Crashed: How a Decade of Financial Crises Changed the World

by Adam Tooze

In 2006 Nashi, the Russian nationalist movement, rallied its rent-a-mob following for street demonstrations against dollar hegemony.

It results in the fact that no one feels safe. I want to emphasise this—no one feels safe! Because no one can feel that international law is like a stone wall that will protect them.

Disingenuous much?

Under such circumstances, for the West to imagine that a global order could be based on its own organizations—the EU and NATO—rather than the truly comprehensive authority of the UN was either self-deceiving or in profoundly bad faith.

Lol man

With global demand booming, Russia had nothing to fear from the judgment of the market. Its experts were gleefully predicting a future in which oil prices would hit $250 a barrel.

God this is so funny in hindsight

At Munich in February 2007 the response of the Czech foreign minister, Karel Schwarzenberg, was immediate. “We must thank President Putin,” he remarked facetiously, “who has not only shown concern about the publicity for this conference, but has clearly and convincingly demonstrated why NATO had to enlarge.”

Romania, as an eager exponent of the new Europe, had joined NATO in 2004 and the EU in 2007. Romanian soldiers were doing policing duty in the former Yugoslavia, Angola and Iraq. Meanwhile, EU accession triggered a subsidy payment of 19.8 billion euros to Romania’s population of 21 million. It also enabled freedom of movement and a massive migration of Romanians to the West, notably to Italy, where the Romanian population topped 1 million in 2007, triggering local anti-immigrant resentment that the Prodi government struggled to contain.

As US subprime was imploding, international investors like ING Real Estate were snapping up Romanian assets to add to their East European property portfolios.

In February 2008 both Georgia and Ukraine formally applied to be put on a NATO fast-track Membership Action Plan (MAP).46 After the Baltics they would be the fourth and fifth Soviet republics to join the Western alliance. Georgia, like the Baltics, was touchy but small. Ukraine was in a different league.

In February 2008 the West had rubbed salt in the wounds of Russian resentment by extending recognition to an independent Kosovo, overriding the claims of Serbia, which Russia regarded as its client.

Condoleezza Rice was less sanguine. The clashes she witnessed between the Germans and the Poles were disturbing. The arguments in Bucharest were, in her words, “one of the most pointed and contentious debates with our allies that I’d ever experienced. In fact, it was the most heated that I saw in my entire time as secretary.”50 No formal process of membership application was initiated.

Though he liked to present himself as a modernizer, Putin’s successor as president, Medvedev, continued to steer a hard line. As the financial markets in the United States convulsed in the summer of 2008, dark rumors circulated that Moscow was about to move from verbal attacks on dollar hegemony to concerted action. US Treasury Secretary Paulson had not named his sources, but in the run-up to the Olympics, his Chinese contacts informed him that they “had received a message from the Russians which was, ‘Hey let’s join together and sell Fannie and Freddie securities on the market.’”

over the course of 2008, Russia did unload its portfolio of $100 billion of Fannie Mae and Freddie Mac bonds. As Reuters reported it, the decision was motivated primarily by domestic political concerns.54 “The holdings have met hostility from some Russian media and the public, who are wary of risky investments.” By the summer of 2008, one didn’t need to be a Russian nationalist to view American mortgage securities as a bad investment.

As the awe-inspiring opening ceremony of the Beijing Olympics exploded across Western TV screens, Georgia launched its army and air force into an invasion of South Ossetia. Moscow’s response was devastating. In a matter of days the Russian army crushed Georgia’s undersized forces, inflicting hundreds of casualties. According to Georgian sources, 230,000 civilians were put to flight. After a rapid advance, Russian tanks halted on the Gori-Tbilisi highway, an hour’s drive from the capital.

Though Chancellor Merkel now came out in favor of admitting Georgia to NATO, on September 1 at a special EU summit, any drastic anti-Russian moves were blocked by a united front of France, Germany and Italy. Russia was given three months to withdraw its forces. But Moscow had made its point.

When added to the incomplete project of the eurozone and the missing political frame for the North Atlantic financial system, the unresolved geopolitics of Europe’s “Eastern Question” completed a trifecta of unanswered political questions that hung over Western power in the summer of 2008.

Heedless of the precariously balanced state of the global economy, for the first time since the end of the cold war, Russia and the Western powers had engaged in a proxy war. Russia had announced that it would resist any further extension of Western influence and it had made good on that threat. For its part, the West was disunited. For all the saber rattling in Warsaw and Washington, there was neither the political will nor the resources to back up further eastward expansion.

For the immediate future, the sheer shock of the financial crisis would tend to dampen geopolitical tensions. But the damage done by the escalation of 2007–2008 would prove to be long lasting.

As house prices fell, equity dwindled, and the hardest hit slid into negative equity. Families scrambled to slash spending and pay down credit card and other short-term debt.

Through securitization, risks were supposed to have been spread so that even severe losses would be absorbed across the broad base of the economy. That was the theory. By the late summer of 2007 it was evident that the reality was different.

The first mortgage issuers to die were in the bottom tier.2 The aptly named Ownit Mortgage Solutions, one of the feeders for Merrill Lynch’s securitization pipeline, was the first to go, on January 3, 2007. On February 8, 2007, the crisis moved up the food chain when HSBC, whose offices spanned Hong Kong, Shanghai and London, announced it was making a $10.6 billion provision for losses on mortgage investments.

On August 8, 2007, another of Germany’s overextended regional banks, WestLB, announced outsized losses on a real estate fund and stopped payouts. Within days it was followed by Sachsen LB. But the really decisive break in market confidence came on the morning of August 9, 2007, when BNP Paribas, France’s most prominent bank, announced that it was freezing three of its funds.

Without valuation the assets could not be used as collateral. Without collateral there was no funding. And if there was no funding all the banks were in trouble, no matter how large their exposure to real estate.

Quite how bad things were soon going to get was suggested three weeks later, when on September 14, Northern Rock, one of Britain’s largest mortgage lenders, failed. On TV screens, the Northern Rock panic looked like a classic bank run. Anxious depositors queued up outside beleaguered bank branches to retrieve their funds. News photographers and camera crews had a field day. But off camera something even worse was happening. The trillion-dollar global funding market was shutting down.

What triggered the collapse in 2007 were not the loans on its balance sheet but the mechanism of their funding. Northern Rock was the model of a modern highly leveraged bank: 80 percent of its funding was sourced not from deposits but wholesale, at the lowest rates global money markets would offer.

Northern Rock had minimal exposure to US subprime. But that didn’t matter, because it sourced its funding from markets heavily used by banks that did.

Given Northern Rock’s extreme dependence on wholesale funding, it took only two working days after the markets dried up for the bank to notify the Financial Services Authority of an impending crisis.12 But the Bank of England was in no mood to help. Governor Mervyn King took the view that the overextended mortgage lender should suffer the consequences of its irresponsible expansion.

After that, the main damage to Northern Rock’s balance sheet was done by online withdrawals. The elderly savers queuing in the streets made for alarming TV footage. But it was not their panic that was bringing down the bank. It was a bank run operating on an altogether different scale at the speed of computer terminals in money markets across the world. It was a bank run without deposit withdrawals. There had been no deposits. There was nothing to withdraw.

ABCP was always the weakest link in the shadow banking chain. Repo, as fully collateralized lending, was supposed to be safe. Initially, that expectation was borne out.

Initially, Bear was able to make up for this shortfall by increasing its repo funding from $69 billion to $102 billion. To back this up, as late as Monday, March 10, 2008, Bear still held an $18 billion “pool” of ultraliquid, high-quality securities. But then collateralized borrowing began to fail too.

Unlike the implosion of ABCP, the “run on repo” was a surprise.14 Under British and American law, the holder of repo collateral is entitled to seize it ahead of any other claimant in the bankruptcy queue. So even allowing for Bear’s large portfolio of toxic mortgage-backed securities, its repo ought to have been good. A Treasury security is a Treasury security. Unfortunately for Bear, given that there were plenty of other counterparties to engage in repo trades with, no one wanted to take the risk of having to seize collateral from a failing bank, even if the collateral was as highly rated and as liquid as US Treasurys.

A bank that in early March had easily been able to raise $100 billion overnight in exchange for good collateral could no longer fund itself. On Thursday, March 13, with its liquidity reserve down to only $2 billion, Bear’s directors were told that $14 billion in repos would not “roll” the next day and that they were at imminent risk of running out of cash.

The uncertainty spread from individual weak banks to the entire system. First in the spring of 2008 and then in June, the haircuts on bilateral repo took a severe step up across the board, for all asset classes, for all parties.15 This meant that the amount of capital that was required to hold the outstanding stock of bonds leaped upward, across the entire banking system.

The step up in haircuts would put huge pressure on the investment banks that relied most heavily on short-term funding markets. And it was clear which of those, after Bear, was most vulnerable. The warning signs at Lehman were unmistakable.

What pushed Lehman over the edge were collateral calls by anxious lenders. Given the falling value of its stock, J.P. Morgan demanded large postings of collateral to back up daytime triparty repo risks. By Tuesday, September 9, allowing for liens on its assets, Lehman’s liquidity pool was down to $22 billion. Two days later, on Thursday, September 11, Lehman was still posting $150 billion as collateral in the repo market.

$20 billion in repo did not roll and J.P. Morgan demanded $5 billion in collateral to sustain even the most essential part of Lehman’s triparty repo business. Within a matter of hours on Friday, September 12, the Lehman liquidity pool was down to $1.4 billion and it was clear that, barring a weekend rescue, it would be forced to file for bankruptcy.

Bear and Lehman were badly run. Under intense competitive pressure they made high-risk bets on some of the worst parts of the mortgage securitization business. But they were not exceptional. Merrill Lynch too had huge real estate exposure, and it was funding $194 billion of its balance sheet on a short-term basis in the summer of 2008.

prior to the Lehman bankruptcy, $2.5 trillion in collateral was posted in the triparty segment of the repo market alone on a daily basis. This gigantic pile of claims and counterclaims could become destabilized in a matter of hours.

In trilateral repo, given the unimpeachable quality of the collateral used, there was effectively no price adjustment mechanism. One day the investment banks, dealers and those they borrowed from and lent securities to all functioned as a gigantic trillion-dollar machine based on confidence and widely acceptable collateral. The next day even a very large player in the system could be shut out.

After Lehman, the next link in the shadow banking chain to come under acute pressure was AIG, the insurer. In a dramatic burst of expansion from the 1990s onward, the Financial Products division of AIG had developed into a major player in the derivatives markets.

Given its inside knowledge of the property market, AIG had stopped writing new CDS already in 2005. But given the relatively small size of the portfolio and the AAA rating of the assets it had written CDS on, it had not thought it necessary to insulate itself against losses. It was a fatal mistake.

Out of a total of 44,000 derivatives contracts on the books of AIGFP, there were, it turned out, a cluster of 125 CDS on mortgage-backed securities that were about to go bad in a spectacular way. Those 125 contracts would inflict book value losses on AIG of $11.5 billion, twice what the ill-fated AIGFP unit had earned between 1994 and 2006.

it was not the slow-moving crisis in real estate markets that threatened AIG. An avalanche of defaults and foreclosures would in due course grind its way through the system. But that would take years. The first credit default event on which AIG had to pay out did not occur until December 2008. The problem was the anticipatory reaction of financial markets and the fast-moving revaluation of securitized mortgages and the derivatives based on them.

as it lost its top-tier credit rating, this triggered immediate margin calls from the counterparties to AIG’s insurance contracts. They wanted collateral to prove that AIG could meet its obligations if the mortgages did go bad. It was these collateral calls, running into tens of billions, that threatened to tip AIG over the edge.

Perversely, the securities lending office of AIG began to take those risky bets in 2005 precisely at the moment that AIG’s own Financial Products division decided it was too risky to continue writing CDS on mortgage-backed securities. By the summer of 2007, AIG’s securities lending program had $45 billion invested in high-yield private label MBS.

In search of profit, a cash-rich insurance company sitting on a giant portfolio of high-quality securities had turned itself into a dangerously leveraged shadow bank with a serious maturity mismatch. And to make matters worse, it was dealing with some of the most heavy-hitting players in global finance.

For AIG the consequences were drastic. It was scrambling for cash at the worst possible moment. With its rating on the downgrade it could not borrow tens of billions through ordinary channels. It could raise the funds only through fire sales, and that meant recognizing the losses on its balance sheet, which would make its position only even more precarious. By the morning of September 16, AIG was hours away from default.

individuals, pension funds and other investors.25 An essential part of their appeal was that while they offered better returns than ordinary savings accounts, they also promised that the principal invested was safe. They would return a dollar on the dollar whatever happened. The day after Lehman, on September 16, that illusion burst.

In August 2007 the Reserve Primary Fund had been under intense competitive pressure. To improve its yield and attract more investors it had committed 60 percent of its funds to buying ABCP just as other investors pulled out.26 The high yields on offer from desperate borrowers catapulted the fund from the bottom 20 percent to the top 10 percent in the performance league and doubled its assets under management in a single year. But it also exposed its investors to serious risks.

An index of haircuts on lower-quality collateral used in the biparty repo market surged from the elevated level of 25 percent it had reached over the summer of 2008 to 45 percent.28 This had the effect of doubling the amount of money an investment bank would have to mobilize to hold anything other than top-quality securities on its books. Even at Goldman Sachs, the strongest of the stand-alone investment banks, its vital liquidity reserve, which it had pumped from $60 billion in 2007 to $113 billion by the third quarter of 2008, plunged on September 18 to a nominal total of $66 billion.

Loans by banks, investment banks, hedge funds and mutual funds to big businesses in the United States—so-called syndicated loans—fell from $702 billion in the second quarter of 2007 to as little as $150 billion in the fourth quarter of 2008.