% of Japanese debt and stock trading is domestic)

• Greek financial sector only 2 X GDP but 2/3 of its debt is to foreign lenders

• Greek public and private debt 250% of GDP (much less than US or UK)

Austerity

• Neo-liberal economics has constrained the capacity of states, particularly on money supply

• Assumes that money can only be issued as bank debt

• Assumes that reducing state expenditure will increase private expenditure

• Blames states for failures of the private sector

Austerity

• States are asked to cut expenditure and raise more taxes to ‘pay’ for the deficit caused by the crisis

• Already economic decline/stagnation – UK lost 6% of GDP in 2009 - less impact in BRIC countries

• Unemployment rising rapidly – particularly youth unemployment over 40% in Spain

• Public anger in many countries

Is this the 30’s?

• 1929-1930 US GDP fell 14%; 1931 25.3% 1932-3 25% (Greece – 4.5% 2010 15% overall)

• Unemployment 25% (Spain, Greece ?)• US debt service 20% of GDP • Nearly all banks collapsed • FDR removed gold standard in 1933 – floating

exchange rates today except in eurozone• Overall rate of debt higher than 1930s