Crashed: How a Decade of Financial Crises Changed the World

by Adam Tooze

Anticipating shipwreck, the holders of the big short were making advanced bookings in the lifeboat. They could either hold their insurance until the bonds failed and their payouts were due or they could sell their positions at a huge profit to lenders who were desperate for default protection.

Going long in CDS when majority opinion was still driving the market up was an expensive and nerve-racking proposition. You were on the other side of the last surge in ABCP and repo deals. At Citigroup in the summer of 2007, CEO Chuck Prince was still telling journalists that “as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”

Americans liked to think of their problems as American and outsiders were only too happy to concur. As the mortgage meltdown spread like a lethal virus across urban America in 2007–2008, European commentators took up the narrative of an American national crisis.

When the storm broke in 2008, the Schadenfreude among European politicians was palpable.

On September 16, 2008, as Wall Street unraveled, Peer Steinbrück, Germany’s tough-talking SPD finance minister, went before the Bundestag to announce that the global financial system faced a crisis originating in America from which Germany had so far been spared. “America’s laissez-faire ideology,” as practiced during the subprime crisis, “was as simplistic as it was dangerous,” he later told Germany’s parliamentarians. He confidently expected that America would soon forfeit its role as financial superpower.

Wooooof

And just in case anyone wondered where the home of that mad idea was, Giulio Tremonti, Silvio Berlusconi’s outspoken finance minister, boasted that Italy’s banking system would be fine because “it did not speak English.”

Womp womp

America’s securitized mortgage system had been designed from the outset to suck foreign capital into US financial markets and foreign banks had not been slow to see the opportunity.

Since the 1980s Americans had grown used to the idea that Asians—first the Japanese, now the Chinese—owned their government debt. That was the anxiety that haunted the Hamilton Project. What they did not reckon with was that foreigners owned a large portion of America’s houses.

By 2008 roughly a quarter of all securitized mortgages were held by foreign investors. Fannie Mae and Freddie Mac funded $1.7 trillion of their portfolio of $5.4 trillion in mortgage-backed securities by selling securities to foreigners. China was by far the biggest foreign investor in these “Agency bonds,” with holdings estimated at $500–600 billion.5 But in the riskier segment of the securitized mortgage business it was Europeans, not Asians, who led the way.

For nonconforming high-risk MBS, those not backed by Fannie Mae or Freddie Mac, the share held by European investors was in the order of 29 percent.7 In 2006, at the height of the US mortgage securitization boom, a third of newly issued private label MBS were backed by British or European banks.

In the summer of 2007, though it was Citigroup that had the largest off balance sheet SIV exposure, it was European banks that dominated the market. Overall, two thirds of the commercial paper issued had European sponsors, including 57 percent of the dollar-denominated commercial paper.

Among the European sponsors, German financial institutions were particularly prominent, and what was remarkable was the kind of German bank that was involved.

it was Germany’s smaller regional banks, the Landesbanken, that threw themselves head over heels into the American adventure. In the early 2000s, at the insistence of Brussels, the Landesbanken were stripped of the local state guarantees that lowered their funding costs. They responded by taking a punt on adventurous financial engineering.

At least four German sponsors—Sachsen, WestLB, IKB and Dresdner—had ABCP exposure large enough to wipe out their equity capital several times over.

Nor did European banks confine themselves to dealing in the securities. The Europeans went native, joining their American counterparts in integrating down the supply chain so as to control mortgage origination itself.

From the mid-1990s banks like Britain’s HSBC aggressively bought into the American mortgage market. By 2005 HSBC could boast of having serviced 450,000 mortgages to a total value of $70 billion.

Deutsche Bank had close relationships with the giant mortgage-generating machines at Countrywide and AmeriQuest. In 2006 the German bank bought the subprime specialists MortgageIT Holdings and Chapel Funding LLC. As a Deutsche Bank press release glowed, ownership of these operations at the bottom of the US credit pyramid would “provide significant competitive advantages, such as access to a steady source of product for distribution into the mortgage capital markets.”

The EU current account surplus with the United States was modest compared with that of China. With the world as a whole, Europe’s current account was in modest deficit. The Europeans did not peg their currencies against the dollar. There was no agency in Brussels accumulating foreign assets as part of a currency stabilization effort, no German sovereign wealth funds. So how did European banks end up owning such a large slice of American mortgage debt?

European banks operated just like their adventurous American counterparts. They borrowed dollars to lend dollars. And the scale of this activity is revealed if we look not at the net flow of capital in and out of the United States (inflows minus outflows), which has its counterpart in the trade deficit or surplus, but at the gross flows, which record how many assets were bought and sold in each direction.

by far the largest purchasers of US assets, by far the largest foreign lenders to the United States prior to the cri...

Before 2008 the net financial flow from Asia to the United States could reasonably be construed as the financial counterpart to America’s trade deficit with Asia. By contrast, the financial flows between Europe and the United States made up a financial circulatory system quite independent of the trade connections between the two.

Europe’s banks did not have branches spread across the United States. But a Wall Street firm like Lehman didn’t either. This was the beauty of the market-based model of banking. You borrowed the dollars on Wall Street to fund your holdings of mortgages from all over the United States.

The ABCP conduits organized bundles of securitized assets from the United States and Europe.13 With those securities as collateral they then issued short-term commercial paper, which was bought by the managers of cash pools in the United States. In 2008, $1 trillion, or half of the prime nongovernment money market funds in the United States, were invested in the debt and commercial paper of European banks and their vehicles.

hundreds of billions of dollars took a more circuitous route. They flowed out of the United States from the branches of foreign banks in New York to the head offices of European banks, from which they returned for investment in the United States, sometimes by way of an offshore tax haven such as Dublin or the Cayman Islands.

The bank did not have an existing depositor base in dollars. Its existing liabilities—deposits, bonds issued and short-term borrowing—were in euros. This meant that the German bank had a funding problem if it wanted to lend in dollars. But in that respect it was no different from a Wall Street investment bank.

the German bank could borrow directly in the United States (option 3), for instance from an American money market fund eager to earn slightly more than the returns offered by Treasurys, now that the Chinese were buying them. The result would be a German bank with a balance sheet that featured liabilities and assets of different maturities and denominated in a variety of currencies.

In the national balance of payments statistics one would see both borrowing from and lending to America happening within the accounts of the same bank. One could net the flows out to identify how much, on balance, flowed one way rather than the other, but that would give no idea of the scale of the commitments on each side.

But if we map not annual flows but cross-border banking claims, this gives further proof of how one-sided the Sino-American view of the buildup to the crisis was. The central axis of world finance was not Asian-American but Euro-American.

European banking claims on the United States were the largest link in the system, followed by Asian claims on Europe and American claims on Europe. European claims on Asia exceeded the much commented upon Asian-American connections.

West European claims on emerging Eastern Europe alone were more than three times the size of American claims on Asia.

The European financial centers offered a safe channel through which funds from Asia and the Middle East were then sluiced into more speculative investments in the United States. It was not for nothing that China preferred to channel many of its claims on the United States through Belgium.

In the process, the European financial system came to function, in the words of Fed analysts, as a “global hedge fund,” borrowing short and lending long.

If it is misleading to construct our image of financial globalization around the Sino-American trade balance, to imagine it as centered on US securitization with outsiders being “sucked in” misses the point too.

the entire structure of international banking in the early twenty-first century was transatlantic. The new Wall Street was not geographically confined to the southern end of Manhattan. It was a North Atlantic system.

In the aftermath of World War II, the Bretton Woods monetary system had sought to restrict speculative capital flows. This gave the US Treasury and the Fed controlling roles. The aim was to minimize currency instability and to manage the global shortage of dollars. But it meant that the US authorities had to operate the kinds of controls that we now associate with China.

From the 1950s, with connivance of the UK authorities, the City of London developed as a financial center that sidestepped those constraints.18 British, American, European and then Asian banks too began to use London as a center for unregulated deposit taking and lending in dollars.

Among the first to avail themselves of these “eurodollar” accounts were Communist states that wanted to keep their export earnings safe from meddling by the US Treasury.

So...laundering

By the 1960s eurodollar accounts in London offered the basic framework for a largely unregulated global financial market. As a result, what we know today as American financial hegemony had a complex geography.

Driven by the search for profit, powered by bank leverage, offshore dollars were from the start a disruptive force. They had scant regard for the official value of the dollar under Bretton Woods and it was the pressure this exercised that helped to make the gold peg increasingly untenable.

By the early 1980s both Britain and the United States had abolished all restrictions on capital movements and this was followed in October 1986 by Thatcher’s “Big Bang” deregulation.

Within a decade the UK’s own investment banks had been swallowed by their American and European competitors.20 American, Asian and European capital flooded in. This involved not only regulatory change and huge financial flows but the physical reconfiguration of the medieval heart of the City of London. To house the gigantic new offices and electronic trading desks needed by global banks, Canadian real estate moguls undertook the construction of a massive new office complex in the abandoned postindustrial docklands of Canary Wharf.

For many of the most fast-paced global transactions, it was London, not Wall Street, that was the location of choice. By 2007, 35 percent of the global turnover in foreign exchange, running at a staggering $1 trillion per day, was conducted between computer systems in the City of London.

Of an annual turnover in interest rate derivatives in excess of $600 trillion, London claimed 43 percent, to New York’s 24 percent.

The FSA was required to apply cost benefit analysis to its own interventions and benchmark its operations against other countries.27 Perhaps not surprisingly, given this mandate, the FSA’s staff was a fraction of that of its US counterparts.

As a result, according to investigations by a team of analysts from the IMF, the City of London came to function as a “platform for higher leveraging not available in the United States.” The scale of this activity was enormous. According to the IMF team, trading in and out of London the main European and US banks achieved a collateral multiplication of 400 percent, amounting to roughly $4.5 trillion in additional funding, effectively out of thin air.

The UK’s liberalization not only freed up UK markets but acted as a crowbar to dislodge regulation worldwide. A transatlantic feedback loop drove regulation down on both sides.

The 1999 law was not called the Financial Services Modernization Act for nothing. There was a distinct vision of modern finance that the US industry was chasing and it was defined by global competition, above all by the City of London.

New York, certainly, stood to benefit, but that should not mislead one into thinking in terms of national champions. No one had been more active in shaping the global marketplace in London than expat American bankers working for the London offices of the major Wall Street firms.

European politicians and cultural critics might be skeptical of freewheeling “Anglo-Saxon” finance. But this downplays the extent to which Europeans coconstructed global finance. From the 1980s onward, Swiss, German, French and Dutch banks began to buy into the City of London with aggressive acquisitions.

All told, in 2007 the City of London was home to 250 foreign banks and bank branches, twice as many as operated out of New York.33 But the European footprint in Wall Street was very substantial. Of the top twenty broker-dealers in New York, twelve were foreign owned and held 50 percent of the assets.