Ten Weeks That Shattered a World

Fifth in a Series on the Subprime/Securitization Panic

By Larry Peterson | November 7th, 2008

This is a web-only article from the website of Dollars & Sense: The Magazine of Economic Justice available at http://www.dollarsandsense.org/archives/2008/1108peterson.html


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This is a web-only article, available only at www.dollarsandsense.org.

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Make no mistake about it. The world has experienced in the last few weeks events comparable in historical significance to the fall of the Berlin Wall. Like the fall of the Wall, there was an exceptionally sudden collapse of an hegemonic—in this case primarily financial—system that had seemed, to the vast majority of observers, and only weeks before the event, to be at least somewhat secure in its continued existence, if irreversibly committed to an inevitable, fundamental process of reform. And, like the fall of the Wall, the post-collapse situation is characterized by enormous uncertainty on the part of hundreds of millions of people (at least). But unlike the beginning of the end of Soviet domination in Eastern Europe and in Russia and its “near abroad,” there is now virtually no sense of liberation or jubilation: only a menacing sense of foreboding, before an increasingly bleak short- to medium-term economic future. And, unlike the events in Europe twenty years ago, there is now the prospect of a vast increase in state power in countries all over the earth. But it also certain that the financial crisis that has now extended its reach throughout the globe will play a major role in the reconfiguration of the international balance of power that will define the coming decades: in that sense, too, the fall of Wall Street-led globalized and deregulated finance will follow the fall of the Berlin Wall rather closely. And it is by no means clear that the present events will not create as much, if not more, instability and chaos than the ones of 1989.

During the period between the July bailout and eventual September full-government takeover of Fannie Mae and Freddie Mac, there elapsed a period during which factors that were to contribute mightily to the turmoil of September and October were percolating under the surface. Amongst these, three deserve particular mention. First, the delicate duel between inflationary and deflationary influences in the major economies that had been playing out for some time gave way to the decisive victory on the part of the latter (though inflation remains worryingly high in the UK and dangerously so in some emerging economies). This was due in part to the bursting of the enormous speculative bubble in commodities (particularly oil) in August, which forced hedge funds and other big investors, that had bet big on continued commodity price appreciation, to unwind their positions exceptionally rapidly. In the weeks to come, the magnitude and speed of these forced sales would wreak havoc not only in stock markets, but also have knock-on effects in relatively arcane—but seminal—areas of finance like money markets, and play no small role in forcing the entire global financial system to its knees. This would be the second factor.

The forced selling only exacerbated the impact of the downward indicators concerning economic activity that were accumulating from all over the globe, even in regions that had been, not too long before, expected to pick up the slack for the expected slowdown in America. Thus, economic conditions in Europe and Britain deteriorated at an amazing pace during the summer, and the euro and pound sterling, which had seen historic rises against the US dollar only weeks before, began a process of steady reversal, under the influences of seemingly runaway inflation that halted domestic demand dead in its tracks, and the currency strength that threatened to choke off exports. Also, Asian exporters, who had ramped up European-destined production in order to exploit this perceived demand as a potential safety-vent given the seemingly inevitable American slowdown, found themselves over-extended once again. This decline in European demand, and the subsequent susceptibility of Asian consumer goods and emerging-market commodity producers to severe economic slowdown and financial crisis, then, would constitute the third factor.

But it was the run on and eventual nationalization of Fannie Mae and Freddie Mac in late August and early September that would directly set off a series of panics at other financial institutions, and would, in turn, lead to the breathtakingly sudden dismantling and replacement of the global financial architecture. For these panics would be swiftly accompanied by increasingly drastic measures taken by central banks and finance ministries in an attempt to perform the impossible quadruple-feat of mitigating asset-market losses, avoiding the appearance of moral hazard, keeping costs to taxpayers (in an election year) as low as possible, and keeping recession at bay. And that would require them— some of whom were known to be market fundamentalists of a particularly obdurate sort—to hurriedly nationalize large chunks of their banking systems as all else failed.

The main weaknesses that forced Fannie and Freddie into “conservatorship” by the government, or the making explicit of the implicit guarantee the Treasury had won in July to take over their liabilities (and remove their executives), had to do with the other conspicuous peculiarities of the GSEs (Government-Sponsored Enterprises): the bloated balance sheets they were allowed, nay encouraged, to run up, at first in order to sustain the housing bubble, and then, in the last few months, simply to slow its collapse (and that in a time of plummeting demand, and huge rises in foreclosures); the precarious state of their capital cushions, which were long permitted substantial exemptions from normal practice even by the standards of a highly deregulated financial industry, in order to keep the agencies buying more and more mortgages and investor dividends extra-high; the substantial further strain on these cushions caused by the credit crisis, which made capital more expensive while collateral declined in value and more of it was demanded by lenders; and the precipitous falls in equity investment in the GSEs that accompanied and amplified the deterioration of the rest of its financial structure. In addition, doubts arose, no doubt encouraged by recent accounting scandals at the GSEs, that they were not showing accurate losses on the mortgages they held in a rapidly falling market. The holes in the GSE’s finances were just too big for anyone but the government to try to plug, especially given horrific prognostications for the housing market. And if those holes weren’t patched rapidly, the gargantuan size of the GSEs (they were the largest financial institutions in the world) meant that a full meltdown would have equally outsized effects worldwide (not to mention in the US itself).

But the manner in which the government acted would have an ominous impact on other financial institutions worldwide in spite of its extraordinary gesture concerning the guarantee. Back in July, investors (especially hedge funds) had been selling the GSEs’ (and other financial firms’) shares short, in an attempt to force the government to guarantee their debt (which they piled into, needless to say) as equity prices plunged. So when the Treasury received the implicit takeover guarantee, Secretary Henry Paulson likened it to a “bazooka” that might not have to be used, if everyone knew he had it. By this, he meant that the government’s resources were presumably so great that the Treasury could break up this little game. Investors could sit tight in the face of sell-offs, because the government was there with a blank check to see off the speculators. But there were a few problems with this strategy. Paulson neglected the importance of the fact that much of Fannie and Freddie’s debt was held by foreigners; and large Asian and Russian central bank cutbacks in purchases of Fannie/Freddie debt added to the already considerable pressure on the shares of the companies; and Fannie and Freddie’s borrowing costs continued their vertiginous ascent. In a last-ditch attempt to gain funding before the situation became unsustainable (which would have a severe knock-on effect on the already staggering US economy: Fannie and Freddie, after all, held or guaranteed some $5 trillion of mortgages, and employment and profits in housing and related industries, though falling fast, had constituted a truly outsized proportion of national profits and jobs in the last few years; and there was simply no way such a enormous companies could realistically be allowed to default on its payments to creditors without huge deleterious effects rippling through the rest of the economy), executives met in New York with potential investors, and many of them made it known (especially to Freddie’s former CEO Richard Syron, who was all the more desperately trying to raise cash in light of the fact that Freddie had failed to meet a pledge to raise $7 billion in new capital) in the final days of August that they would not commit to further funding, fearful as they were that the fruits of any such commitment could be nullified at any future point by regulators. In other words, they called Paulson’s bluff: the bazooka could always conceivably be turned on them, after all; there was no reason why, if the situation got bad enough, that the Treasury wouldn’t simply allow shareholders to be wiped out.

Why was this? Well, it seems that Paulson ignored or resisted the idea that an unlimited guarantee of debt is a singularly unhelpful indicator of potential commercial viability, upon which equity performance depends, particularly in such a singularly forbidding—and still declining—economic environment. And in this extreme case, equity investors wanted something along the lines of the guarantee given to creditors, too, if they were going to commit their money to shore up the GSEs. But this guarantee was not forthcoming, and the share prices of the GSEs continued to plummet. And, as Anatole Kaletsky keenly observed, foreign equity investors, who were the only private investors with anywhere near the means to save Fannie and Freddie during the summer, found themselves taking huge losses because Paulson would not provide them with a guarantee. Eventually, they and other equity investors who didn’t join the late-summer panic selling would be more-or-less wiped out, holding shares that had been reduced to truly miniscule values.

But the damage that was done as a result of the policy choices surrounding the nationalization of Fannie and Freddie didn’t stop there. A mere 24 hours after the nationalization, another Wall Street firm, Lehman Brothers, found itself under serious threat. In this case, it had to do with Lehman’s large but opaque exposure to subprime-related debt writedowns, considerable losses and increasing difficulties raising capital. Lehman was also a big player in the derivatives market (it even traded derivatives it held in custody as collateral for hedge funds it served as a “prime broker,” or banker to hedge funds, on its own account), so, somewhat like Bear Stearns in March, some considered it “too interconnected to fail.” But coming a mere couple of days after the commitment of $200 billion to the Fannie/Freddie conservatorship, Secretary Paulson feared that any even a Bear-style heavily-subsidized rescue would send markets a signal that investors in smaller Wall Street firms like Lehman could expect the sort of guarantee that had just been extended to the humungous Fannie and Freddie, and that speculators would manipulate the situation accordingly, by running shares of other financial firms into the ground and forcing further bailouts. This was complicated by the fact that many regional banks, which held a lot of Fannie/Freddie stock, were looking ever weaker as economic conditions turned downwards. Indeed, such banks looked set to bear the brunt of another wave of defaults on credit card debt and commercial property that would certainly go bad in the coming months. Another bailout could set the speculators’ sights on these firms as well.

But the Lehman case went beyond that of Bear because, by this point in what can still be called the subprime saga, investors tended to believe that many of the troublesome assets would eventually, somehow, find a price and become tradable again, and the truly hopeless minority would simply become worthless. This meant that most assumed that, at some point, loss-exposure would become more-or-less transparent on a large scale. But, as a senior Lehman executive told bankers and regulators at the weekend prior to Lehman’s bankruptcy filing, “[w]e have no idea of the details of our derivatives exposure, and neither do you.” So if one of the big players in the market was conceding that the firm had no idea of what the most basic conditions in that market were, it showed that the opacity that could exist there might, far from becoming reduced, be worse than pessimists had feared. And if that was true, Lehman, with estimates of $400 billion of written credit default swaps alone, sent a clear signal that the ramifications of letting it, or any other likewise exposed firm fail, could be horrific indeed, and extremely prolonged and tortuous (as the vastness of the competing legal claims could conceivably beggar belief); and the generalized impact of such failures could have a fearsome effect on further lending and, hence, on economic activity vital to the avoidance of recession.

But the Treasury let Lehman fail. In addition to wiping out shareholders, though, certain classes of bond holders also lost out; the government wouldn’t guarantee all of Lehman’s enormous and, as mentioned before, frustratingly convoluted debt. And the confluence of these two factors would take the crisis, again within days, to another level entirely: to that of insurance companies, and, by extension, to the whole of the “shadow banking system.” The turn of AIG had come.

But we’re getting a little ahead of ourselves. For the same day Lehman filed for bankruptcy, Merill Lynch, yet another titan of Wall Street, was purchased by Bank of America. The problems surrounding Merill were the similar to those that afflicted Lehman: falling profits, rapid markdowns of assets, forbiddingly higher charges for increasingly scarce capital, and a loan book full of mortgage-related securities that couldn’t be priced, let alone sold, in an attempt to shore up capital. Oh, and large debts from leveraged (trading with heaps of borrowed money, often large multiples of the amounts actually put up by the trader) trading. Because of this toxic mix, the shares of Merill collapsed as quickly (shares in Merrill lost half their value in a few days) as Lehman’s had, after stumbling through the summer. For investors, already shellshocked by the events of the last few weeks (if not months), with many facing serious losses on assets themselves and considerably lower profits given the ever bleaker global economic outlook, and utterly confused by US policy regarding the safety of potential investments, saw no reason not to head for the exits en masse. And after Lehman’s collapse, the process was accelerated because, with the extremely sudden fall of Lehman, investors had no way of knowing if counterparties to everyday transactions would even be in business long enough to execute them properly. Even if investors had made the right bets on CDSs, if counterparties went bankrupt, they would be out of luck too.

These points should be spelled out in further detail. For the fall of these companies was so rapid that it seemed to defy sense. What could account for such a phenomenon?

To start with, all these Wall Street firms were highly leveraged. This meant that they could borrow large multiples of the money they themselves put on the market. The reason they could do this had, in the last few years, a lot to do with securitization. Securitization is the fee-based division, repackaging and subsequent dispersal of debt. It cheapened the cost of borrowing, and made the terms of borrowing much more lenient, both on its own terms, and because banks and others, who had to compete with firms that originated or sold securitized assets on to investors, were under pressure to reduce their own lending standards. Accordingly, securitized products became very popular with corporate and individual borrowers, and to such an extent that the very popularity of securitized loans would generate the very outsized revenues that would lead financial firms to securitize more loans, thereby earning ever more fee income. Any limit to this kind of business seemed to recede further off as markets for securitized products grew in size.

Now Wall Street firms usually bought bundles of loans from banks and smaller financial firms (and the mammoth GSEs, as well), and, for a fee, resold the loans, but with a twist. They bundled the loans in “tranches” that reflected different degrees of risk, but they did so in a way that would, seemingly, ensure that defaults triggered by the higher risk component-loans contained in the lower levels would cancel themselves out before they could infect the next level up. And, in this way, the whole security, composed of a huge number of loans, could receive a single, unitary rating, one that was higher than that attained by its more risky components, on the assumption that the loans at the lower level were so many, and hedged so minutely, that any failures there would be cancelled out, and the higher tranches, with less risk, would remain uncontaminated. In this way, the more risky loans came to look like a sure, if somewhat counter-intuitive, economically speaking, bet: more income, for taking on less risk. And this would prove irresistible to big investors who could purchase only the safest assets: public pension funds, and so on, especially the biggest ones who were facing huge shortfalls due to large legacy costs and so on. Of course, that was only possible because the ratings agencies, which were paid according to the volume of business they did, went along with story.

Anyway, the enormous profitability of this business made banks eager to lend to the big Wall Street firms that had the technological, financial and other means to churn out these products on the gigantic scale at which they were demanded. That, coupled with the ratings agencies’ imprimatur (they were likewise impressed by such profitability, and assumed that the Wall Street firms would thereby almost certainly avoid crises involving solvency) assured that the companies would be able to borrow vast amounts at low cost, especially for collateral. And this meant that the hedge funds that were clients of, associated with, or even wings of the Wall Street firms could play the markets with big pockets, even if the money wasn’t their own.

But when the extent of potential defaults on subprime mortgages started to become clear in the spring of 2007—back in the day when “teaser” rates were to begin their appalling re-sets, and at the same time as the proportion of subprime loans to mortgages had reached clearly insane levels—such bonds began rapidly to lose their value (it seemed the hedging of the lower level tranches was no longer as water-tight when defaults on this scale threatened), while the market for further securitizations, on which the spectacular profitability of the Wall Street firms was to a good extent based, simply dried up. As these firms not only sold securitized assets, but held them as well (they had, after all, been steady and even profitable investments while things were good), this meant that their asset bases would shrink at the same time as their collateral costs were going up, and this at a time when important growth markets—and profit levels—were reversing, and acquisitions and other expansive investments made during the boom had to continue to be financed. Meanwhile, share prices were declining, due to the singularly nasty mix of financial challenges, as well as to deteriorating economic conditions that would severely constrain the future purchases potential customers, many of whom (including consumers and the government) were also up to their necks in debts they no longer knew how to fund so easily.

And that brings us back to the question of leverage. Not only were the Wall Street firms’ (and those of hedge funds associated with them) assets shrinking in value, making collateral more expensive and, hence, further leveraged investments less profitable; but the Wall Street firms had to continue to pay the debt on the loans they had already taken out, which were falling in equity value compared to the amount that had to be paid to service the debt. And that meant they had to sell off assets that were already declining in value for other reasons, and which only served to hasten, and even compound, the price decline. This is deleveraging. And it was because of the enormous scale (US debt amounts to three times world GDP, according to the Financial Times’ Martin Wolf) of the deleveraging, and the seeming impossibility to stop it (due to the opacity of so many of assets that, despite their impenetrability, had proliferated into every nook and cranny of the financial world) that resulted in the truly astonishing pace of the meltdowns of the share prices of Merill, et al.

And Merrill wasn’t alone during this particular bout of selling off: but Washington Mutual, the largest savings and loan association in the US, found itself under an additional threat: that of a good, old-fashioned bank run. After a credit downgrade that reflected its fearsome exposure to subprime loans and other debt associated with the housing bust, like option adjustable-rate mortgages, home-equity loans, and credit-cards, depositors, many of them businesses, began withdrawing their money. But while Bank of America would purchase Merrill, WaMu, as it was once familiarly known, was closed down, with its deposits being taken over by the Federal Deposit Insurance Corporation, and its assets sold to JP Morgan Chase, for $2 billion. And then all eyes were on AIG.

AIG, an insurance company, wasn’t technically eligible to take advantage of the emergency-financing lifelines the Treasury had thrown Wall Street firms after the fall of Bear Stearns. After all, it was their job to insure others—which seemed to entail an operative familiarity with risk—no? But AIG had a little trading business on the side that was involved in the creation and selling of credit default swaps. These instruments, a significant part of the $515 trillion (in 2007) derivatives market, allow investors to bet on the financial health of companies. So, many investors could hedge their investments against default by companies they had invested in, while other investors could draw income from the former investors, while remaining liable for big payouts in case of actual default. Investors could even buy CDSs on companies they didn’t even invest in; and this inverted pyramid structure was one reason why the market attained the gigantic size it did. The CDS market was also super-charged by the extra-low default rates after the dot.com era, which were, in turn, made possible, to no small degree, by the very low interest rates that characterized that period. Now these unregulated bets didn’t require AIG or any of the other sellers of derivatives to provision reserves against failure to pay out. And they weren’t traded on central exchanges, so there existed no register that sorted out who owed what to whom once-and-for-all. Indeed, derivatives of CDSs were created that amplified the complexity and opacity of liability schemes even beyond this almost indecipherable primary level. As Ambrose Evans-Pritchard put it, regarding CDSs on Lehman, “[p]erversely the insured volume is greater than the $150bn total of Lehman debt. Some $400bn of CDS contracts were sold. Many were used by hedge funds to take “short” bets on the fate of the bank. The contracts nevertheless have to be honoured.” The derivatives market isn’t worth $500 trillion (almost 9 times global GDP) for nothing.

Anyway, the London office of AIG had earned tidy sums for some time selling CDSs on, among other things, collateralized debt obligations related to subprime-tainted mortgages. Adam Davidson of Reuters provides a neat account of what CDSs were, and of the attractions that made them big sellers, and a big source of revenue for firms like AIG:

In fact, beginning in the late ‘90s, CDSs became a great way to make a lot more money than was possible through traditional investment methods. Let’s say you think GE is rock solid, that it will never default on a bond, since it hasn’t in recent memory. You could buy a GE bond and make, say, a meager 6 percent interest. Or you could just sell GE credit default swaps. You get money from other banks, and all you have to give is the promise to pay if something bad happens. That’s zero money down and a profit limited only by how many you can sell. Over the past few years, CDSs helped transform bond trading into a highly leveraged, high-velocity business. Banks and hedge funds found that it was much easier and quicker to just buy and sell CDS contracts rather than buy and sell actual bonds. As of the end of 2007, they had grown to roughly $60 trillion in global business.

When these started to go bad, AIG found itself on the wrong side of the trade, precisely because banks and hedge funds had hedged CDSs with other CDSs. But AIG had sold them all, and hadn’t provisioned any to hedge. It was on the hook to both buyers and sellers of protection. Though many of these wagers would cancel out, the complexity of the deals meant it would take a long time before the claims and counter-claims could be examined, and by then, as hinted at above, a lot of other key players may well be bankrupt themselves. And this at a time when, as economic conditions only got worse and worse, more and more of the bonds CDSs provided protection against were, in fact, defaulting. Estimates in September of the worth of CDSs that AIG had written amounted to $440 billion, which it didn’t have close to enough to cover (remember, it wasn’t required to provision any sort of reserves on CDSs). This led to a credit downgrade from Moody’s, a ratings agency, and this meant AIG’s cost of capital would go up at the very time when it was liable for impossible payouts. And this meant that equity investors, seeing the increasingly desperate situation the firm was in, sold off, making even less capital available. Once again, an erstwhile pillar of the rough-and-ready super-individualistic model of capitalism would have to go, cap in hand, to the state in hope of a bailout. Or see all its equity capital go up in flames over the course of a few days. But this time the Treasury switched sides again. It offered an emergency loan of $85 billion to AIG (which has subsequently been topped up to $130 billion, and hasn’t necessarily stopped there) in an attempt to set its accounts straight, so as to keep paying its creditors. Once again, “too interconnected to fail” was the order of the day.

So between the two of them, and in a breathtakingly short period, Lehman and AIG not only revealed the extent of the damage highly-leveraged investments that went bad could do to a single firm’s financial footing, they also showed how such investments could proliferate with the aid of derivatives, and be strewn all over the world in virtually unrecognizable ways. But as Lehman was allowed to fail, markets no longer had and confidence in any big counterparty to derivatives trading; and even though AIG wasn’t allowed to fail, the fact that it distributed derivatives products on such a vast and minute scale meant that virtually anyone could suffer if any other big counterparty, faced with huge (and rapidly accumulating) liabilities, failed to pay out or was allowed to go under. There was a fundamental contradiction at the heart of policymaking that could no longer be ignored.

One question many may have at this point is the following: who was buying? After all, when there’s a sale, there’s a buyer, as well as a seller, even if the sale is for a reduced price compared to the price that was originally paid for it. Well, the Wall Street firms and banks who had financed hedge funds during the boom now found themselves being forced to take back many of the tainted assets they had peddled to the hedge funds under so-called “covenant-lite” agreements. These agreements were made when expectations of default were exceptionally low. But now they would make the situation of the Wall Street firms even worse, and contribute to their breathtaking decline. Something similar was happening at banks: many of them had offered generous lines of credit to corporate clients on lenient terms during the boom, as an alternative to the short-term bond issuance these clients favored in case market conditions somehow reversed. When they, did, the banks found firms more than happy to take them up on their offer.

So this was one source of demand. One other was hedge funds. Despite their losses, one thing they still made money on was shorting financial firms’ stock, and for that, they provided a market, once removed, for financials’ shares. And this source of demand, too, would soon disappear for different reasons altogether: as a part of more comprehensive legislation, short selling of financials’ shares was banned between September 19th and October 3d. Notwithstanding these players, however, buyers were few and far-between (not least because potential buyers were finding it increasingly difficult to obtain financing). So the financials’ share prices continued their dramatic falls, generally, as did collateralized debt obligations and other classes of debt. And it was at this point that Paulson, prodded by Federal Reserve chairman Ben Bernanke, addressed that policy contradiction mentioned earlier, even if they did so in a way that would ultimately lead to the next stage of the crisis.

Paulson and Bernanke knew at this point that, because too many assets could not find a price on markets, the government would have to step in somehow and provide a means whereby prices could be established. This could be done either by recapitalizing the banks, with the government purchasing important stakes in financial firms, and with the understanding that the public would eventually be liable for paying off any bad debts that would subsequently be encountered on the taken-over firms’ books. It could also, conceivably, be accomplished by attempting to segregate the bad debts from good ones, with the government simply buying up the latter. Ever fearful of the appearance of socialism, Paulson opted for the latter approach when he, on September 19th, announced the proposal of the “Troubled Asset Relief Program,” or TARP. In a 3-page document, Paulson asked Congress for $700 billion and virtually unlimited power to buy any asset the Treasury Secretary considered necessary in the quest to regain full-scale price transparency.

But Paulson, as was the case in the summer with foreign holders of Fannie and Freddie debt, hadn’t taken into consideration the potential opposition of a key party to the arrangement: the US Congress (and, by distant implication, the US taxpayer). In an extraordinary rejection fuelled both by popular revulsion at Wall Street, as well as (unfortunately) a right-wing revolt by Congressional Republicans (spurred on by the luminaries of hate-radio) over the intrusiveness of big government (they didn’t seem to have as many qualms when the biggest government department ever, that of Homeland Security, was being established), Paulson’s dictat was rejected by the House of Representatives on September the 29th. Asset prices continued to fall, but buyers simply became all more fearful. This situation would shift the crisis to its next phase.

Dating back to the early days of the crisis, the London Interbank Overnight Rate, or LIBOR, a key benchmark for interest rates worldwide, had been subject to large and, sometimes, seemingly inexplicable spikes upward. These rates, calculated in London (there’s also a “EURIBOR” rate for the Eurozone, and a US dollar-based LIBOR) daily, are compiled based on the estimates of the cost of borrowing by a number of important banks. Many markets are aligned to LIBOR (US mortgages, for instance), so, in a sense, LIBOR rates can at times be more important than the Federal Funds rate, the key rate the Federal Reserve sets. On September 30th, dollar-LIBOR skyrocketed to a record 6.88% from 2.57%, and one-month EURIBOR shot to 5.05%, another record. This indicated that, without doubt, the overwhelming fear that characterized trading in shares had now spread to the most elementary level of the global financial system, the interbank market.

The interbank market is where banks lend money to each other so they can meet their reserve requirements daily. Banks are required to maintain a certain percentage of assets on reserve, so as to cover potential depositor withdrawals. If they lend too much in a given day, they use the interbank market to make good the difference, usually only overnight, or in the very short term, until they can come to a more longer-term financing solution or strategy, or simply until their lending adjusts to trend. Because the lending is so short-term, interest rates tend to be extremely low. But, to some extent before the House vote, and to a much larger extent thereafter, banks began to hoard money. They did this for a number of reasons (banks were being hit up from all sides at this point): as mentioned before, by this stage of the crisis, counterparties having anything to do with derivatives were shunned, so that meant huge swathes of the business landscape worldwide were now effectively quarantined, ranging from Hong Kong, Brazilian and Mexican exporters eager to hedge their exposure to the dollar weakness of the early summer to default insurance on Jefferson County, Alabama’s sewer warrants; banks had to provision against the increasing likelihood of large default increases and, contrariwise, on the possibility of depositor withdrawals due to emergency expenditures prompted by economic decline on the one hand, or even bank runs, on the other; the cost of deposit insurance contributions was set to go up dramatically, to assist in paying for bailout schemes; those banks (albeit few, but important) associated with hedge funds had to take covenant-lite loans and other bad loans and assets back on their books, and, this time, to provision against them accordingly; and last, but not least, the meltdown was by this time clearly going global, and holdings denominated in other currencies were being liquidated, with the proceeds being parked in “safe” US dollars. These proceeds were finding a home in US banks, and, facing such challenges on at every turn, banks were desperately shoring up the only thing they had that seemed to hold value: dollars, and lending activity came to an effective standstill, even between partners previously considered completely safe, as reflected by the historic jump in LIBOR. But, meanwhile, US Treasury bond yields, reflecting a dismal economic outlook (and an expected big Fed cut), trended downward. That meant that bank lending was prohibitively expensive at the same time as US dollar obligations were supposed to be becoming, if only they weren’t being hoarded, enticingly cheap! A dire situation, indeed.

But the critical situation in the interbank market was only to be redoubled—more or less simultaneously—by the troubles in an even more obscure part of the financial system, the commercial paper (CP) market (See Dollars and Sense’s special primer on Commercial Paper by the New School University’s Max Fraad Wolff http://www.dollarsandsense.org/archives/2008/1008wolff.html ). In this market, companies and banks sell short-term IOUs at a discount so they can access funds to cover operating expenses, and even payrolls, in a way that that avoids regulatory hassles and the rates charged by commercial banks. Because of this, CP became extremely popular with ordinary businesses. Commercial paper includes asset-backed securities (which, in turn, includes mortgage-backed securities), so the CP market actually dried up once before during the current financial crisis, in the late summer of 2007. But at that time, suspicions were limited to mortgage companies, so when some of them (like Countrywide) exited the market, it revived.

Unfortunately, the biggest buyers of CP were money market mutual funds. And these conservative investors looked for steady performance above everything else. After the fall of Lehman, one of them, the Reserve Primary Fund, broke what was, in the industry, a fearsome taboo: it “broke the buck,” or became worth less than what its contributors put into it, because it had invested in Lehman CDSs which, as we have seen, might not be honored, due to Lehman’s bankruptcy. Money market mutual funds had only broken the buck once before, and the effect of the present occasion was potentially chilling enough considered on its own terms. But, if that weren’t enough, another negative influence exerted an utterly unwelcome effect on the CP market. The flight to safety in US dollars saw a pronounced movement within money market mutual funds themselves towards those that invested only in US Treasury bonds. So, even after the purview of the FDIC was extended to include money market mutual funds (although MMMFs were widely considered safe as cash prior to this point, they were not actually insured) as a part of yet another Fed/Treasury intervention, MMMF purchasers of CP could hardly, burdened by redemption requests accompanying the flight to safety to Treasury-heavy ones, be expected to buy anything. So the CP market shut down. And this is when the crisis really entered its acute stage, and authorities worldwide (CP is used throughout mich of the world, by the way) became involved in a desperate race to prevent the unthinkable: the prospect that payrolls and pensioners might not be paid in countries which had long since looked at such nightmares as the relic of a foregone, less finely-tuned financial period.

So: banks not lending to each other; the widespread prospect of ordinary companies not being able to finance their day-to-day activities; what else could go wrong (and, as we have seen, these catastrophes merely followed, at breathtaking speed, albeit, other disasters that had been building up for more than a year)? Here we meet up with our old friends, credit default swaps, again. By this time, CDSs were becoming very expensive for companies (and this made them liable to ratings downgrades, and further increases in capital costs, at a time when capital was become, well, simply unavailable). Financial firms had long faced daunting costs of protection. But with the shutdown of the most primary funding markets for the most everyday firms, the widespread increase in these costs turned a merely nightmarish situation into a truly intolerable one. And that would compel Paulson, kicking and screaming, and only after the Europeans had forced his hand, to submit large parts of the US financial system to government supervision. But, once again, we’re getting ahead of the story. When we take it up again, though, CDSs will be back, smack in the center of the action.

Let’s backtrack a bit. The weekend after the TARP program was announced, the two remaining Wall Street financial firms were converted to bank holding companies. This meant that they would have to submit to capital provisioning requirements and regulatory oversight like banks did. It would also allow them to take advantage of federal deposit insurance and greater access to capital. And they could use their heft to try to acquire banks to ramp up their depositor bases. In the weeks ahead, suspicions would arise as to the permissible extent to which the big bank holding companies (which would include behemoths like Citibank) should use taxpayer-provided funds to pay dividends, bonuses to executives and to engage in acquisitions (though this latter should be no surprise: one of the goals of saving the banks was to concentrate an industry whose fragmentation—fostered, of course, by unscrupulous financiers and irresponsible regulators—had clearly had a lot to do with the breakout of the crisis). Notwithstanding this, however, another “Wall,” whose extent of influence had far outstripped that of the Soviet empire, had clearly fallen.

The Emergency Economic Stabilization Act of 2008 finally made it through Congress and into law on October the 3d, 2008. The revised bill considerably increased Congress’ oversight of the Treasury Secretary’s activities, but the essential framework of the TARP remained: The Treasury would try to isolate and buy up troubled assets, but not to recapitalize, or buy stakes in, the banks. By this time, the crises in the interbank and commercial paper markets had concentrated the minds of many lawmakers who had originally opposed the package as a bailout of some of the very people who were most responsible for the overall financial crisis (and, it must be noted, so did popular sentiment: calls and emails to Congress supporting the revised bill came in around fifty-fifty, while the first bill was opposed by an overwhelming majority): they no doubt feared what would happen even if some of their more rabid opposing constituents started missing a paycheck or two. But the new law would be eclipsed within a fortnight. And the impetus behind this change would originate beyond America’s shores.

On October 8th, the Federal Reserve, in concert with other central banks, which took down their own interest rates, (and followed by the People’s Bank of China), cut the US Federal Funds rate .5% to 1.5 per cent. This move was meant both to flood the US interbank market with cash (and was effectively topped up when the Fed started paying interest rates on banks’ deposits with the Fed later in the month), and to stimulate activity in the wider economy. But, as we have seen, the banks largely hoarded the cash, and economic indicators continued their decline into October. On the other side of the world, though, another set of problems were brewing, which would force the Fed and Treasury to change their course in the most fundamental way.

In late September, a number of European banks/financial companies began to come under attack, which had exposure to US subprime debt, or other debt in their own overextended property markets, as was the case especially in the UK and Spain. This forced the UK to rescue Bradford and Bingley, Spain Santander, the Benelux (Belgium, Netherlands and Luxembourg) countries Fortis, and Germany Hypo Real Estate (though Germany had no domestic real estate problem). But it was the meltdown of Iceland’s banks that, once again, change the complexion of the crisis once again.

Iceland (population 330,000), as one might imagine, had no exposure to US subprime debt whatsoever: not even via derivatives. But with its affluence and highly educated (and almost universally English-speaking) population—which was extremely internet-savvy—the island attracted lots of foreign capital, and entrepreneurs there founded successful fledgling firms in biotechnology (Iceland’s population is one of the most homogeneous in the world), information technology, and…banking. Within a few years, Icelandic internet banks had established quite a hold in big overseas markets like the UK and the Netherlands, specializing in offering depositors higher rates than their traditional banks had done. But their assets were denominated in Icelandic Kroner, and liabilities mostly in Euros. Iceland is a place where the population, used to a high standard of living, imported a lot, and subsequently ran large current account deficits, which required unusually high interest rates, even when times were good. This situation became blown completely out of proportion when huge numbers of foreigners started taking out deposits in Icelandic banks. Eventually, Iceland’s banks amassed liabilities that amounted to several times the country’s GDP (a situation that would also hold in places like Switzerland, the Netherlands, and Belgium). It was strange: Iceland’s comparative advantages involving education and social stability were seemingly condemning it to run constant current account deficits. Then again, that story used to be told about the US.

Anyway, the flight to the dollar mentioned above set off an acute period in which leveraged investors had to cash out of their positions in other countries very rapidly, even if these investments were more-or-less sound, or uncontaminated by subprime-related assets. And Iceland was no exception. Investors rushed out of Iceland, the currency fell, and depositors of Icelandic banks, fearing depreciation of the Icelandic currency, began to demand their money, something that only accelerated the spiral. Iceland’s banks then began to fall very rapidly.

This was bad enough, but an unanticipated effect of the Icelandic collapse would become manifest in another star-performer of the new economy era, Ireland. After the fall of Bradford and Bingley, pressure had mounted in the UK for Prime Minister Brown’s government to guarantee all bank accounts. Brown, true to his “New-Labour” convictions, resisted, as Paulson did, such an intrusion on the sanctity of private enterprise. Next door in Ireland, though, perhaps due to the fact that Ireland was small, like Iceland, and had developed a number of its own peculiarities where its international accounts were concerned—which might make it extra-vulnerable to a financial meltdown—the authorities were not put off by such stodgy considerations. For instance, it had long operated as a tax shelter for companies like Microsoft (its corporate tax rate is one of the lowest in the world, and many companies, like Microsoft, have established “offices” in Ireland that are little more than facilities to park tax-free stashes until the funds can be repatriated). Accordingly, they decided to guarantee all bank deposits on the books of the six largest Irish banks. Other European countries followed suit quickly. Prime Minister Brown of Britain was enraged, but within a week, he would not only guarantee bank accounts, but indeed spearhead an international effort to save the global financial system by shifting the focus to recapitalization and, accordingly, the partial nationalization of banking systems. The reasons for his reversal were no doubt tortuous, he being Gordon Brown, but the competitive advantage British banks would lose to Irish ones, whose liabilities were protected by the state in an atmosphere so universally characterized by fear and insecurity, certainly concentrated his mind. The possibility to reverse his party’s self-destruction with a series of popular measures no doubt played a role, too.

Meanwhile, extraordinary measures were being taken by many governments in an increasingly desperate attempt to get money markets moving again, as stock markets, increasingly hit by forced sales due to huge hedge fund redemptions (hedge fund performance declined precipitously starting in the summer, as their strategy of going long on commodities and short on financials went sour), chalked up some of the most volatile daily performances ever. These measures generally consisted of the establishment of various “backstops” for the affected markets: governments started to buy commercial paper, thereby directly lending to private businesses, for example; or the standards of collateral accepted by governments for firms to participate in generous lending schemes were made more lenient. But the money markets remained frozen, and stock markets continued their historic gyrations, mostly downwards.

Finally, Paulson threw in the towel. On Tuesday, October 14th, he announced a plan to recapitalize the US banking system, by buying $250 of equity in the country’s biggest banks. He did this because, like Brown, he knew US banks would be shunned if all the other major banking systems were supported by their governments and that of the US was not. But, there was one major difference: Paulson directed the purchase of preference shares, which do not carry a vote at company meetings. The US public would bail the system out, and be paid back, presumably, and with dividends, but it would not have a say in the way the beneficiaries would run their businesses.

With this radical step, one would have thought markets would respond enthusiastically. But that was not to be the case. The next day, US markets were hammered, even as money and credit insurance markets began to revive, due to the publication of a series of horrific economic indicators. This had the effect of focusing investors’ minds on the truly dire outlook of consumers and businesses in the developed economies, and that revealed that the easing problems involving money markets, which were confronted with the truly extraordinary measures taken by governments, constituted only half the battle—if that. On the other side, deleveraging firms and overextended consumers (who were facing large upticks in unemployment) promised a lengthy period of highly inhibited demand that seemed to guarantee poor profit performance for some time to come. And even where the money markets were concerned, the fact that banks needed extra cash to cover their year-end expenses cast a pall on the incipient recovery. Also, US states and municipalities were facing enormous shortfalls due to asset losses on one hand, and the reduction in tax revenues that would result from those losses. Pension funds, too, were falling to levels that would require top-ups.

So the situation was bleak enough in the developed economies. But the full fury of the financial crisis now became directed at the emerging economies. This was largely because of the unwinding of the yen carry trade. The yen carry trade involved taking out loans in low-interest currencies like the Japanese yen, and buying assets in countries that had much higher interest rates. This strategy was very popular with hedge funds and other highly levered investors, but when the yen began rapidly to gain value as other currencies besides the US dollar fell, losses mounted, and yet another leveraged trade had to be unwound, with all the associated multiplier effects and complications. And, in this case, the chief victims were the emerging markets: hedge funds and other investors had to repatriate funds to pay off investors in dollars who were heading for the exits. This impacted economies that had nothing at all to do with subprime lending (though some emerging markets, especially in Eastern Europe, had property bubbles that developed out of the extension of loans from Western banks, denominated in Western currencies like euros or Swiss francs). CDSs on emerging markets’ sovereign debt skyrocketed. Now countries like Hungary and Ukraine (not to mention Iceland) are going to the recently-dormant IMF, which is itself running out of money. This has necessitated the extension of dollar swap lines, which were implemented amongst developed countries earlier in the month, to a group of important, stable emerging markets (that are also staunch US allies): Brazil, South Korea, Singapore and Mexico, so these countries can replace the dollars they had recently lost to capital flight. Once again, though, the strategy creates losers who don’t have similar access (yet); and the losers count amongst them some US allies (sort of, anyway) like Pakistan, which are highly unstable, as well as huge economies that are also important politically, like Turkey, that are also extremely vulnerable due to huge economic imbalances.

The situation in these countries is exacerbated the collapse of yet another market, that of letters of credit, that serve as a kind of currency in international trade. Letters of credit assure shippers of payment. Recently, banks have been refusing to honor these letters, as part of the general panic. But with the rapid decline in world economic activity, shipping costs are dropping precipitously, to levels that make it uneconomical to ship at all. Such a breakdown in global trade, if it is sustained, will only accelerate the already breathtaking pace of the decline of the economic condition of the emerging markets. It could also lead to periodic price spikes within an overall atmosphere characterized by deflation, that will make policymaking all the more difficult.

Mercifully, that brings us to the end of this sorry recital. I write these lines on the eve of the US presidential election. It seems the Obama campaign has already started trying to reduce expectations, although some, like Anatole Kaletsky, think the new administration will (have to) pursue a vigorous recovery agenda even before the inauguration. However that may be, it’s hard to say how Obama (and I’m expecting a big Obama victory) will keep to his promises of restructuring the health care system, maintaining military commitments, shoring up pensions, replacing infrastructure and rescuing the economy (never mind dealing with the speedily oncoming ecological reckoning in a serious way) without restructuring the entire economic edifice in ways he seems resistant to even contemplate (consider his stance on single-payer health care, for instance). But that means massive public pressure must be brought to bear to force him and the new Congress to do so. For half-measures are surely a recipe for disaster.

The US economy requires fundamental restructuring. The very interconnectedness and debt that fuelled the crises we are facing thrived on the weakness of labor: the interconnectedness of markets created unprecedented opportunities to arbitrage labor, while the unprecedented proliferation of debt allowed for the temporary sustenance of demand in the face of falling compensation levels that inevitably followed from the latter. This contradiction must be faced—soon—if the crisis is to be resolved. Unfortunately, I don’t yet see much of a political will, certainly on the part of the Obama economic team, but also on the part of the American people, to make a serious effort in this direction.

Larry Peterson is a member of the Dollars & Sense collective.

Sources: Syncora Holdings Ltd. Comments on Status of Jefferson County Alabama, Reuters, August 4th, 2008; Charles Duhigg, Stephen Labaton and Andrew Ross Sorkin, As Crisis Grew, a Few Options Shrank to One, New York Times, September 7th, 2008; Anatole Kaletsky, Hank Paulson Has Turned a Drama into a Crisis, The Times (London), September 16th, 2008; Adam Davidson, How AIG Fell Apart, Reuters, September 18th, 2008; LIBOR Surges to Nearly 7%, But US Stock Futures Rise on Bailout Bill Revival Hopes, Naked Capitalism Blog, September 30th, 2008; Martin Wolf, Preventing a Global Slump Must Be the Priority, Financial Times, October 28th, 2008; Carter Dougherty and Edmund L. Andrews, Central Banks Coordinate Cuts in Interest Rates, New York Times, October 8, 2008; Ambrose Evans-Pritchard, Fears of Lehman’s CDSs Haunt Markets, The Telegraph, 17 October, 2008; Francesco Guerrera and Nicole Bullock, Struggle to Unearth Quake’s Epicentre, Financial Times, October 31st, 2008; Currency Bets Gone Bad Hit Companies in Emerging Economies, Naked Capitalism Blog, October 22d, 2008; John Authers, Chaos Carries a Risk for Emerging Markets, Financial Times, October 25th-26th, 2008; David Pilling, Beware the Unwinding of the Yen Carry Trade, Financial Times, October 29th, 2008; Confirmation of the Role of Financing Difficulties in Collapsing Trade Volumes, Naked Capitalism Blog, October 28th, 2008; Tim Read, Barack Obama Lays Plan To Deaden Expectation after Victory, The Times (London), October31st,2008; Anatole Kaletsky, Change of Guard Could Administer Adrenalin Shot, The Times (London), November 3rd, 2008.
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