Crashed: How a Decade of Financial Crises Changed the World

by Adam Tooze

With so many currencies fixed against the dollar, without the possibility of adjusting export competitiveness by means of devaluation or appreciation, it was no surprise that the world economy polarized into export surplus and import deficit countries.

For those on the surplus side of the “global imbalances,” so-called sovereign wealth funds (SWF) became huge repositories of capital.

Economists Nouriel Roubini and Brad Setser warned that if investors were to lose confidence, the United States could face a very sudden depreciation of the dollar and a massive hike in interest rates.

At the heart of the world economy, he told Washington audiences, was a “balance of financial terror.”35 The difference was that in the cold war the economy had been America’s strong suit. Now America’s trump card consisted of the hope that it was simply “too big” for China to let it fail. It was hardly a reassuring diagnosis.

If Cheney’s version of Republicanism prevailed, it undermined the basis for turn taking in America’s two-party system. How could the Democrats conduct responsible “national” economic policy if the Republicans viewed the economy as a resource to be milked for the benefit of its privileged constituency?

“Rubin and us spear carriers moved heaven and earth to restore fiscal balance to the American government in order to raise the rate of economic growth. But what we turned out to have done . . . was to enable George W. Bush’s right-wing class war: his push for greater after-tax income inequality.”

Then, from 2004 on, the Fed started raising rates. Faced with America’s trade deficit and its rapid domestic boom, this was the standard prescription. It should increase private saving and restrict investment.42 But to the Fed’s dismay, the results were feeble.

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.

Meanwhile, hip-hop star Jay Z took to thumbing wads of euros on MTV.

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.

hen the economists linked to the Hamilton Project envisioned disaster, they worried about excessive public debt, underperforming schools and a Chinese sell-off. What they did not put in question was the basic functioning of America’s economy, its banks and financial markets.

But compared with the grand sweep of global economic imbalances and the Sino-American relationship, the mechanics of American mortgage finance cannot but appear a parochial concern. How could this domestic drama shake the world’s financial system and precipitate a global crisis? The simple answer is that real estate may be mundane, and McMansions may be nondescript, but they account for a huge share of total marketable wealth worldwide.

In 2007 American consumers bought c. 16 percent of global output, and nothing made them feel better than surging real estate prices.

Real estate is not only the largest single form of wealth, it is also the most important form of collateral for borrowing.4 It is mortgage debt that both amplifies the broader economic cycle and links the house price cycle to the financial crisis.

But with prices accelerating toward annual increases of 14 percent in 1979, Volcker and the Fed decided that it was time to apply the brakes. It was the moment the power of the modern Fed was born. The interest rate was its weapon. As Germany’s outspoken chancellor Helmut Schmidt put it, Volcker pushed real interest rates (interest rates adjusted for inflation) to levels not seen “since the birth of Christ.”

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.

To borrow from money markets or issue bonds, they now faced the withering interest rates set by the Fed. Meanwhile, their portfolios of fixed interest mortgages were devalued as rates on new loans soared.11 By the early 1980s the vast majority of the almost four thousand savings-and-loan banks still in operation were insolvent.

Lending for thirty-year terms at fixed rates is a viable business proposition only under the kinds of conditions of stability that prevailed under Bretton Woods between 1945 and 1971.

Fannie Mae did not issue mortgages. It bought them mainly from commercial banks across the United States that specialized in issuing FHA-insured mortgages. By acting as a backstop, Fannie Mae lowered the cost of lending and set a national standard for both lenders and “prime” borrowers.

To get them off at a time of fiscal stress during the Vietnam War, in 1968 Fannie Mae was privatized. The branch still devoted to making loans to public employees and veterans was split off as Ginnie Mae.

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.

In 2008 there were only six AAA-rated corporations and no more than a dozen countries enjoying that ranking. This was despite the fact that since

the ratings agencies to make their classifications, not the subscribers to their information services.

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.

The industry churned as it had never churned before. 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.

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.

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.

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.

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.

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

2007 the six top hedge fund managers earned at least a billion dollars each in compensation.

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.

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.

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.

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.64

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.

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

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.

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.

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.

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

how did European banks end up owning such a large slice of American mortgage debt? 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.

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

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.

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.16

N]ot damaging the competitive position of the United Kingdom” was its top priority.26 The FSA was required to apply cost benefit analysis to its own interventions and benchmark its operations against other countries.

Howard Davies, the FSA’s first chair, put it in the libertarian language of the day: “The philosophy of the F.S.A. from when I set it up has been to say, ‘Consenting adults in private? That’s their problem.’”28 The sort of thing that you could do in London but not in New York is exemplified by “collateral rehypothecation.”

Congress did not pass the bill, London, Frankfurt or Shanghai would take over.31 New York, certainly, stood to benefit, but that should not mislead one into thinking in terms of national champions. No one had been more active in shaping the global marketplace in London than expat American bankers working for the London offices of the major Wall Street firms. What Wall Street wanted was license to bring back home the adventurous practices developed among “consenting adults” in London.