Crashed: How a Decade of Financial Crises Changed the World

by Adam Tooze

1:49 p.m., at the end of the normal voting period, the votes stood 228 to 205, against. The party leadership on both sides were staring into the abyss.

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.

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.

Merkel let it be known that she would not attend the summit in Paris if it was labeled a crisis meeting. As if to bind herself, the chancellor gave an interview to the popular tabloid Bild-Zeitung, soon to become notorious for its nationalist coverage of the crisis, denouncing any blank check for bankers.73 And Berlin could count on support from Frankfurt. Jean-Claude Trichet of the ECB told journalists that a common European solution was inappropriate because the eurozone wasn’t a fiscal union.

Why were the Germans so resistant? After all, Germany had its fair share of ailing banks that might have benefited from a common fund. But the hard truth was that German taxpayers did not want to pay for other people’s bailouts, inside Germany or out.

As the European heads of government made their way home from Paris, the news broke that the rescue of Hypo Real Estate had broken down. Depfa’s condition was worse than had been realized. An expert team dispatched by Deutsche Bank to Dublin had found that Hypo would need to come up not with 35 billion but with 50 billion euros to fill the gap at Depfa.

On the afternoon of Sunday, October 5, Merkel and Steinbrück went before the TV cameras. They didn’t have a legislative mandate from the Bundestag. They were deliberately vague about the details. But the leaders of the two political parties that had ruled Germany since 1949 jointly declared that all savings deposits were safe.

Was Germany positioning itself to take advantage of a global bank run? Berlin gave neither London nor Washington prior warning.

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.

Against the backdrop of the TARP debacle and the shambles in Europe, Gordon Brown’s scheme looked like a breakthrough.

The reaction of investors was not so enthusiastic as that of the pundits. When the G7 finance ministers assembled on Friday, October 10, global markets were in a state of panic.

On Monday, October 13, 2008, the UK nationalized Lloyds-HBOS and RBS. That same day Germany announced that it was putting up 400 billion euros in guarantees and 100 billion euros for recapitalization. France guaranteed 320 billion euros in medium-term bank debt and set up a 40 billion euro capitalization fund. Italy budgeted 40 billion euros for capitalization and “as much as necessary” in guarantees. In the Netherlands the guarantees came to 200 billion euros. Spain and Austria each put up 100 billion euros.93 In proportion to GDP, the largest program was that in Ireland. But Belgium and the Netherlands also made huge commitments.

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.

As Barclays was to do in the UK, Deutsche preferred to rely on accounting tricks and investments from gulf state sovereign wealth funds to see it through the crisis. It too would later face legal action over its makeshift crisis management, but in the United States, not in Germany.

Rather than buying bad assets or guaranteeing more borrowing by the banks, government should inject share capital. Having obtained the funds from Congress for asset purchases, TARP would now be repurposed as a vehicle for injecting capital.

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.

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.

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.

Whereas in the UK and Germany the nationalization of Lloyds-HBOS, RBS, Hypo and Commerzbank was akin to bankruptcy restructuring and led to wholesale changes in management, America’s more comprehensive approach was necessarily light touch.109 If robust J.P. Morgan was to participate in the scheme alongside ailing Citigroup, the terms could not be too onerous.

The Treasury’s aim was to persuade all banks to participate en masse so as to ensure that state support was not taken as a signal of weakness that would attract the attention of short sellers.

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.

By Friday, November 21, 2008, Citi’s market valuation was $20.5 billion, down from $250 billion in 2006.

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.

Indeed, even to talk in terms of a transition from the Bush administration to Obama is to exaggerate the break. Well before November 4, the baton had already passed. The political party that had demonstrated its willingness to mobilize the full resources of the US government to fight the financial crisis was the Democratic Party.

n retrospect it can seem as though it was the decisions taken in the first weeks of October 2008 that decided the future course of events. The United States moved concertedly toward recapitalizing its banks. In Europe, proposals for a common approach were vetoed by Berlin.

In the end Europe could not escape a common solution, but it would take years of economic uncertainty and distress before it arrived at that point.

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.

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.

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.

Starting from a conventional trade-based view of international economics, it is not easy to see how a shortage of dollars could have been so threatening to Europe.

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.

Where could more dollar funding come from? One might think of central banks as a possible source of foreign exchange. But the dollar reserves of the European central banks were, by themselves, nowhere near large enough to meet the funding needs of the banks.

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.”

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.

Of the collateral provided by the Term Securities Lending Facility, 51 percent was lent to non-American banks, with RBS, Deutsche and Credit Suisse alone taking up more than $800 billion.

On top of the conventional purchase of Treasury securities, the Fed bought $1.85 trillion in GSE-backed mortgage-backed securities by July 2010.

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.

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.

So from 2007 the Fed repurposed an instrument that was first developed in the age of Bretton Woods. To manage the fixed currency system in the 1960s the central banks had developed a system of so-called currency swap lines that allowed the Fed to lend dollars to the Bank of England against a reverse deposit of sterling in the accounts of the Fed.18 Having gone out of use in the 1970s, the swap lines had been briefly revived in 2001 to deal with the aftermath of 9/11.

In 2007 faced with the implosion of the transatlantic banking system, they were repurposed and expanded on a gigantic scale to meet the funding needs not of sovereign states but of Europe’s megabanks.

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.

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.

Pdf copy off actual swap agreemeenet

The first agreements were reached with the ECB and the Swiss National Bank in December 2007.24 As the crisis became critical in September 2008, the swap facilities were rapidly expanded to a total capacity of $620 billion.

Where were major emerging market central banks to get their dollars from? For a nation like South Korea to have approached the IMF was out of the question given live memories of the Asian financial crisis of 1997–1998.25 So on October 29 the Fed’s favor was extended to four key emerging market central banks: Brazil, Korea, Mexico and Singapore.26 All told, fourteen central banks would be included in the program.

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.

What the Fed had done for money markets, the central banks now did for the global provision of dollar bank funding. They absorbed the currency mismatch of the European bank balance sheets directly onto their own accounts. Compensating public action ensured that private imbalances did not spill over into a general crisis.

But this sober accounting understates the drama of this innovation. Responding to the crisis in an improvised fashion, the Fed had reaffirmed the role of the dollar as the world’s reserve currency and established America’s central bank as the indispensable central node in the dollar network.

“In a way,” one European central banker remarked, “we became the thirteenth Federal Reserve district.”28 But if that was the case, the American public was not informed about the extension of their country’s monetary territory.

The ultimate destination of the trillions of dollars that had flushed back and forth between the central banks of the global system was not under direct American oversight. There was little doubt, of course, that the Swiss National Bank channeled the dollars it received from the Fed to its ailing giants, UBS and Credit Suisse.30 But from the point of view of the Fed, it was far better that the swap be done with a central bank than with the fragile banks themselves.

As Neil Irwin describes it, “[T]he scale of lending to foreign banks . . . was a closely guarded secret even by standards of the always secretive Fed. . . . During the panic, this information was so closely held—and had it been known publically, so potentially explosive—that only two people at each of the dozen reserve banks were allowed access to it.”