Crashed: How a Decade of Financial Crises Changed the World

by Adam Tooze

As both household consumption and business investment plummeted, of the sixty countries that supply the IMF with quarterly GDP statistics, fifty-two registered a contraction in the second quarter of 2009.67 Not since records began had there been such a massive synchronized recession. Tens of millions of people were thrown into unemployment. Though it was dazed bankers with boxes of belongings stumbling out of office towers in London and New York that attracted the TV cameras, it was young, unskilled blue-collar workers who suffered the worst.68 In the United States, the epicenter of the crisis, the month-on-month fall in employment over the winter of 2008–2009 was breathtaking. In the worst period, the monthly rate of job losses topped 800,000. Among the African American population the surge was particularly dramatic, with unemployment rising from 8 percent in 2007 to 16 percent by early 2010.

Gross Capital Flows as a Percentage of World GDP

But whichever metrics we use, it is clear that there had never before been anything so extensive or massive in scale. Commitments were made in excess of $7 trillion. The main mechanisms for intervention were fourfold: (1) loans to banks; (2) recapitalization; (3) asset purchases; and (4) state guarantees for bank deposits, bank debts or even for the entire balance sheet. Everywhere the crisis struck, states were forced to take some combination of these measures. The agencies involved were central banks, finance ministries and banking regulators. What summary statistics cast as cool enumerations were, in fact, frantic, improvised solutions that emerged from barely coordinated sessions of all-day, all-night problem solving. As the crisis intensified it put the financial and political resilience of states to the test. Broadly speaking, this produced four types of outcome, which reflect the degree of immersion in global finance, the resources of the states at risk, the shape of the governing elite and the balance of power within the financial sector itself.

Good summary

But whichever metrics we use, it is clear that there had never before been anything so extensive or massive in scale. Commitments were made in excess of $7 trillion. The main mechanisms for intervention were fourfold: (1) loans to banks; (2) recapitalization; (3) asset purchases; and (4) state guarantees for bank deposits, bank debts or even for the entire balance sheet. Everywhere the crisis struck, states were forced to take some combination of these measures. The agencies involved were central banks, finance ministries and banking regulators. What summary statistics cast as cool enumerations were, in fact, frantic, improvised solutions that emerged from barely coordinated sessions of all-day, all-night problem solving. As the crisis intensified it put the financial and political resilience of states to the test. Broadly speaking, this produced four types of outcome, which reflect the degree of immersion in global finance, the resources of the states at risk, the shape of the governing elite and the balance of power within the financial sector itself.

Goof summary

For Geithner and his cohorts it was clear that swift and decisive action paid dividends. Compared with the disastrous performance of the European economy, the United States was set back on track.5 The leadership of American finance renewed itself. Even when viewed narrowly in accounting terms, many of the Treasury and Fed support programs made a profit for the American taxpayer.6 The benefits of preventing a second Great Depression were vast. By contrast with the European experience it is not hard to see how this self-congratulatory American narrative gained purchase. But its economic merits are not so obvious as its proponents presume. And it offered no comfort to the advocates of laissez-faire. Gone were the days when economic policy was about shrinking the state to set free the spontaneous order of market liberty. No longer did wisdom lie in devising predictable rules to curtail the arbitrary discretion of policy makers. Economic policy modeled on warfare was a matter of will, vigilance, tactical nous and firepower. And despite the populist appeal of the military rhetoric, there was a political price to pay.7 The crisis fighting of 2008–2009 scrambled American politics.

In the United States the amalgamations began in earnest with Bear Stearns, which came to the point of failure on the night of March 13–14, 2008.14 If it had unloaded its portfolio of $200 billion in asset-backed securities and CDO at fire sale prices, the effect would have been catastrophic. It would have forced all the other banks to recognize crippling losses, spreading the panic. To the relief of the Treasury and the Fed, J.P. Morgan was interested in buying out Bear. Its hard-charging CEO, Jamie Dimon, was confident that his robust balance sheet put him in a position to safely pick over the carcass. But to finalize the deal, Dimon needed the right inducement. Under the emergency powers provided by section 13(3) of the Fed’s statutes, $30 billion in the most toxic assets were taken off Bear’s books by a SIV funded by the New York Fed.15 Then, at five a.m. on the morning of March 14, with the repo markets closed to Bear, the New York Fed lent $12.9 billion to J.P. Morgan, which J.P. Morgan then lent to Bear. After that, the die was cast. J.P. Morgan initially agreed to pay the laughable price of $2 per share for what was left of Bear. This compared with a valuation of $159 per share only one year earlier. When Bear’s shareholders protested, the price was raised to $10 per share. Whether at $2 or $10, J.P. Morgan was confident it would make a profit.

The Fed’s actions forestalled what might have been a disruptive and chaotic bankruptcy. But the inducements that J.P. Morgan had extracted were debatable, to say the least. Paul Volcker, the legendary ex-chairman of the Fed, would characterize them as extending “to the very edge of its lawful and implied powers.”16 Strict advocates of moral hazard logic would forever after argue that it was the Bear rescue that set up the Lehman disaster.17 With one investment bank having been rescued, Lehman’s management felt safe. A solution for their problems would be found too. They could afford to take their time finding the best possible deal, an attitude that would cost them dearly.

Whether it was legal or wise, rescuing investment banks by means of obscure balance sheet transactions was a technical business that could be kept out of the political headlines. That changed with Fannie Mae and Freddie Mac. As the indispensable government-sponsored backdrop to the American housing market, they were at the center of one of the most formidable political networks in Washington. By the summer of 2008, with private securitization stalled, they were also responsible for backstopping 75 percent of new mortgages in the United States. The vast bulk of the Fannie Mae and Freddie Mac balance sheet consisted of top-quality conforming mortgages. If they had had conventional balance sheets, they ought to have been able to ride out the storm. The problem was they did not. In June 2008 Fannie Mae and Freddie Mac held MBS valued at $1.8 trillion and guaranteed another $3.7 trillion on the basis of shareholder equity, which in the case of Fannie Mae came to only $41.2 billion, and in the case of Freddie Mac, to $12.9 billion.18 It was a leverage ratio that would have made even the boldest investment banker blush. It was conceivable only because Fannie Mae and Freddie Mac were go...

As Paulson famously put it to the Senate Banking Committee, “[I]f you’ve got a squirt gun in your pocket, you may have to take it out. If you’ve got a bazooka, and people know you’ve got it, you may not have to take it out.”

The Chinese might be excused their confusion. The political theater being played in Washington, DC, was new and strange. A conservative, free-market administration led by businessmen was proposing unlimited state spending to nationalize a large part of the housing finance system. The Republican electorate was outraged by the thought of assisting undeserving mortgage borrowers and the New Deal machinery that had aided and abetted their fecklessness. But to Paulson the systemic imperative was obvious. And President Bush stood behind him. “It was a tremendous act of political courage,” Paulson gushed, “It was as if, in the last days of his administration, the president were suddenly switching sides, supporting Democrats and opposing Republicans on matters that went against the basic principles of his administration. But he was determined to do what was best for the country.”25 Paulson was registering a basic rift within American conservatism. The right wing of the party could not be counted on to give support to measures that were unpopular and distasteful, but were clearly necessary to save “the system.” Paulson recognized that the authorization he was asking for was unprecedented. “I don’t know if any executive branch agency had ever before been given the authority to lend to or invest in an enterprise in an unlimited amount. All I could do was argue that the extraordinary and unpredictable nature of the situation warranted the authority in this case.”26 He also knew that i...

But on August 29 he nominated the populist Alaskan governor Sarah Palin as his vice-presidential running mate. Palin did not have coherent views on the GSEs or the financial crisis. But her bluff persona fired up the passions of the Republican base.

Lol

The culminating moment came on the weekend of September 13–14. What exactly happened in those forty-eight hours will remain forever a matter of controversy. What is beyond dispute is that Bank of America, the giant commercial bank that had been expected to act as the white knight for Lehman, bought Merrill Lynch instead.

If Bank of America had chosen Merrill, what was wrong with Lehman? They told Paulson that London did not want to “import America’s cancer.”29

Savage

The best available contemporary evidence, rather than the self-justifications that the actors fashioned for themselves after the catastrophic consequences of Lehman’s failure became apparent, suggests that the basic constraint on the Lehman rescue was Paulson’s refusal, from the outset, to consider another bailout.38 British chancellor Alistair Darling was in frequent contact with New York throughout the critical weekend. His perspective is telling: “What was worrying was that it was becoming more evident that the US Treasury was reluctant to provide the financial support to make the deal work. I was not entirely surprised. . . . I didn’t think he had enough political capital to persuade the Republicans to nationalize another bank.”

Impt

The Fed was notably uncooperative in the desperate efforts of Lehman’s management to buy time. Contrary to the impression created by Bernanke’s retrospective testimony, the Fed concertedly pushed Lehman toward bankruptcy. The argument made at the time was that ending uncertainty by means of bankruptcy would help to calm the markets. It is easy to say with hindsight, but it was a spectacular error of judgment. The scale of that error became clear within hours as the shock wave from the Lehman failure impacted the American and the world economy. A day later, Paulson, Bernanke and Geithner had to face the question of what to do about the insurance giant AIG.40 Here too their first impulse was to look for a private solution, with J.P. Morgan and Goldman Sachs leading “frenetic” discussions throughout Monday, September 15.

Ouch

Most generous of all was the resolution of the CDS portfolio, which was accomplished by buying out the dangerous CDO on which AIG had written insurance. In effect, together with the collateral they had already claimed from AIG, the counterparties received payment at 100 percent of par on $62.2 billion in toxic mortgage-backed securities, the market value of which was closer to $27.2 billion. How little they would have been worth if AIG had been driven into bankruptcy is anyone’s guess. In any case, the subsidy to the counterparties and their clients clearly ran into the billions. Nor was it only the American financial system that benefited. In the course of the bailout, the Fed made sure to leave in place the insurance contracts that AIG had offered to European banks to provide “regulatory relief.” If they had been voided, the Americans estimated that the European banks would have faced calls for at least $16 billion in additional capital. “For fear of shouting ‘Fire!’ in a crowded theater,” the New York Fed later told Congress, it thought it best not even to mention this potential fallout from AIG’s crisis to European regulators.

On September 20 the Treasury sent Congress a three-page legislative proposal asking for authority to spend up to $700 billion to stabilize securities markets. After the unlimited bailout authorization for the GSEs, the Treasury was now asking to spend the equivalent of the entire US defense budget on bad mortgage securities. But what was truly audacious about Paulson’s bill was the nature of the power he was asking for.

Yeah lolz

Recapitalization was a more direct way of intervening in a bank. It was also efficient. Every dollar of bank capital was leveraged. So a dollar of government capital would support ten, twenty or thirty times as much in lending. But recapitalization was rejected on political grounds. Paulson had no desire to go down in history as the Treasury secretary who nationalized America’s banking system. And even if Paulson had been willing to pay the personal price, an open call for government recapitalization would never have passed Congress. The Republicans would have voted en bloc against nationalization, and without bipartisan cover the Democrats could not take the risk.45 Already in the spring of 2008 the Treasury team thus decided that asset purchases were the path of least resistance. Buying debts did not involve ownership of banks. It did not raise issues of control or corporate governance. It could all be done through “the market.” An auction mechanism could be used to determine the price. It was also, admittedly, slow moving and expensive: $700 billion would cover barely more than half the outstanding subprime securitization. It wasn’t the perfect solution. But after Lehman, AIG and WaMu, the Treasury and the Fed were desperate. They needed something that might pass, and pass quickly.

After the Fed and the Treasury had allowed Lehman to fail, America’s elected representatives had refused to back their own government’s emergency rescue effort. The reaction in the markets was one of terror. The Dow Jones index plummeted by 778 points, wiping $1.2 trillion off the value of American businesses in a matter of hours. It was the biggest loss on record, worse than on 9/11, when the index had plunged by 684 points.60 The shock to global confidence was devastating. It produced a terrifying synchronization of the crisis on both sides of the Atlantic.

After a panic-stricken night of discussion, early in the morning of September 30 the Dublin government announced that for fear of dying it would commit suicide. As Europe turned on the morning news it learned that the Irish government was fully guaranteeing not just the deposits but all the liabilities of six major Irish banks for a period of two years. No other government had been advised in advance, nor had the ECB, nor had the Irish taxpayers.66 It stopped the run, but it left Ireland, with a population half the size of New York City, guaranteeing 440 billion euros in bank liabilities. The losses the banks incurred would bankrupt the Irish state. They would become the telltale link connecting the banking crisis of 2008 to the eurozone sovereign debt crises of 2010. But that was music of the future. The issue on September 30 was the immediate impact on the rest of the world. If Ireland was offering a safe haven, would the run now extend to the rest of Europe?

Brutal

Ahead of the meeting French finance minister Christine Lagarde spoke to the German business daily Handelsblatt about the need for joint measures.69 After the fraught transnational negotiations to rescue Dexia and Fortis, she was seriously concerned about the ability of small countries to cope with the crisis. “What would happen if a little European Union state confronted a bank collapse?” she asked rhetorically. “Maybe the government would not have the means to save the institution in question. So the question arises of a solution at the European level.”

Likewise, Jean-Claude Juncker, prime minister of Luxembourg and long-serving chair of the Eurogroup, told German radio: “I see no reason why we should mount a US-style programme in Europe.” The crisis came from the United States. It was deeper there. Europe could get by with national solutions.

Sarkozy retreated, saving face by dismissing the idea as an unauthorized personal initiative on Lagarde’s part. But 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. On October 4 Sarkozy, Merkel, Brown and Berlusconi convened in Paris. The result was disappointing. 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.”75 Sarkozy commented resignedly, “If we cannot cobble together a European solution then it will be a debacle. . . . But it will not be my debacle; it will be Angela’s. You know what she said to me? ‘Chacun sa merde!’ (To each his own shit!).” According to the German side, the chancellor’s language had been less vulgar. “Merkel had quoted a proverb taken from . . . Johann Wolfgang Goethe: ‘Ein jeder kehre vor seiner Tür, und rein ist jedes Stadtquartier’ (Everyone should sweep in front of his door and every city quarter will be clean).”76

With the basic political frame of the EU in flux, Berlin was not going to support a huge increase in the powers of the European Commission to enable a bank bailout.77 Whatever solution was found would be based on intergovernmental agreement, not enhanced federal powers.

Despite the uncomfortable and ominous surroundings, the meetings were productive. Whereas Paulson’s TARP model was based on the idea of buying bad assets, London brought together two ideas: guarantees and recapitalization. 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 details were worked out in frantic meetings in Whitehall and road tested with focus groups of investment bankers who were sworn to secrecy.

Against the backdrop of the TARP debacle and the shambles in Europe, Gordon Brown’s scheme looked like a breakthrough. From New York, Paul Krugman lavished praise on Britain’s Labour government. Britain’s Social Democrats had figured out how to rescue financial capitalism.88 It certainly helped that the Labour government was less averse to nationalization than Hank Paulson was. 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. It was a monster they had helped to create. In any case, given the enormous burden that UK taxpayers were going to have to bear in supporting HBOS and RBS, it was hard to see that there was ever any alternative to nationalization.

To turn the discussion in a more positive direction they proposed a short five-point plan: There would be no more failures of systematically important institutions. There would be measures to assist recapitalization. They would work to unfreeze liquidity in interbank markets. They would provide adequate deposit insurance. They would rebuild markets for securitized assets. As a surprise treat for the finance ministers, President Bush made an impromptu appearance to add some easy charm to the discussions. Unfortunately, Bush’s remarks were not well calculated to reassure his guests. “You folks don’t need to worry,” he told them. “Hank’s got a handle on this. He’s going to freeze that liquidity.”90 Given that TARP was still in limbo and that freezing liquidity was the last thing anyone needed, it can hardly have been comforting.

In total, the commission would review and approve twenty schemes for bank-debt guarantee and fifteen for recapitalizations.92 On top of that came applications for support for individual banks—forty-four from Germany alone. But it was case by case, country by country. Merkel’s veto was decisive. It would be three long years before a common European bailout was back on the agenda.

On October 16 an emergency recapitalization and refinancing program was ramrodded through the French parliament. The urgency was commonplace. What was different in France was the response of the private sector. All of the major banks, led by BNP Paribas, agreed to take capital from the Société de Prise de Participation de l’État (SPPE). A second tranche followed in January 2009. Again, all the banks took the capital. Even more unusual was the refinancing scheme headed by the Société de Financement de l’Économie Française (SFEF). This entity was legally entitled to issue state-guaranteed bonds on behalf of banks up to a total of 265 billion euros, but 66 percent of its shares were subscribed by the six major French banks. Even HSBC France signed on. 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. It was an efficient mechanism for restoring confidence made possible both by the relative lack of pressure on France’s biggest banks and close cooperation within France’s extraordinarily tight-knit elite.95 Though they work in very different ways, business and government are every bit as interconnected in Paris as they are in New York and Washington, DC, enabling that rarest of things un...

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. In exchange for accepting the capital injection, the banks would receive an FDIC guarantee on all business checking accounts and a guarantee on any new debt issued by the summer of 2009, up to a total of 125 percent of the debt maturing by the end of that year. The two were linked. No FDIC guarantee without government capital injection. Characteristically, Ben Bernanke sought to calm the fraying nerves in the room by appealing to everyone to consider their common interests. They were all in it together. “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.

Beyond the general sense of shock, the reactions came down to business logic. For the weakest in the group it was evidently a great deal, and Vikram Pandit of Citigroup said so. Given the state of his balance sheet, he couldn’t afford to be fussy. As he blurted out: “This is cheap capital.” Indeed, it was. The yield on Citigroup bonds that day was 22 percent. Paulson was asking for 5 percent.103 A better-placed bank, like J.P. Morgan, could have got by without the TARP money. But Dimon understood the systemic logic and was among the first to sign, though he made his signature conditional on the rest of the group agreeing. It was California’s Wells Fargo that forced the government side to show its hand. 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. They would find themselves locked out of capital markets. When they came back to Paulson for help, the terms would be less attractive than those available that afternoon. The CEOs were then dismissed to call their boards. Within a matter of hours they had all agreed. Under the Capital Purchase Program facility, America’s nine largest banks took $125 billion in preferred stock from the government.

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.104 Advocates of strong executive branch prerogatives would later celebrate these actions as an essential assertion of sovereign authority. As it had done after 9/11, the American state had declared a state of exception and it had risen to the occasion.105 But 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. In September political and commercial considerations had prevented a deal to save Lehman. It took a month of panic, political confusion and unprecedented financial turmoil to reach the point in mid-October when the barons of Wall Street would listen when Paulson thumped the table and declared that everyone must take the Treasury’s money. Even then, the executive branch had the power that it appeared to do in large part because J.P. Morgan swung behind the Trea...

Very impt

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. They had to recognize that in the event of a truly comprehensive crisis their cherished margin of superiority would not save them from disaster.

The result of the Treasury’s “sovereign” intervention was to extend a huge subsidy to the banks, increasing the value of their businesses by perhaps as much as $131 billion.110 The biggest beneficiaries were the fragile investment banks and the sprawling colossus of Citigroup. Citigroup received $25 billion from the Treasury in exchange for securities valued at $15.5 billion and soon to be worth much less. In contrast, Wells Fargo, widely regarded as one of the banking industry’s stronger players, gave approximately $23.2 billion worth of securities for its $25 billion in government capital.111 J.P. Morgan did not need the money, and by agreeing to go along with the government’s efforts to stop the run, Dimon passed up the opportunity to predate any more of his weaker competitors. 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.

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 Octobe...

In an urgent series of negotiations culminating with “Citi weekend” on November 22–23, another deal was patched together. A second capital injection of $20 billion reinforced Citi’s balance sheet while a so-called loss protection plan protected it against losses on $306 billion in toxic assets. In exchange the government received $7 billion in preferred shares paying 8 percent.

Headdesk

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. At a moment when Paulson and the Treasury were struggling with Congress to mobilize political support for a backstop for the American financial system, the Fed, without public consultation of any kind, made itself into a lender of last resort for the world. 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. It transformed what we imagine to be the relationship between financial system...

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. The Bank of England supplied sterling, the ECB euros. 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.

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.4 At the same time, the market for currency swaps was becoming dangerously congested, with Europeans bidding for dollar credits and ever fewer counterparties willing to take the other side of the trade. 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. When markets are functioning normally, this premium should be close to zero. In September 2008 it exceeded 200 basis points.

In the autumn of 2008 the stark truth could no longer be escaped. As Tim Geithner of the New York Fed told the FOMC, the Europeans “ran a banking system that was allowed to get very, very big relative to GDP with huge currency mismatches and with no plans to meet the liquidity needs of their banks in dollars in the event that we face a storm like this.”9 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. It was to hold those portfolios of dollar-denominated assets in place that from the end of 2007 the Fed began to provide dollar liquidity in unprecedented abundance not only to the American but to the entire global financial system, and above all to Europe. In 2008 that flow of dollars grew to such proportions that it rendered any effort to write a separate history of the American and European crises anachronistic and profoundly misleading.

Impt

As Fed economists observed, this was no longer conventional monetary policy in which the Fed manipulated interest rates to affect market behavior. 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 relationship between the state, as represented by the central bank, and the financial markets was nakedly revealed. The Fed was not just any branch of government. It was the bankers’ bank, and as the crisis intensified, the money market reorganized itself accordingly, taking on the shape of spokes with the Fed as the hub.

Between December 2007 and March 2010 TAF expanded on a gigantic scale. The maximum outstanding balance in the spring of 2009 was almost $500 billion. 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. Hundreds of smaller American banks took advantage of TAF, but the biggest beneficiaries were the giant American and European banks with Bank of America, Barclays, Wells Fargo and the Bank of Scotland heading the list. Among the large borrowers the foreign share was well over 50 percent.

The largest backstop for the repo market that the Fed operated during the crisis was the Primary Dealer Credit Facility (PDCF).17 It was introduced after the run on Bear Stearns under the emergency 13(3) powers of the Fed. The PDCF offered the key operators in the repo market discreet and unlimited access to overnight Fed liquidity in exchange for a wide range of collateral. Not surprisingly, the dealers took ample advantage. Total lending under PDCF came to $8.951 trillion. This was a huge amount, but the loans were made overnight and they should be seen in relation to the daily collateral posting in repo markets that peaked at $4.5 trillion in March 2008. The maximum amount outstanding on the PDCF was on September 26, 2008, at $146.57 billion. PDCF had the distinction of being the only large Fed liquidity program to have supported predominantly American banks. Merrill Lynch, Citigroup, Morgan Stanley and Bank of America were the heaviest users. But appearances were to a degree deceiving because the Fed allowed the London-based subsidiaries of Goldman Sachs, Morgan Stanley, Merrill Lynch and Citigroup to take advantage of the program. The Fed was thus remotely backstopping the City of London repo market.

When the crisis in the money market funds knocked the last remaining support out from under the commercial paper market, the Fed took the unprecedented decision not just to backstop banks and the mutual funds but to enter the lending business directly. It established its own SPV, the Commercial Paper Funding Facility, to buy top-quality short-term commercial paper. In total it provided $737 billion in funding through this facility, with a peak outstanding in January 2009 of $348 billion. The largest user of the system was the troubled Swiss giant UBS, which soaked up 10 percent of the Fed’s funds. Another 7.3 percent went into Dexia, and 5 percent each into Fortis and RBS. Some of the most severely stressed European banks received 27 percent of the entire program. In total, the European share cannot have been much less than 40 percent.

Finally, in early 2009, the Fed began to move from emergency liquidity provision to what would subsequently become known as QE1—the buying up and holding on the Fed balance sheet of large quantities of mortgage-backed securities. For a central bank, buying securities was a conventional mechanism of monetary policy. But it would now be done on a far larger scale than ever before and with a wider array of assets. On top of the conventional purchase of Treasury securities, the Fed bought $1.85 trillion in GSE-backed mortgage-backed securities by July 2010. The busiest week of purchases was the third week of April 2009, and holdings (net of sales) peaked in June 2010 at $1.129 trillion. Crucially, what the Fed was doing was not just pumping liquidity into the system. It was also absorbing onto its balance sheet the maturity mismatch, which had done such damage in markets like ABCP. The Fed took the long-term asset in exchange for immediate liquidity.

Quantitative easing, or QE, is generally thought of as the quintessential “American” policy, the symbol of the Fed’s adventurousness. It would earn Bernanke regular scolding by conservative policy makers in Europe. But after what we have already said, it will come as no surprise that 52 percent of the mortgage-backed securities sold to the Fed under QE were sold by foreign banks, with Europeans far in the lead. Deutsche Bank and Credit Suisse were the two largest sellers, outdoing all their American rivals by a healthy margin. Barclays, UBS and Paribas came in eighth, ninth and tenth. Having kept open the basic institutions of transatlantic shadow banking during the most acute phase of the crisis in 2008, the Fed now worked hand in glove with the European megabanks to unwind the transatlantic balance sheet.

Jerks

Having reached the limit of the dollars it could provide directly to Europe’s tottering banks, the Fed now lent to the ECB, the Bank of England, the National Bank of Switzerland and the central banks of Scandinavia. They then channeled the precious dollar liquidity to the European megabanks at one remove.20 The Fed and the central banks it was supporting agreed on an exchange rate. The European central bank needing the dollars deposited the required amount of local currency in an account in the name of the Fed. The Fed credited the European central bank with the equivalent amount in dollars. The two sides agreed to reverse the trade at a future date at the agreed exchange rate. The terms were spelled out with a minimum of fuss in a contract running to no more than seven pages.21 The Fed received an interest premium that ensured that the swap lines would be used only if market funding was not available. The European central banks passed that cost on to the banks that were the ultimate recipients of the dollars.

one American journalist put it, the Fed’s proposal “ran up against a strong effort,” on the part of the ECB, “to pin the Great Panic on the United States.” The ECB’s reply to the Fed was blunt: “[I]t’s a dollar problem. It’s your problem.”22 As Bernanke was later to remark, the ECB “had some difficulty coming to the realization that Europe would be under a great deal of stress and was not going to be decoupled from the United States.”23 With regard to the swap lines, that attitude did not last much beyond 2007.

Four central banks—the ECB, the Bank of England, the Bank of Japan and the Swiss National Bank—were given unlimited access to dollars.

The total amount outstanding on the network of dollar swap lines reached its peak in December 2008 at $580 billion. Briefly, the swaps touched 35 percent of the Fed’s balance sheet. But even these gigantic figures do not do justice to the scale of the program. The essence of the swap line was to provide easy access to short-term dollar funding. With the New York Fed and its counterparts across the world working on a hectic schedule, new dollar funding was flushed into the system on a daily basis. In a single week in late October 2008, as dollars previously sourced from American money markets hemorrhaged out of the global banking system, the Fed lent $850 billion through the swap lines. It was this circulation of funds that allowed the Bank of England, the ECB and the Swiss National Bank to meet huge demands for dollars without running down their exchange reserves to even more critical levels. But for the swap facilities, between September 2008 and May 2009, monthly demand for dollars at the auctions organized by the ECB would have wiped out its reserves several times over.