Crashed: How a Decade of Financial Crises Changed the World

by Adam Tooze

With ABCP, repo and CDS having gone into crisis, the next link to snap in the shadow banking chain was the money market funds. On September 10, ahead of the Lehman failure, MMF collectively administered $3.58 trillion in savings and cash resources for individuals, pension funds and other investors.

In August 2007 the Reserve Primary Fund had been under intense competitive pressure. To improve its yield and attract more investors it had committed 60 percent of its funds to buying ABCP just as other investors pulled out.

The eventual losses at Reserve Primary were tiny. By 2014 the fund would pay out 99.1 cents on the dollar, but in the days following September 15, with investors no longer certain that they would get full reimbursement, half a trillion dollars fled out of exposed mutual funds looking for the safety of US Treasurys.

Loans by banks, investment banks, hedge funds and mutual funds to big businesses in the United States—so-called syndicated loans—fell from $702 billion in the second quarter of 2007 to as little as $150 billion in the fourth quarter of 2008.

While J.P. Morgan would retreat to the safety of its legendary “fortress balance sheet,” they should brace for the bankruptcy of every investment bank on Wall Street, not just Lehman, but Merrill Lynch, Morgan Stanley and Goldman too.

Meanwhile, on the other side of the Atlantic, the impact of the funding crisis on a string of big European lenders was devastating. HBOS and RBS in Britain, Fortis and Dexia in the Benelux, Hypo Real Estate in Munich, Anglo Irish Bank, UBS, Credit Suisse and dozens of others all faced failure.

And the pain was compounded by the distribution of losses between wealthier and poorer households. Between 2007 and 2010 the mean wealth of American households fell from $563,000 to $463,000. But those figures are elevated by the huge fortunes of the very wealthy. If we look instead at the median household—the household that sits at the 50 percent mark in the wealth distribution—it saw its net worth halved from $107,000 to $57,800.

As demand fell, so did production and employment. In the Central Valley in California, which witnessed a collapse of 50 percent in home values, consumption was cut by 30 percent.

GM paid $476 million in salaries each month as well as the health-care and pension benefits for 493,000 retired workers. Its production operations generated $50 billion in orders for parts and services supplied by 11,500 vendors.

On November 7, 2008, GM declared that, barring government aid, it would face insolvency by the summer of 2009.

In 2007, 80 percent of Mexico’s exports were sent to the United States. As the American crisis hit, Mexico’s GDP fell by almost 7 percent, a worse contraction even than during the homegrown financial crisis of 1995—the so-called Tequila Crisis.

All in all, in January 2009 Japan’s economy contracted at a rate of 20 percent per annum and exports by 50 percent year on year.

What made the collapse of 2008 so severe was its extraordinary global synchronization. Of the 104 countries for which the World Trade Organization collects data, every single one experienced a fall in both imports and exports between the second half of 2008 and the first half of 2009. Every country and every type of traded goods, without exception, experienced a decline.

Luxury cars were abandoned in droves as Western contract workers scuttled to the airport to escape debtor’s prison.

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.

Precisely how many people lost their jobs across the global economy depends on our guess as to joblessness among China’s giant migrant workforce. But reasonable estimates range between 27 million and something closer to 40 million unemployed worldwide.

On the morning of September 20, the US Treasury secretary alerted Congress to the fact that unless they acted fast, $5.5 trillion in wealth would disappear by two p.m. They might be facing the collapse of the world economy “within 24 hours.”

At the height of the crisis, between the last quarter of 2008 and the first quarter of 2009, those flows collapsed by 90 percent to less than 3 percent of global GDP.77 In the second half of 2008 capital flows between rich countries plunged from $17 trillion to barely more than $1.5 trillion. No other aggregate in the global economy was affected on anything like this scale or with this suddenness.

But as an economist and an economic historian, Bernanke understood the scale of what he was up against. What threatened in 2008 wasn’t 1929. What threatened was something even bigger and quite possibly even worse.

But beyond such immediate rescue measures, did the all-out focus on the financial system really serve the interests of the real economy?86 Was the inability to borrow causing a failure of investment and thus the ongoing depression? Or were the collapsed housing market and cash-strapped households curtailing economic activity such that there was no incentive to invest and thus no demand for loans?

Amid the intensity of the financial crisis, why should anyone care? Because the decision made by the American crisis fighters to take those questions off the table and to give absolute priority to saving the financial system shaped everything else that followed.

To mobilize trillions of dollars on the credit of the taxpayer to save banks from the consequences of their own folly and greed violated maxims of fairness and good government. But given the risk of contagion, how could states not act? Having done so, however, how could they ever go back to the idea that markets were efficient, self-regulating and best left to their own devices?

Martin Wolf, the Financial Times’s esteemed chief economic commentator, dubbed March 14, 2008, “the day the dream of global free-market capitalism died.”1 That was the day the Bear Stearns rescue was announced. It was only the beginning.

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.

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.

When major global competitor HSBC announced that it would absorb the full amount of $45 billion in losses suffered by its SIVs onto its balance sheets, its largest American rivals could not be seen to be settling for a second-best option.11 By December 2007 the private bad bank plan had collapsed.

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.

Allowing for only minimal losses, the capital of both Fannie Mae and Freddie Mac would be completely wiped out. If they folded they would take down the last remaining lenders in the mortgage market and put in doubt the credit of the United States. They would put in jeopardy a huge portfolio of securities widely held by foreign investors. In the summer of 2008 foreign investors held $800 billion in debt issued by the GSEs. Fannie Mae and Freddie Mac were, as the influential blogger Brad Setser quipped, “too Chinese to fail.”

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.

Paulson’s extraordinary plenipotentiary authorization to rescue Fannie Mae and Freddie Mac passed Congress on July 26, with three quarters of House Republicans voting against. It was signed into law on July 30. The White House thought it best to forgo the usual festive Oval Office ceremony.

The Fed provided credit lines and undertook to buy whatever MBS the ailing GSEs needed to offload. It wasn’t so much a bazooka as the nuclear option.

Despite the machinations of Russia, the breakdown of America’s government-sponsored mortgage machine did not spill over into a global crisis.

Palin did not have coherent views on the GSEs or the financial crisis.

For months the Treasury had been anxiously watching as Lehman Brothers looked for a buyer.

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.

After Lehman it would certainly have been the next to fail.28 But unlike Lehman, Merrill’s management was nimble and saved its bank by pushing for direct talks with Bank of America.

The basic question is why the options for Lehman were so narrow? Why were the Fed and the Treasury unwilling to sweeten the Lehman deal in the way that they had J.P. Morgan’s takeover of Bear Stearns?30 Why, following the failure of the private option, was some other kind of backstop not worked out, of the kind that they would provide so liberally in the weeks to come?

At the time Lehman’s failure was seen as the result of a deliberate decision, and a welcome one. On September 17, Democratic congressman Barney Frank declared in a hearing with Treasury officials that Monday, September 15, the day of Lehman’s failure, would long be celebrated as “Free Market Day.”33 Frank was joking. But others were not. As one of Paulson’s assistants remarked, September 15 felt like a “good day at the Treasury.” They had let markets do their work.

On this interpretation of the crisis, Geithner would go on to base an entire program of state building. If in 2008 what had been missing were adequate state powers of intervention, the answer was to equip the Fed and the Treasury with the right tools. What Geithner could not admit is the possibility that “Hank and Ben” had, in fact, made a mistake. That they might have underestimated the severity of the fallout that Lehman’s failure would cause. Or that Paulson, as a Republican Treasury secretary, might, in fact, have been constrained by politics. But this is what subsequent forensic reconstruction suggests.

Contrary to the impression created by Bernanke’s retrospective testimony, the Fed concertedly pushed Lehman toward bankruptcy.

The scale of that error became clear within hours as the shock wave from the Lehman failure impacted the American and the world economy.

Letting AIG fail would, in the words of one Wall Street player, have been an “extinction-level” event. Instead, the Fed stepped in. As it had done with Bear Stearns, the Fed declared a section 13(3) emergency.

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.

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.

With money hemorrhaging out of the money market funds, the Treasury made the extraordinary decision on September 19 to offer a guarantee to any fund willing to pay an insurance fee, with the coverage to be backed by $50 billion in the Exchange Stabilization Fund.

The fund was tiny compared with the scale of the trillion-dollar cash pools that were running in September 2008. But using it to back an insurance fund allowed it to be leveraged, and, more important, it was the only pot of money immediately available to the Treasury.

One week after Lehman, they were rescued by the transparent expedient of redesignating them as commercial bank holding companies so that they might benefit from the protection of FDIC deposit insurance.

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.

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.”

the British journalist Paul Mason remarked, Paulson’s cack-handed proposal triggered an “accidental synergy between the right-wing populist opposition to the bailout and the left-liberal stance.”53 History would prove it to be more than accidental.