Crashed: How a Decade of Financial Crises Changed the World

by Adam Tooze

Given how tightly the Irish banks were integrated with the British financial system, it was in London that the pressure was most acute. The UK was forced immediately to raise its deposit insurance limit. London and Paris were conferring urgently, as were the Dutch. The Germans were less cooperative.

Europe needed something on the scale that Paulson was asking for in the United States. Suddenly, Berlin sprang to life. There must be no talk of joint bailouts, Steinbrück announced. Merkel let it be known that she would not attend the summit in Paris if it was labeled a crisis meeting. As if to bind herself, the chancellor gave an interview to the popular tabloid Bild-Zeitung, soon to become notorious for its nationalist coverage of the crisis, denouncing any blank check for bankers.

the French and the Dutch were right. Within twelve months, precisely the scenario that Lagarde had sketched for Handelsblatt would come to haunt the eurozone. Crippled banks and ailing government borrowers would pull one another down. But prescient though the French might have been, nothing could be done without Berlin.

Gordon Brown came away impressed by the sense that the Europeans thought the crisis to be an American problem.74 As one disillusioned British official remarked, the Europeans “didn’t see it coming. They didn’t understand the economics. They didn’t understand how collective action could work.”

the hard truth was that German taxpayers did not want to pay for other people’s bailouts, inside Germany or out. In a broader sense, the question of national versus federal solutions was for Merkel not just a matter of euros and cents. Since 2005 she had been toiling amid the wreckage of Europe’s failed effort to give itself a constitution.

The most that the summit on October 4 could agree on was a statement calling for coordinated action, rebuking Ireland for its unilateral action the previous week. All the more shocking was what happened next. As the European heads of government made their way home from Paris, the news broke that the rescue of Hypo Real Estate had broken down. Depfa’s condition was worse than had been realized.

As one German banker later put it to the investigative inquiry of the Bundestag, if Lehman’s failure had been a tsunami, then the bankruptcy of Hypo Real Estate would have been Armageddon for the German economy.

What really worried Berlin were rumors that German savers were panicking. As cash withdrawals spiked, the Bundesbank registered unprecedented demand for large-denomination euro notes. Abruptly, less than twenty-four hours after returning from Paris, Merkel decided that she must make a statement. It was all Steinbrück could do to persuade her that she should not do it entirely alone.

They were deliberately vague about the details. But the leaders of the two political parties that had ruled Germany since 1949 jointly declared that all savings deposits were safe. This was directed at a German audience. But it had far wider implications. Germany was not Ireland. Even on the most restrictive definition, Merkel and Steinbrück had given a guarantee in the order of at least a trillion euros.

In the absence of a clear European policy, smaller countries with big banks, such as Denmark, were forced to make unilateral decisions and to extend guarantees of their own.

Like Ireland and Germany, London would offer guarantees. The Bank of England and the Treasury would underwrite debt issuance by the banks. But these guarantees would be conditional on recapitalization either through market investment or from public funds.

The UK bank bailout package launched on October 8, 2008, after a night of cliff-edge negotiation with the leading banks, was an accomplished piece of political theater. Compared with Paulson’s struggles with Congress, Brown and Darling had the huge advantage of a solid majority in the House of Commons. Though Brown’s position at the head of the Labour Party was far from secure, he did not have to fear the parliamentary mutiny faced by President Bush.

Perversely, the ailing banks resisted to the bitter end. None of them wanted to become a ward of the state. On the brink of failure they were still angling for whatever margin of advantage they could extract.

Less charitably it might be said that since the 1990s, New Labour, like the Democrats in the United States, had entered into an enthusiastic partnership with the City of London. It was, therefore, no coincidence that it was now Labour in Britain and the Democrats in the United States who were showing such energy in the struggle to fix the banking crisis.

For the duration of the crisis European states were free to pump capital into the banks. The EU would act as an agency of oversight and try to minimize the extent to which the European common market would be torn apart. But it was not a crisis fighter in its own right.

Europe’s national programs were defined by the circumstances of the banks and local politics. France’s large banks were in relatively good shape. Société Générale was fortunate that the so-called “Kerviel scandal” involving 50 billion euros in unauthorized positions and losses of almost 5 billion euros, unwound in January 2008, rather than six months later at the height of the crisis.

It was an elegant construction. With the French state holding only a minority stake, the SFEF’s liabilities were not counted toward the French public debt. At the same time, thanks to a special arrangement with the banking regulators, the SFEF was not required to meet Basel II capital rules, so the actual financial call on the banks was minimal.

as in Britain, any possibility of a general solution was spoiled by the power of the dominant player. With the regional Landesbanken ailing and Commerzbank struggling with the ill-advised takeover of Dresdner, Deutsche Bank saw the opportunity to put distance between itself and the rest.

And now they're screwed

As Barclays was to do in the UK, Deutsche preferred to rely on accounting tricks and investments from gulf state sovereign wealth funds to see it through the crisis.

Rather than immunity for the Treasury secretary, the law now provided for multiple overlapping layers of oversight. On October 3 TARP passed into law, carried by 74 percent of the Democratic votes in the House, but only 46 percent of the Republicans.

Having obtained the funds from Congress for asset purchases, TARP would now be repurposed as a vehicle for injecting capital. At the same time, events in Ireland, Germany and the UK had changed the conversation about deposit insurance.

The new package was worked out between the Treasury, the Fed and the FDIC over the weekend of October 11–12, in the shadow of the G7/G20 meetings. It was presented to the stunned CEOs of America’s nine largest banks on the afternoon of Monday, October 13, just as the Europeans were rolling out their guarantees.101 It was a take it or leave it offer. In rations fixed by Tim Geithner as president of the New York Fed, all nine major banks would be required to take slices of government capital. The shares would be preferred shares. The guaranteed dividends that the federal government would require were low, but would escalate after five years to give the banks an incentive to repay early.

“I don’t really understand why this needs to be confrontational,” he said soothingly.102 The bankers stared at him in disbelief. The core of American financial capitalism was about to be partially nationalized.

When Wells objected to bailing out New York banks, Paulson coolly pointed out that Wells Fargo was sitting opposite its regulator. If they did not take the capital on offer that afternoon, they would be notified the following morning that they were undercapitalized.

Oh my God

By comparison with the less encompassing effort in Europe, America’s recapitalization would come to look very impressive. And this judgment was reinforced by hindsight. America’s banks recovered from the crisis more quickly and comprehensively than their European counterparts. The meeting of October 13, 2008, it seems, is when the great transatlantic divergence began.

comforting as it may be to invoke sovereign power at moments of great uncertainty, this is a mystification of the events in September and October of 2008. The path from Lehman to TARP was less one of a sovereign state rising to a crisis than of a dysfunctional power struggle within the social and political network that tied Washington, DC, to Wall Street and to the European financial system beyond.

The Treasury’s act of power would have been more impressive if the injection of capital had been on onerous terms. But the opposite was the case. Vikram Pandit was right. The capital the Treasury was “forcing” on the banks was cheap, in every respect.

The Treasury’s aim was to persuade all banks to participate en masse so as to ensure that state support was not taken as a signal of weakness that would attract the attention of short sellers. As Steinbrück had spelled out in his furious reaction to Deutsche Bank, at a moment of crisis, defense of the system involved both treating everyone as though they were healthy and the healthier banks being willing to play along.

For critics of the bailout, like Sheila Bair of the FDIC, it seemed that the entire process was a smoke screen put up to hide a bailout of Citigroup.112 The Clinton-era network was still at work. Citi was not just too big to fail. It was too well connected. Whatever one thinks of this interpretation, it is undeniable that as soon as the extreme panic of early October had passed, the pretense of equal treatment was dropped.

Bank of America was struggling too and that put Merrill Lynch in jeopardy. As the takeover proceeded, the full scale of Merrill’s mortgage losses was becoming apparent and CEO Ken Lewis and his team at Bank of America were desperate to pull out of the deal that had saved the investment bank on September 14. No one wanted to go back to Lehman weekend. Under heavy pressure from Paulson and Bernanke, Lewis pressed on with the deal, withholding crucial information from Bank of America’s shareholders, but taking another $20 billion in government capital and a “loss-protection arrangement” on $118 billion of Merrill’s troubled assets.

The only figure on the Obama economics team who did not belong to the Clinton-era “old boys” networks was Christina Romer, a “new Keynesian” economist from Berkeley and noted expert on the history of the Great Depression, who was appointed to be chair of the Council of Economic Advisers.

Well before November 4, the baton had already passed. The political party that had demonstrated its willingness to mobilize the full resources of the US government to fight the financial crisis was the Democratic Party. The Republicans weren’t so much a partner in managing the crisis as a symptom of it.

In the course of the crisis the GOP had shown itself to be less a party of government than a political vehicle through which conservative, white Americans expressed their alarm at the earthquakes shaking their world.

As the eurozone crisis would reveal, the national approach insisted on by Berlin was fundamentally unfit for purpose. But by focusing attention on the European dimension of interdependence, that judgment in fact understates the case. The banks and the borrowers of Europe were indeed interdependent. But even more basic and far more pressing in the fall of 2008 was their dependence on the United States.

The closure of interbank and wholesale funding markets created huge pressures in the dollar-funding markets all over the world, and it was in Europe that the pressure was most acute. This was a shortfall that even the strongest European states were powerless to address. That it did not result in a spectacular transatlantic crisis was decided not in Europe but in the United States, where the Fed, acting in the enlightened self-interest of the US financial system, acknowledged the compelling force of financial interconnectedness and acted on it.

When the music in the private money markets stopped, the Fed took up the tune, providing a stopgap of liquidity that, all told, ran into trillions of dollars and was tailored to the needs of banks in the United States, Europe and Asia. It was historically unprecedented, spectacular in scale and almost entirely unheralded.

These were not bailouts but money market transactions, of the type that central banks routinely conduct to tighten and ease financial conditions, but now on a scale never seen before. As they lent cash or cash equivalents against collateral—good and bad—the balance sheets of all the major central banks began to expand. Potentially, at least, this could be done without limit within a closed national economy, or a large currency zone like that of the euro or the dollar. But what such operations could not conjure up was liquidity in foreign currencies.

This domestic currency constraint was a crucial limit on the power of central bank operations and particularly so in 2008, because what the European banks desperately needed were dollars. It was into this breach that the Fed stepped with a program of liquidity provision that matched the global reach of the offshore dollar banking system.

this is where the disparity between the trade-based view of the economy and global financialization becomes starkly evident. In 2007 Germany’s exporters earned a trade surplus with the United States of roughly $5 billion per month. According to calculations by economists at the Bank of International Settlements, what the European banks needed was not $5 billion, or even $10 billion. Prior to the crisis they had funded their dollar operations with c. $1 trillion in commitments from US money market funds. On top of that they had borrowed $432 billion in the interbank market, $315 billion on the foreign exchange swap markets and $386 billion in short-term funding from those monetary authorities that were managing dollar cash pools.

What the 2008 crisis exposed was a dangerous imbalance in the business model of the European banks. As the American money markets shut down, all the European banks were scrambling for dollar funding. They tried to borrow from one another, which led to a painful surge in short-term funding costs as measured by the so-called Libor-OIS spread.

The cross-currency basis swap spread, which measures the interest rate spread that European banks were willing to pay to transfer euro or sterling funding into dollars, became strongly negative, indicating that it was extremely difficult to access dollar funding directly.

Where could more dollar funding come from? One might think of central banks as a possible source of foreign exchange. But the dollar reserves of the European central banks were, by themselves, nowhere near large enough to meet the funding needs of the banks.

Throughout July, in the dollar auctions held regularly by the ECB, the bids exceeded the allotted sums by a factor of four. Little wonder that as the crisis deepened, the dollar was not falling in value, as standard macroeconomic models had predicted, but rising.

In any case, the Fund was still defined by the basic rationale of the 1944 moment in which it was born and had the proportions to match. The IMF financed trade deficits and handled public debt crises. It was not in the business of filling gigantic private sector funding gaps. Its programs were denominated in tens of billions of dollars.

As Bernanke remarked with typical understatement, the dollar funding needs of Europe’s banking system were “a novel aspect of the current situation.”10 It was a novel aspect with potentially drastic implications for the United States. If the Fed did not act, what threatened was a transatlantic balance sheet avalanche, with the Europeans running down their lending in the United States and selling off their dollar portfolios in a dangerous fire sale.

The Fed labeled its liquidity facilities in a bamboozling array of acronyms—among insiders the programs were known collectively as the “hobbits.” But when broken down by function, they mapped directly onto each of the key elements of the shadow banking system: the asset-backed commercial paper market, repo lending, the market for the mortgage-backed securities, currency swaps.

Instead, the “Federal Reserve’s balance sheet expansion” was an “emergency replacement of lost private sector balance sheet capacity by the public sector.”12 The Fed was inserting itself into the very mechanisms of the market-based banking model.

The scale of the Fed’s liquidity actions was so large and varied that it poses problems of accounting.

If anything, the stigma of using the discount window was less severe for non-American banks. So alongside the American strugglers, the Fed’s accounts also prominently featured two of the European basket cases: Franco-Belgian bank Dexia and the ill-fated Irish branch of Hypo Real Estate, Depfa.

If TAF loans of varying duration are converted to a common twenty-eight-day basis, the total sum loaned came to a staggering $6.18 trillion in twenty-eight-day loans.