Crashed: How a Decade of Financial Crises Changed the World

by Adam Tooze

Substantial ongoing deficits may severely and adversely affect expectations and confidence, which in turn can generate a self-reinforcing negative cycle among the underlying fiscal deficit, financial markets, and the real economy.” Conventional analysis, in short, was not sufficiently alarmist. What it did not “seriously entertain” was the possibility that America was headed toward “fiscal or financial disarray.”

Chief political adviser James Carville was left to ruminate: “I used to think if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody.”

After a brief storm over the Taiwan Strait in 1995–1996, diplomatic relations calmed. But China’s sheer size made it a contender. With the Tiananmen crackdown of 1989, the Communist Party had signaled its intent not to abandon its one-party leadership. Since then it had fashioned a popular ideology that was as much nationalist as Communist.18 If Washington was betting on international trade and globalization to “Westernize” China, the Chinese Communist Party took the other side of the bet.

China had no intention of becoming either the victim of a sudden stop or the needy recipient of US assistance.26 To reverse the balance of risk, when Beijing pegged its exchange rate it chose one that was not too high, but too low. This was what Japan and Germany had done in the 1950s and 1960s.

to hold the value of the yuan down the Chinese central bank had to continually buy dollars and sell its own currency. To do so it printed yuan. In the normal course of things this would have unleashed domestic inflation, wiping out any competitive advantage and triggering social unrest. So, to “sterilize” the effects of its own intervention, the People’s Bank of China required all Chinese banks to hold large and growing precautionary reserves, effectively removing the currency from circulation.

Under the chairmanship of first Paul Volcker (1979–1987) and then Alan Greenspan (1987–2006), the authority of America’s central bank soared to new heights. In terms of its expert authority and unassailable position within the structure of the US government, it came to rival the US security apparatus.41 The irony, however, was that as the Fed’s reputation and authority grew, its key tool of policy seemed to be losing its effectiveness. The short-term interest rate set by the Fed no longer seemed to be setting the pace for the rest of the economy.

The Fed found itself boxed in between China’s determination to peg its currency and the refusal of Congress to curb America’s budget deficit. China’s unbalanced growth path created an excess of savings that needed to be invested abroad. AAA-rated US Treasurys were the reserve asset of choice.

But to promote the IMF as an arbiter had serious implications. China could not be expected to take advice from the IMF until it had representation on the IMF’s board that was commensurate with its size. Furthermore, Beijing would expect IMF monitoring to apply to the United States as well. That wasn’t likely to appeal to a Republican White House.

The best and brightest in American economic policy were not wrong to worry about the Sino-American imbalance. If it had blown up, it would have been a disaster. Ten years on, the scenario still hangs over the world economy.

But in the meantime, what became increasingly clear was that the US policy-making elite had been focused, as Bradford DeLong would put it, on the “wrong crisis.”57 The crisis that will forever be associated with 2008 was not an American sovereign debt crisis driven by a Chinese sell-off but a crisis fully native to Western capitalism—a meltdown on Wall Street driven by toxic securitized subprime mortgages that threatened to take Europe down with it.

By one estimate, the share of American real estate in global wealth is as much as 20 percent.1 American homes account for 9 percent of the total. At the time of the crisis 70 percent of American households owned their own home—more

Fluctuations on such huge scales can clearly help account for a business-cycle downturn in 2007. But to explain how this could trigger a financial crisis, with bank failures spreading panic and a credit crunch across the world, there is one crucial thing to add: Real estate is not only the largest single form of wealth, it is also the most important form of collateral for borrowing.4 It

Between the 1990s and the outbreak of the crisis in 2007, American housing finance was turned into a dynamic and destabilizing force by a fourfold transformation—the securitization of mortgages, their incorporation into expansive and high-risk strategies of banking growth, the mobilization of new funding sources and internationalization. All four of these changes can be traced back to the transformation in world economic affairs between the late 1970s and the early 1980s in the wake of the collapse of Bretton Woods.

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Volcker’s shock set the stage for what Ben Bernanke would later dub the great moderation.9 It was an end not just to inflation but to a large part of the manufacturing base in the Western economies, and with it the bargaining power of the trade unions. No longer would they be able to drive up wages in line with prices. And there was another part of America’s postwar political economy that did not survive the disinflationary shock of the 1980s: the peculiar system of housing finance that had emerged from the New Deal era.

In a new age of flexible monetary arrangements it was dangerously one-sided, especially if the risks were concentrated in small mortgage lenders with limited means of funding themselves. The solution was to go for scale, to adopt a new market-based model of financing and to place government institutions at the center of the system.

By the end of the century Fannie Mae and Freddie Mac together were backstopping at least 50 percent of the total national mortgage market.

It was this conservative critique of the GSEs that shaped the Republican reaction when the crisis reached fever pitch in 2008. For many in Congress the bailout was not just of the banks—they at least were private businesses trying to make a buck. The bailout was also a desperate effort to make the taxpayer pay for the rescue of a Democrat-controlled parastate housing welfare apparatus designed to serve pampered minorities. This was powerful mobilizing rhetoric for the Republican base. But as an explanation of the crisis that was brewing in 2006, this political critique is wide of the mark. Fannie Mae and Freddie Mac set a high minimum standard for the quality of loans they would buy. The GSEs didn’t support the kind of low-quality, subprime loans that were beginning to fail in droves in 2005–2006. Those toxic loans were the products of a new system of mortgage finance driven by private lenders that came into full force in the early 2000s. Though the GSEs met their government lending quotas, private lenders driven by the search for profit were far more adventurous in lending to underserved communities.

In this sense the GSEs did not create the crisis. But what they did contribute were two innovations without which the crisis is hard to imagine: the originate-to-distribute mortgage lending system and securitization.

This was the basic structure of what became known as “originate to distribute.” Mortgage lenders no longer needed to hold the mortgages on their balance sheets; they became brokers operating for a fee. The government-backed credit rating of the GSEs backstopped the entire system. Starting in the 1970s, as they confronted the instability of interest rates and its damaging implications for America’s mortgage model, the GSEs took a further critical step. Working with the help of investment banks, they pioneered securitization.19 Rather than holding the locally originated mortgages on their own books and financing them by issuing bonds, they would sell the mortgages directly to investors.

By the 1990s, Moody’s Investors Service and Standard & Poor’s divided 80 percent of the global debt-rating business between them.21 Fitch took another 15 percent of the market. They did not attain that control of the global market by freely handing out top AAA ratings. In 2008 there were only six AAA-rated corporations and no more than a dozen countries enjoying that ranking.

Payment by the issuer created a conflict of interest. But the agencies had much to lose if they appeared to be selling good ratings and relatively little to gain if they showed favor to a client that was involved in only occasional bond issues. The mortgage securitization business changed that calculus. The sheer volume of mortgage-backed security issuance, involving tens of thousands of tranches, combined with the fact that the flow was concentrated in the hands of a few issuers, gave the ratings agencies a significant incentive to be “helpful.”22 But even more important was the nature of MBS as such. What made rating MBS different was that the underlying assets were not bonds issued by a company facing the unpredictable force of global competition. The MBS bundled thousands of what were supposed to be predictable assets—regular domestic mortgages. The ratings agencies did not have to calculate the risks of default on the basis of more or less subjective evaluations of a company’s business prospects. Nor did they have to render a judgment on a country’s fiscal policy. Instead, they could apply standardized financial mathematics to a population of mortgages that was assumed

In 1980, 67 percent of American mortgages had been held directly on the balance sheets of depository banks. By the end of the 1990s, the risks involved in America’s system of long-term, fixed interest, easy repayment mortgages were securitized and spread across a much wider segment of the financial system than had been the case in 1979 when Volcker made his shock announcement. The GSEs held them. Banks held them. But so too did pension and insurance funds.

Wow

by the 1990s American mortgages were passing through at least five different institutions—originators, wholesalers of packages of mortgages, underwriters who assessed risk, government-sponsored enterprises and servicers who managed the flow of interest income—before being sold to an investor. Along that chain, what confidence could an investor have that the job was being done correctly? At each step of the way the main concerns were volume and fees. Who had an interest in maintaining quality? Perhaps it was not the government subsidy but these perverse incentives that led to the huge boom in bad lending and the crisis of 2007–2008.

It is a theory that would have a superficial plausibility if the 1990s model of GSE-centered mortgage finance had still been dominant in the early 2000s. But, in fact, in the early 2000s, when the subprime boom unfolded, the industry had changed again. Securitization was more dominant than ever. The GSEs were still responsible for buying and securitizing the top-tier conforming mortgages. But as a new range of actors entered the mortgage market with a more dynamic and expansive agenda, their principal business model was not to disaggregate and to spread the risk but to integrate every step of the process, including the holding of large quantities of securities on their own balance sheets.25 It was this growth model, based on integration, not disintegration, that would blow the system up.

ConsolidAtion!

To reestablish profitability in the 1990s America’s high street banks underwent spectacular consolidation. The top ten banks increased their share of total assets from 10 to 50 percent between 1990 and 2000. In addition they looked for a new business model.36 Rather than thinking of themselves as maintaining lifelong relationships with clients and their communities, they repurposed themselves as service providers for a fee. They had always originated mortgages but had generally sold them to the GSEs. Given the pressure that they were now under, the mortgage market, with its multiple layers of origination, securitization, selling and servicing, seemed like a natural bridge between their familiar high street banking business and their aspirations to high finance. But to engage in that full range of activities they needed regulatory relief. The New Deal–era regulations that separated retail from investment banking had to fall. The Clinton Treasury, first under Rubin and then under Larry Summers, gave them what they needed. In 1999 the last remnants of 1930s banking regulations were swept aside.

As compared with $1 trillion in new mortgages issued in 2001, in 2003 mortgage origination soared to $3.8 trillion, of which $2.53 trillion were for refinancing. In this huge boom the GSEs were still the major players. They continued to monopolize the prime mortgage segment. Their share of the market reached its maximum point in 2003 at 57 percent. But at that point it stalled. In the huge surge of business in the early 2000s not everything at the GSEs was aboveboard. Accounting and regulatory irregularities piled up. Fearful of another Enron, regulators subjected first Freddie Mac and then Fannie Mae to capital surcharges. They either had to raise new capital or contract their balance sheets. To make sure it was the latter, caps were imposed on their total balance-sheet size.39 The door to the private issuers was opened.

By combining them together and tranching, you could make a large pool of BBB assets yield further tranches of AAA securities. Once you had done that you could then go one step further. You could take the low-rated mezzanine slices of the CDO and pool and tranche them once more to create CDO-squared. And once again by the logic of independent risks and the good graces of the ratings agencies, a portion even of those securities would warrant an AAA rating.

This points to the third historic transformation that made possible the 2000s boom, a change not on the supply but on the demand side: the surging demand for safe assets and the mobilization of institutional cash pools for mortgage finance.41 It is at this point that the technical mechanics of mortgage banking reconnects with the grand theme of the rise of China, the emerging markets and the mounting inequality and wealth polarization in the Western world.

In the early 2000s, China and other emerging market sovereigns bought all the Treasurys that even the gaping budget deficits of the first Bush administration could provide. Macroeconomists worried about the current account imbalance that resulted and the possibility of a catastrophic sudden stop unwinding. What they did not pay attention to, because they did not dirty their hands with technicalities like MBS, was the effect the influx of emerging market funds might have in financial markets. Emerging market investors bought first Treasurys and then GSE-issued agency debt. This left other institutional investors looking for alternatives. What filled the gap was financial engineering. If pension funds, life insurers and the managers of the gigantic cash pools accumulated by profitable corporations and the ultrawealthy needed safe assets, AAA-rated securities were a product America’s mortgage machine knew how to synthesize.

But once again we have to be careful. The shuffling of global demand for dollar-denominated safe assets helps to explain why the mortgage pipeline did not result in an oversupply of AAA securities. But to the extent that private label asset-backed securities were actually sold off to investors, little more was heard of them. When the market turned bad, they would sit on balance sheets as an illiquid entry. They were no longer counted as safe assets. There would be lawsuits against investment banks that had knowingly repackaged unsafe mortgages. Certainly the losses would have an impact on investment allocation and on the spending decisions of millions of pensioners. But this would not by itself create a financial crisis, with bank failures rippling out across the world. The comparison with the dot-com bubble is instructive. It created a huge surge in wealth followed by a collapse. It triggered a severe recession. But it did not lead to banking crises. The subprime mortgage boom of the early 2000s led to a financial crisis because, contrary to the professed logic of securitization, hundreds of billions of private label MBS were not spread outside the banking system, but were stockpiled on the balance sheets of the mortgage originators and securitizers themselves.44

So why not get rich too? It was a choice. Not every bank did it. Those that took the biggest risks were large mortgage originators and the most aggressively expansive commercial banks—Citigroup, Bank of America and Washington Mutual—and the two smallest and scrappiest investment banks—Lehman and Bear Stearns. By contrast, J.P. Morgan began throttling back its mortgage pipeline already in 2006 and bought as much protection as it could in the CDS market. Goldman Sachs went beyond hedging to place a large bet on an imminent housing market collapse.

And this brings us to the true heart of the 2007–2008 crisis. If 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 wholesale by tapping the cash pools and so too would the new mortgage lenders, including Lehman. This was the truly lethal mechanism at the heart of the crisis. Funds from money market cash pools were channeled into financing the holding of large balance sheets of MBS.

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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. Inflating the balance sheet was risky but it raised rates of return on capital. Further profits were to be made by trading on the spread between long-term returns and short-term funding costs. Typically, an ABCP vehicle would hold a portfolio of securities with maturities of three to five years and would fund those securities by selling commercial paper repayable between three months and as little as a few days. For the managers of cash pools, the commercial paper was more attractive than the underlying securities, because it was very short term and backed by a top-rated commercial bank. For the parent banks, the spread between the return from the high-risk cocktail of assets held in the SIV and the low rate paid on the highly rated ABCP was handsome.

Gahhhh

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, with a promise to repurchase at a certain price.

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 lose access to the repo markets, at a stroke its business model would collapse, taking its entire balance sheet—not just its MBS business, but its derivatives book, currency and interest swaps—down with it.

Jesus

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.

A top Wall Street name was scraping the very bottom of the credit barrel. The Rise and Fall of Subprime Lending in the United States, 1996-2008 (in $ billions) Note: Percent securitized is defined as subprime securities issued divided by originations in a given year. In 2007 securities issued exceeded originations.

Good chart

By the magic of independent probabilities, the worse the quality of the debt that entered into the tranching and pooling process, the more dramatic the effect. Substantial portions of undocumented, low-rated, high-yield debt emerged as AAA. In any boom, irresponsible, near criminal or outright fraudulent behavior is to be expected. 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 incomplete or zero documentation, and 30 percent were interest-only loans to people who had no prospect of making basic repayment.52

But payment was by results. Fitch, which applied a risk assessment model that generated fewer of the coveted AAA-rated securities, found itself largely cut out of the subprime securitization business.53 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 all wealthy and retired by the time this house of cards falters. :o).”54

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.

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.

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 ABCP, enough to wipe out its entire Tier 1 capital.

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 collateral provided with special protection to include mortgage loans and mortgage-related securities. Not surprisingly, in the wake of the act there was a surge in bilateral repo secured on nonstandard assets.

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.

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

The answer is that 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. As the gross inflow data show, by far the largest purchasers of US assets, by far the largest foreign lenders to the United States prior to the crisis, were not Asian but European. Indeed, in 2007, roughly twice as much money flowed from the UK to the United States as from China.

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. Across the Pacific, from Asia to the United States, money flowed one way. In the North Atlantic financial system it flowed both ways, both in and out of 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.

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. It would be akin to noting that two elephants on either end of a circus seesaw leave a net balance of zero. It would be true, but it would not be a very adequate description of the forces in play.

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. Indeed, of the six most significant pairwise linkages in the network of cross-border bank claims, five involved Europe. 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. Indeed, West European claims on emerging Eastern Europe alone were more than three times the size of American claims on Asia. It was also noticeable that oil- and gas-rich Middle Eastern investors preferred to channel their funds through Europe rather than directly to the United States. This was a pattern already established in the 1970s and only reinforced by the aggressive politics of Bush’s “War on Terror.” 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.