Crashed: How a Decade of Financial Crises Changed the World

by Adam Tooze

The Republicans had convinced themselves that surpluses tended to encourage more government spending. Their approach was the obverse, what Republican strategists of the Reagan era first dubbed “starving the beast.”7 By entrenching tax cuts and courting a fiscal crisis they would create an irresistible imperative to slash spending, curb entitlements to social welfare and shrink the footprint of government.

Real estate is not only the largest single form of wealth, it is also the most important form of collateral for borrowing.

By the early 1980s the vast majority of the almost four thousand savings-and-loan banks still in operation were insolvent.

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 to have well-known statistical properties. If you knew default rates and could make assumptions about the degree of correlation between them, once you assembled enough mortgages and tranched them,

Compared with the model of the savings and loan, securitization thus did its job in spreading risk. But did it by the same token reduce the incentive to carefully monitor the underlying loans? By

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.

The top ten banks increased their share of total assets from 10 to 50 percent between 1990 and 2000.

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.

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.

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.

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,

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

Many of the subprime mortgages were on balloon rates that would rapidly increase after a period of two or three years. In 2007 the typical adjustable-rate mortgage in the United States favored by low-income borrowers was resetting from an annual rate of 7–8 percent to 10–10.5 percent.65 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. Once that began it was only a matter of time before house prices stopped increasing and the market turned.

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.

Unlike the more traditional central banks, like the Bank of England or the Fed, the ECB did not hold large quantities of government debt. It managed Europe’s financial system by repoing a wide range of bonds including both private debt and public bonds.28 Rather than the ECB, it was Europe’s banks that bought their governments’ debt. But they did so with the understanding that if they needed cash in a hurry, the bonds could be exchanged with the ECB on a repurchase basis.

the ECB relied on markets to exercise discipline over public borrowers while the markets came to assume that the ECB’s “one bond” policy implied an implicit European guarantee for even the weakest borrowers.

After the formation of the eurozone, Greek borrowing costs and debt service charges fell by more than half. It could have been the opportunity for a substantial fiscal consolidation. Instead, Athens let its tax revenue decline. The primary surpluses evaporated and the deficit expanded to 5.5 percent, twice the Maastricht limit. This was bearable only because nominal income growth was so rapid.33 What made Greece’s situation dangerous, however, was not the pace of borrowing after 2001 but the debts built up in the 1980s and 1990s,

The backdrop to the eurozone crisis was, indeed, a gigantic surge in debt, but it was in the private, not the public, sector. The eurozone played host to the same runaway, market-driven process of credit creation that European banks were contributing to so actively in the North Atlantic economy.

In the case of Spain, the larger, internationalized banks were, in fact, held on a tight leash. Foreign investors expected high governance standards. And they came through the crisis well.41 But the same cannot be said for the local mortgage lenders, the cajas that made up 50 percent of the credit market.42 They were tightly connected with local politics and deeply immersed in the real estate boom. Between 2002 and 2009 their business grew by a factor of 2.5, resulting in a combined balance sheet of 483 billion euro, or 40 percent of Spanish GDP.43

In 2007 the three largest banks in the world by assets were all European—RBS, Deutsche Bank and BNP. Combined, their balance sheets came to 17 percent of global GDP. The balance sheet of each of them came close to matching the GDP of its home country—Britain, Germany and France—the three largest economies in the EU.

On “Black Tuesday,” October 11, 1994, in one single session of frantic currency trading, the ruble lost more than a quarter of its value against the dollar.

The problem was the anticipatory reaction of financial markets and the fast-moving revaluation of securitized mortgages and the derivatives based on them. In the case of AIG, as it lost its top-tier credit rating, this triggered immediate margin calls from the counterparties to AIG’s insurance contracts. They wanted collateral to prove that AIG could meet its obligations if the mortgages did go bad. It was these collateral calls, running into tens of billions, that threatened to tip AIG over the edge.

when the Chinese looked to the United States, what they saw was not capitalist democracy, but “socialism with American characteristics.”

As the proponents of “functional finance” have argued since the 1940s, the state must act as a borrower of last resort.26 In so doing it preserves aggregate demand and provides a flow of safe long-term bonds to financial markets.

One study estimated that in the wake of the crisis the advantage in funding costs enjoyed by the larger banks relative to their smaller peers had more than doubled, from 0.29 to 0.78 percent. For the largest eighteen US banks, this implied an annual subsidy of at least $34 billion.

To actually stabilize its debts it would, according to one calculation, need to raise tax revenues by 14 percent of GDP and cut expenditure by the same amount. That was politically impossible.

It was this three-tiered structure of debt that drove the politics of the eurozone crisis from the French point of view: the small bankrupt sovereign debtors—Greece and Portugal—at the bottom; then the victims of the real estate boom with big liabilities from the banking crisis—Ireland and later Spain; and finally the really big public debtors, led by Italy. As far as Paris was concerned, the long-term sustainability of Greece’s debt was less important than holding this giant pyramid in place.

As restructuring was, in the end, inevitable, the question ought to have been how to make it safe, how to build a framework within which debts could be written down and losses inflicted on creditors without unleashing a general panic. The problem was that to even say this out loud was to risk triggering a run before the safety net was ready.

Not only would their rates have to adjust by at least the same amount as the United States, but they would face an amplification effect through the exchange rate. As the Economist explained, a “stock of dollar debt is like a short position,” i.e., a speculative position assuming that the dollar exchange rate will either remain level or fall.17 A Fed interest rate increase signaled not only higher borrowing costs but a likely upward movement in the dollar. Exposed emerging market borrowers would run to cover their dollar exposure, amplifying the currency adjustment and increasing the pressure on other dollar borrowers.