[Every now and then, the law throws up something really fascinating. This week's exercise in fascination was instructions to prepare a briefing note on the causes and consequences of the global financial crisis, directed at yours truly.
What made these instructions so difficult to follow is that while the causes and consequences of the GFC are beginning to come clear (with, of course, the benefit of 20/20 vision in hindsight), explaining them is anything but an exercise in clarity, especially in just half-a-dozen pages (which is pretty much all one gets in a briefing note).
I set myself a challenge, then: to simplify without simplification, especially when it comes to the financial products everyone was selling like billy-oh and that no-one seemed to understand (buyers and sellers both).
In what follows, names have been changed to protect the innocent (and the guilty!), and a couple of bits have been excised. I have added a couple of links, but only to concepts with which non-lawyers may be unfamiliar (the intended audience is other solicitors). The document is meant, by and large, to stand alone. Does it, I wonder?
In 1921, economist Frank Knight distinguished risk from uncertainty on the basis that the former was susceptible of measurement, while the latter was not. This famous distinction captures the essence of the 2007-8 global financial crisis, which manifested as a liquidity contraction. In short, banks and other financial institutions first stopped lending to each other and then stopped lending to business more generally on the basis that they were no longer able to price risk. ‘Risk’ had become ‘uncertainty’: no one who mattered knew what anything that mattered was worth any more.
In this briefing, I will first outline the significant aspects of the global financial crisis and consider some of its causes, followed by a discussion of industry responses. Next, I will address the vexed question of whether we—in the UK at least—are still in ‘crisis’. Finally, I turn to issues that are pertinent to our client bank. Throughout, I will do two things: first, keep Knight’s distinction between risk and uncertainty foremost in my analysis; and secondly, distinguish—particularly when sharing the blame around—between government behaviour and industry behaviour. Where the two intersected—as in the US subprime mortgage market—I explore why that might have been the case.
The Global Financial Crisis: a recap
The immediate trigger for the GFC differed between jurisdictions: in the US, the ‘housing bubble’ burst. In Britain, banks were unable to borrow from each other in short-term money markets. It is simplest to consider the US first, as the integrated nature of global markets meant that events in the US fed into events in Britain and Europe, and vice-versa.
A growth in credit availability over the period 1997-2006 allowed the emergence of two linked phenomena: first, persons historically unable to secure mortgages over residential property (‘subprime borrowers’) were able to do so, on increasingly easy terms and at low interest rates. That credit boom fuelled an unprecedented appreciation in residential property values. Between 1997 and 2006, the price of the typical American house increased by 124%. The easy credit combined with what appeared to be an investment that never dropped in value saw people pile into the property market, despite the fact that the market value of the properties they were purchasing was often many multiples of their annual income. As a general rule, when purchasing a house, the value should be no more than three times one’s annual income. By 2006, many mortgages—and almost all subprime mortgages—were taken out over properties valued at five times the annual earnings of those purchasing.
Easy borrowing conditions were generated by large inflows of foreign capital, particularly from the rapidly growing BRIC economies. Broker Peter Schiff called it ‘a giant pool of money’, and pointed out that it demanded relatively safe, income producing investments. Historically, US Treasury bonds were emblematic of this type of investment, but in the early years of the century, US paper did not offer high yields, and there were few similar products. In response to Schiff’s ‘pool of money’, investment banks on Wall Street promoted products such as mortgage-backed securities and tweaked them in innovative ways: whence collateralised debt obligations. Credit rating agencies then assigned the new products high ratings; companies that did not appreciate the risks involved insured them—think, for example, of AIG.
At the same time, American (and British, as we shall see) consumers’ capacity to take on debt had a limit: this was reached sometime in 2007. Thereafter, housing values went into decline. As they did so, major global financial institutions that had borrowed and invested heavily in subprime CDOs reported significant losses.
Britain’s experience formed part of the ‘European contagion’ that spread from toxic US assets, to which British financial institutions had considerable exposure. However, it is important to remember that Britain had also experienced a housing and credit bubble. During the summer of 2007, money markets across Europe became increasingly mistrustful of any institution with considerable investment in mortgage debt. In September, the rate at which British banks would lend to each other—known as the London Interbank Offered Rate (Libor)—rose to its highest level in almost nine years. The first casualty was Northern Rock, Britain’s biggest mortgage lender in 2007 and fifth largest overall, which went cap-in-hand to the Bank of England as lender of last resort on 12 September. Northern Rock had become unable to repay maturing money market loans and experienced a liquidity crisis. Always short on deposits, its subsequent experience of both government deposit guarantees and nationalisation came to symbolise two of the worst sorts of over-leveraging: a low reserve ratio (too little cash physically held in the bank’s own vaults relative to the amount of money loaned to customers) and too much uncertain investment (borrowing on the short-term money market coupled with its own subprime lending, often at 125% LTV).
What happened thereafter has become folklore, as financial institutions and insurers fell like ninepins across the US and UK, banks also stopped lending to business, and governments stepped in to prop up the financial services industry in an attempt to stem what had become a catastrophic credit retraction.
Pointing the finger I: collateralised debt obligations
As should be clear, the crisis was caused by a complex interplay of factors. As to which bear the most responsibility, in my view government policies that encouraged home ownership—providing easier access to loans for subprime borrowers—and overvaluation of bundled subprime mortgages based on the theory that housing prices would continue to rise, are most salient. However, questionable trading practices on behalf of both buyers and sellers, and a lack of adequate capital holdings by banks and insurance companies backing the financial commitments they made are also important. In what follows, I will outline two of the less widely understood causes.
Complex financial instruments that undermined the accurate pricing of risk are central [see Fig. #1 below]. While looking at the diagram, it is important to keep two things in mind: first, it was not understood that mortgage defaults tend to occur in clusters, much like communicable diseases such as influenza or measles; and secondly, there were a number of perverse incentives in the mortgage market—particularly in the US, but also in the UK—encouraging lending to just the sort of people who were likely to default on both their mortgages and other credit obligations.
Banks and other financial institutions bought mortgages from ‘originators’, the companies that first made the loans. The banks then repackaged the loans into ‘pools’, which provided the rights to a stream of mortgage repayments (along with the risks that the loans would go unpaid). At this stage the repackaging was known as a ‘residential mortgage backed security’, or RMBS. ‘RMBS’ products are steps one and two on the diagram. At each level, the securities were rated as to their riskiness. The buyer of the lowest rated tranche was like the ground-floor owner-occupier in a flood: he was exposed to the most actual losses, but received a higher rate of interest in compensation. The next tranche’s buyer—the owner of the first floor—took the next wave of losses and in exchange took the second highest interest rate, and so on.
The investor in the top floor of the building—with his AAA rated security—received the lowest rate of interest, but this was coupled with the assurance that his investment would not be wiped out.
Had it not been for the credit-driven explosion in subprime lending, this system seemed logical enough: it was meant to create a safe and predictable income stream which could then be traded between banks, pension funds, and other financial institutions. However, when investment banks went about developing new products beyond RMBS (which had existed since the 1960s in the form of mortgage bonds), it is vital to remember that they created CDOs by taking the lowest rated tranches—the floors most likely to flood—and repackaging them. This repackaging is seen in steps four and five. This process was often repeated, magnifying the risk. However, at the same time as the risk was magnified, mortgagors across the developed world—but especially in the US—began to default in large numbers. Risk had become uncertainty as what looked like highly rated assets turned out to be toxic.
The above account illustrates the power of hindsight, and draws on economic analyses that have, for the most part, emerged since 2009. At the time—before 2007—people trading in CDOs did not know their value, did not understand the products, and relied on credit ratings agencies to price the risk. Some were so complex that even if all component parts were identified and valued separately, they still could not be accurately priced.
Pointing the finger II: everyone should own his own home
Widespread home ownership is linked to a number of positive social effects, especially for lower income households: these include enhanced outcomes for children (most notably higher rates of school completion and lower rates of teen pregnancy), anti-poverty effects, and stronger community involvement. In seeking to enhance these effects, government policies in both the US and the UK encouraged home ownership at the same time as the expansion in credit allowed people to borrow more easily. In the US from 2000 to 2003, for example, the Federal Reserve lowered the federal funds rate from 6.5% to 1.0%; the lower interest rate encouraged borrowing.
In the UK, the ‘Right to Buy’ scheme is emblematic of policies that saw many low-income people enter the property market for the first time, while in the US, pressure (and in some cases, legislation) imposed on both quasi-public and private sector lenders caused mortgage lenders to relax underwriting standards and originate riskier mortgages to less creditworthy borrowers [Fig. #2, left]. It is easy to condemn this kind of ‘own your home at any cost’ policy with the benefit of hindsight, and the collapse in underwriting standards at HBOS or Fannie Mae makes much of the subsequent criticism fair. However, in both countries, historic lender prejudice had denied access to a significant route out of poverty for many prudent people on lower incomes. Most notorious was the practice (in the US) of ‘redlining’: marks on a map to delineate the areas where banks would not invest. This was almost always on the basis of race.
Unfortunately, policies to increase levels of home ownership intersected with the housing bubble and its allied explosion in cheap credit. Indeed, some lenders (notably Countrywide Financial) became notorious for ‘reverse redlining’: deliberately targeting low-income customers with a view to signing them up to a subprime mortgage, often predatory in effect. For these customers, keeping their heads above water depended on the value of their property continuing to rise. No investment increases in value indefinitely, and it was often low-income borrowers who finished up ‘under water’ (owing more than the property was worth) when the housing bubble burst.
Preventing a future crisis: industry responses
Most industry responses since the crisis have come about through government fiat: the state has taken control of much of the financial sector and imposed changes from without. However, two internal changes in response to the crisis are salient. The first is a notable return to prudence in lending practices, particularly for residential mortgages, and the second is a new emphasis on training and background checks for senior financial sector employees. More minor—but publicly popular—responses include either sacking or withholding performance bonuses from individuals culpable for reckless strategies during the crisis. There has also been increased oversight from the private sector regulator—the FSA is not a public body.
It is difficult to convey, post-crisis, the nature of loans widely available before it. Many required no documentation from the borrower—so-called ‘self-certification’ loans. Others demanded no deposit and were deliberately lent at overvalue, often with Britain’s burgeoning army of DIY and ‘buy to let’ investors in mind. Others again were interest only; one Countrywide Financial mortgage in the US demanded no repayments as long as the property continued to rise in value—creating negative amortisation (where the amount owed increases over at least part of the loan lifetime). Trader Michael Lewis argues that products meant for sophisticated investors were deliberately marketed to retail customers, who simply did not understand them.
Banks now expect significant deposits—‘ninjas’ (no income, no job, and no assets) no longer qualify and loan variety has shrunk dramatically. Similarly, banks routinely undertake careful background checks—‘liar loans’ (self-certifications) no longer exist. LTV is often set at 80% and sometimes even lower. Of course, this means it is difficult to get a foot on the first rung of the property ladder, prompting much hand-wringing from social policy analysts keen on the positive effects of home ownership. That said, Australian banks remained fairly conservative in their lending practices in the lead-up to the financial crisis, a practice allied with higher interest rates set by the Reserve Bank of Australia. This had the extraordinary consequence that Australia did not experience the GFC [Fig. #3, left].
Allied to more conservative residential mortgage lending (probably necessary) is the more serious problem of reluctance to lend to even solvent small businesses coupled with the withdrawal of longstanding credit facilities (such as overdrafts). While perfectly understandable in context, this is bad for the British economy, causing serious cash-flow problems.
Preventing a future crisis: government responses
It is fair to say that Britain is still suffering effects from the GFC. While the economy has emerged from recession—as of October 25—there is ongoing retrenchment in the manufacturing sector and over-reliance on service industries. It is important to remember that during the lead-up to the crisis, many sovereign states went on a credit binge of their own and continue to run large deficits: just as banks and households must cut spending, so too must the British government. The recent round of spending cuts goes by the name of ‘austerity’, although it is important to remember that true austerity combines tax rises with spending cuts, and—unlike in Greece or Ireland—Britain has not yet attempted both simultaneously.
‘Austerity’ apart, the most significant government responses are as follows:
- Prudential regulation: the forthcoming Banking Reform Bill seeks to separate retail from investment banking with a view to protecting important retail functions and avoiding the misuse of customer deposits on speculative investments. Business Secretary Vince Cable’s proposed ‘Small Business Bank’ is meant to address the financial sector’s reluctance to lend. This is positive for business and good for the British economy, but does expose the taxpayer to higher levels of risk (ie, the taxpayer will be taking on loans that High Street banks consider uncertain).
- Quantitative easing: meant to inject money into the economy without increasing inflation (it does not involve printing more notes), QE increases the capital available for banks to make loans, once again primarily to small and medium enterprises. It has not been an unqualified success: often banks have simply sat on the funds in order to improve their credit ratios.
- Disengagement from the Eurozone: While the financial crisis was in process, the Eurozone entered a separate crisis of its own, largely to do with the overvaluing of labour and assets in the unproductive ‘PIIG’ economies (Portugal, Ireland, Italy, and Greece) as a consequence of monetary union without sufficient market discipline: in short, the area covered by the single currency was insufficiently homogenous for economic shocks to affect its different regions in similar ways. While Britain stayed out of the euro, much of its trade is still with weak Eurozone economies. This means that Britain is actively seeking more economically robust trading partners. The Eurozone’s financial sector in particular is in such a parlous state that Australia’s (prudently managed) financial sector is now worth more [Fig. #4, right].
Pertinent future issues for our client
Our client is a Scottish bank with Scottish headquarters. This means that—despite the global outlook expected of any large financial entity—there are issues peculiar to its Scottish domicile. The first is the realistic possibility of Scottish independence in the next five years. This may be coupled with a new currency (there is no guarantee that an independent Scotland would keep Sterling, although that possibility is being mooted). Regardless of what currency an independent Scotland adopts, there is also the separate issue of its credit rating, which Fitch broached on 19 October (BBC News):
[T]he rating would depend on the terms of an independence agreement, and how long it takes for the transition to take place. That’s as well as uncertainty on splitting assets and liabilities, and the question over Scotland’s future financial regulation.
The Fitch analyst’s note goes on to point out that an independent Scotland will have no credit history, which means that it may start out without the treasured AAA rating. This would increase its borrowing costs and reduce Scottish banks’ ability to raise finance via corporate bonds.
Should Scotland remain in the UK, the long-term effects of both the Eurozone crisis and new financial sector regulations are still unclear.