Crashed: How a Decade of Financial Crises Changed the World

by Adam Tooze

Building a big balance sheet of MBS didn’t just involve risk on the asset side. It also involved expanding the liabilities of the bank on the funding side. And this brings us to the true heart of the 2007–2008 crisis.

the mortgage production line was holding hundreds of billions of private label MBS and ABS on its own balance sheet, how were those holdings funded? Here too it was the new model of investment banking that provided the answer. If an upstart mortgage lender like Countrywide didn’t have depositors, neither did Lehman. Lehman got its funding whole...

This was the truly lethal mechanism at the heart of the crisis. Funds from money market cash pools were channeled into financing the h...

The largest mechanism for funding mortgage holdings was asset-backed commercial paper (ABCP).46 The three biggest American issuers of ABCP were Bank of America, Citigroup and J.P. Morgan. The vehicles for managing this operation were so-called structured investment vehicles (SIV), legal entities provided with a minimum layer of capital by their “sponsors,” but otherwise separate from the balance sheets of their parent banks. Onto these SIVs the parent bank would offload a large portfolio of mortgage bonds, securitized car loans, credit card debt or student debt. The SIV would pay the parent bank for the securities with funds raised by issuing ABCP. These were three-month notes backed by the assets in the SIV and the good name of the parent bank. Though the SIV had no track record, it could issue the commercial paper at competitive rates because of the value of the securities it held and because it was assumed that it enjoyed the backing of the sponsoring bank. Remarkably, under the bank regulations prevailing until the early 2000s, assets parked off balance sheet in the SIV could be backed by a fraction of the capital that would be required if they were on balance sheet. Inflati...

If the SIV-ABCP model involved a degree of maturity mismatch, the investment banks pushed this to extremes. The entire business model of investment banks was based on wholesale funding. The most elastic vehicles for this were so-called repurchase agreements, or repo. In a repo transaction a bank would buy a security and pay for the purchase by immediately reselling it for a period of as little as one night or as long as three months,...

The investment bank would buy $100 million in securities and repo them with a mutual fund or another investment bank, with the party repoing the paper paying a small interest charge to the investor it was repoing with. It also accepted a haircut. In exchange for $100 million in Treasurys, it did not receive full value, but only $98 million in cash. It would also repurchase them for $98 million. In the meantime, the haircut determined how much of its own money the investment bank would have to put into holding the securities, and thus the leverage in the deal.47 A 2 percent haircut meant that to fund the purchase of $100 million of securities and to receive the interest paid on those bonds, a bank would need $2 million of its own money. The rest it could get out of the repo transaction...

the 2000s the collateral posted in repo markets in New York ran to several trillions of dollars a day. It was split into two markets—bilateral and triparty repo. Both were over-the-counter professional markets, which were only loosely monitored by the central banks or regulators. The best data we have is for trilateral repo where the trade was managed by a third party—either JPMorgan Chase or Bank of New York Mellon—which held the collateral for the duration of the repo.48 In triparty repo the collateral used was of top quality—almost exclusively Treasurys or agency MBS. Given the...

MBS. It was in the bilateral repo market that they could be funded. The best available data suggest that the bilateral repo market was three times larger than the triparty segment.49 Because the players in the bilateral market tended to be investment banks and hedge funds, the types of assets acceptable as collateral were more wide ranging. It is here, along with ABCP and various types of interbank and unsecured borrowing, that the investment banks financed their holding of private label MBS and CDO portfolios. Given the wide range of collateral, haircuts in the bil...

As in commercial paper, repo was exposed to serious funding risk. You might not be rolled over. Specifically, the risk was that if an investment bank like Lehman or Bear was thought to have suffered major losses on some big part of its portfolio—whether that was funded by commercial paper, bilateral repo or other types of interbank borrowing—it would suffer a general loss of confidence. It would then be considered ineligible as a counterparty in the triparty market and would find itself shut out from critical funding. The scale of the potential risk was huge. At Lehman at the end of fiscal year 2007, of its balance sheet of $691 billion, 50 percent was funded through repo. At Goldman Sachs, Merrill Lynch and Morgan Stanley, the share was 40 percent.50 If any one of these investment banks was to ...

With so many interests engaged, the expansion in US mortgage lending in the final burst of the boom was spectacular, not to say grotesque. Between 1999 and 2003, 70 percent of the new mortgages issued in the United States were still conventional GSE-conforming. With the end of the refinancing boom, that balance shifted. By 2006, 70 percent of new mortgages were subprime or other unconventional loans destined for securitization not by the GSE, but as private label MBS. In both 2005 and 2006, $1 trillion in unconventional mortgages were issued, compared with $100 billion in 2001. Fannie Mae and Freddie Mac were scrambling to keep up, purchasing $300 billion in nonagency securitized mortgages to hold in their own portfolios. The GSEs were driven. They were not the drivers. They were competing with upstarts like Countrywide, which in 2006 was responsible for originating 20 percent of all mortgages in the United States.51 They were competing with an ultrasophisticated investment bank like Lehman Brothers that had assembled an entire pipeline. In 2005 two thirds of the mortgages contained in Lehman’s issuance of $133 billion in MBS/CDO were sourced from its own subprime loan originators. A top Wall Street name was scraping the very bottom of the credit barrel.

The message that this communicated down the food chain was simple: We want more mortgage debt to process, and the worse the quality, the better.

Substantial portions of undocumented, low-rated, high-yield debt emerged as AAA.

But the mortgage securitization mechanism systematically produced this race to the bottom in mortgage lending quality. It was the difference between the high yield of the underlying securities included in the collateral pool and the low interest that was paid to the investors who bought the AAA-rated asset-backed securities that generated the profit.

From 2004, fully half the subprime mortgages being fed into the system had incomple...

and 30 percent were interest-only loans to people who had no prospect of ...

The ratings agencies would subsequently face penetrating questions about their complicity in this process. It did not help that they were paid by the banks for which they rated the bonds and that the big three ratings agencies competed with one another to offer the most streamlined and cheap route to AAA ratings.

In their defense they would argue that they were operating tried-and-tested formulae that had the stamp of approval of the smartest economists in the land.

But payment was by...

Fitch, which applied a risk assessment model that generated fewer of the coveted AAA-rated securities, found itself largely cut out of...

As later congressional inquiries revealed, the ratings agency staff at Moody’s and S&P were clearly aware of the monster they were creating. As one ratings expert remarked to another in an e-mail in December 2006: “Let’s hope we are a...

In the early 2000s 35 percent of all profits in the US economy were earned by the financial sector.

The rule was that half of net revenue after interest costs was reserved for staff payments, the other half being paid to shareholders.

The 2006 business year generated $60 billion in bonuses for the finance crowd in New York, and 2007 topped that with $66 billion in bonuses.

For senior staff at the investment banks, that translated into payments in the tens of millions of dollars each. Richard Fuld, who drove Lehman’s dramatic growth as CEO from 1994, earned $484.8 million in salary and bonus between 2000 and 2008. That was staggering enough, but to understand the psychology of those operating the sys...

the real kings of the money game. Their remuneration paled by comparison with that of the hedge fund managers with whom they dealt in the prime brokerage, repo and ABCP markets. At the hedge funds and private equity groups, individuals could earn hundreds of millions, or even billions, of dollars per annum. In 2007 the...

But once a real estate market shifts from a state of equilibrium to one of boom, everyone becomes a speculator willy-nilly. As capital appreciation came to be expected, the meaning of home ownership changed. Home owners, whether they liked it or not, were taking a speculative position. At the bottom, those who got on the housing ladder by taking out adjustable-rate, low-credit-score mortgages were speculating that their properties would rise in value so much that their equity would be sufficient to refinance on better terms. Those further up the ladder engaged in a fiesta of real estate speculation.

In 2006 fully a third of new mortgages issued in the United States were for second, third or even fourth properties. In what became known as the “bubble states”—Florida, Arizona, California—the percentage was as high as 45 percent.56 Obviously, these were not the fortunes being made on Wall Street or on the Gold Coast of Connecticut, but real estate speculation had become a mass sport.

All told, if we focus on that section of the market that was truly a product of the bubble, by the summer of 2007, $5.213 trillion in private-label asset-backed securities had been issued—that is, MBS generated from unconventional mortgages and credit card, student loan and auto debt. Of this total, the most dangerous mortgage component, subprime mortgage MBS, amounted to $1.3 trillion. Though this was “only” 12 percent of the total American mortgage market, the $1.3 trillion had been produced in a single surge since 2003. Of the total sum of $5.23 trillion, more than $3 trillion had been placed with long-term investors and $700 billion were placed directly with investment funds or investment banks. But $1.173 trillion were held by banks that funded them off balance sheet by issuing ABCP. As a result, ABCP had become the largest short-term money market instrument for investors looking to park cash for less than three months. The market for ABCP was larger even than for the short-term Treasury bills issued by the US government to manage its cash flow. If there was a channel through which the crisis in real estate could ramify outward to unleash the global financial crisis, this was it—ABCP, the place where private label MBS met wholesale funding.

Every year in August the elite of the central banking and monetary economics world gathers at a resort in Jackson Hole, Wyoming. In August 2005 the theme of the conference was not the crisis brewing in the US housing market but a celebration in honor of the outgoing Fed chairman, Alan Greenspan.

Raghuram G. Rajan, an Indian

professor at the Chicago Graduate School of Business and chief economist at the IMF. His paper bore the heretical title “Has Financial Development Made the World Riskier?”57 Rajan worried that the dramatic expansion of modern financial i...

Luddite

Briefly, following Enron, there was a push for greater regulation. There was talk about requiring the parent sponsors of the off balance sheet SIVs to put more capital behind them. The threat alone was enough to bring growth in the ABCP industry to a halt.

But in July 2004, as subprime was really hitting its stride, the regulators agreed to provide a permanent exemption that effectively allowed assets held in SIVs to be backed by only 10 percent of the capital that would have been required if the assets were held on the balance sheets of the banks themselves. This was particularly attractive for big commercial banks, like

Citigroup and Bank of America, that were subject to relatively tight capital regulation, putting them at a huge disadvantage to the lightly regulated investment banks.

It was following that regulatory shift that the ABCP market exploded from $650 billion to in excess of $1 trillion.63 By the summer of 2007 Citigroup alone was guaranteeing $92.7 billion in...

More than the grand gestures of deregulation, like the 1999 act, it was this kind of apparently small-scale regulatory change that unfettered the growth of shadow banking. The same was true for repo. Traditionally, repo had been limited by the fact that the categories of assets that were exempt from the automatic stay in case of bankruptcy included only US government and agency securities, bank certificates of deposits and bankers’ acceptances. If those classes of security were offered as collateral in repo, in cases of bankruptcy they could be seized without delay and any losses made good. In 2005 the Bankruptcy Abuse Prevention and Consumer Protection Act gave creditors much stronger protection against defaulting borrowers, which ironically increased their willingness to lend. But it also expanded the repo c...

Could the Fed have contained the bubble through tougher interest rate policy? Greenspan’s cuts of the early 2000s had triggered the lending surge. Indeed, it had clearly been Greenspan’s intention to unleash a refinancing boom to help the recovery from the dot-com bust and the shock of 9/11. But what the Fed did not appreciate was the structural change in the mortgage machine the refinancing boom would trigger. Certainly by 2004 it was clear that it was time to raise rates. In seventeen tiny steps the Fed inched rates from 1 percent in June 2004 to 5.25 percent in June 2006. It was fine-tuning, not shock and awe. The mortgage boom continued undeterred, as did global demand for American safe assets and the expansion of the shadow banking sector. By the spring of 2006, to the alarm of many commentators, the result was that the yield curve was inverted. Long-term rates were below the short-term interest rates set by the Fed. This was usually a signal for trouble. It meant that the normal bank-funding model of borrowing short to lend long no longer made any sense.

In due course, the inversion of the yield curve might by itself have produced a recession. But it wasn’t Greenspan or Bernanke who killed the mortgage boom. It killed itself. By 2005 at the latest it was clear that low-quality mortgage debt was a ticking bomb. Many of the subprime mortgages were on balloon rates that would rapidly increase after a period of two or three years. In 2007 the typical adjustable-rate mortgage in the United States favored by low-income borrowers was resetting from an annual rate of 7–8 percent to 10–10.5 percent.65 As traders such as Greg Lippmann at Deutsche Bank realized, between August 2006 and August 2009, $738 billion in mortgages would experience “payment shock.”66 As the escalated interest payments hit, a wave of defaults was more or less inevitable. Once that began it was only a matter of time before house prices stopped increasing and the market turned. At that point, millions of speculative real estate investments would go bad. Families would lose their homes. Thousands of MBS would suffer default and whoever held insurance would get rich. Nowhere in Lippmann’s extensive document arguing for Deutsche Bank to short MBS was there any mention of Fed tightening. The subprime mortgage machine had a self-tightening timer built in. Unless house prices continued to rise at record rates, it would activate mercilessly and stop the boom in its tracks.

It was the first round of that tightening that was beginning to make itself felt in the most stressed communities across the United States already in 2006. Default rates were rising. It would not be long before the AAA rating granted to the lowest-quality CDO would be in doubt. To take advantage a growing band of contra...

To build the position they bought CDS, derivatives designed to provide protection against default. 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. The question was one of timing and the problem was funding. 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.”67 The question was what would happen when the music stopped.

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.

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 ris...

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.8 The segment of the securitization chain in which European banks were of truly crucial importance was also the weakest link in the chain, ABCP.

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. Europe’s banks had good standing with the ratings agencies, but they did not have large dollar-denominated depositor bases. If they wanted to get in on the MBS boom, they needed to go to the wholesale market.

Among the European sponsors, German financial institutions were particularly prominent, and what was remarkable was the kind of German bank that was involved. Germany’s giant, Deutsche Bank, was a leading player on Wall Street. It is not for nothing that it featured as prominently as it did in Michael Lewis’s bestselling narrative of the crisis, The Big Short, or in the subsequent Senate investigation.9 Dresdner Bank, Germany’s number two, was also heavily involved in the United States. But 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. Banks from the former industrial heartland of Germany, such as Sachsen-Finanzgruppe, WestLB ...

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. After all, if a Wall Street investment bank could do it, why not a European bank with some experience in retail banking? 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.10 Credit Suisse built an American mortgage-servicing department that fed one of the largest ABS CDO operations of the early 2000s.11 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.”12 From the point of view of generating high-yielding CDOs, it was precisely the bottom of the mortgage barrel that was most attractive.