I thought I’d write a brief history of what went wrong in the banking industry. It should be noted that this is essentially an introduction to the current crisis in the financial sector, my article isn’t meant to present a comprehensive version of events but a core narrative that helps explain the problems to someone with no prior knowledge.
The most fundamental misconception people make when asked about the banking industry is the idea that if you deposit Â£1 into an account the bank will loan out Â£1 to someone else.
If this were the case wealth would be a zero-sum game.
Banks occupy a unique position in society they are risk managers and, fundamentally, wealth creators; the reality is for every Â£1 you put in a bank the bank is allowed to loan out a multiple of that core amount, for the sake of argument for every Â£1 you put in the bank lends out Â£9. The first reaction of anyone who hears this is horror; after all how can banks simply be allowed to ‘create’ money.
The reality is the idea of fractional reserve banking (as its called) is very intuitive.
If you’re constructing a new building the only money you need is for the day to day cash flow of actual construction – you may not have the absolute amount the building will finally be worth, but as long as you can incrementally fund the construction, and as long as the final value of the building is worth more than the sum of its building materials; you’ll have created wealth.
Banks only need to lend out the amount that is needed at a particular moment in time for a particular investment; that allows them to fund more than one investment with a limited amount of money and crucially it allows them to operate on a basis that isn’t quid pro quo. Its a crude analogy but think of that core money that ‘actually exists’ acting as the ‘incremental cash flow’ for multiple investments. The banks lend out more than they have, but as long as they manage the risk carefully and keep a very careful eye on the flow of money they help society by amplifying wealth creation.
That core money that the banks multiply their lending from is called the core capital and its divided into different tiers, as an example tier 1 capital would essentially consist of the hard cash that shareholders put in, whilst tier 2 capital is capital that is less reliable than the hard cash (this covers a wide variety of things). The types of capital allowed in either tier as well as the ratios allowed between tiers varies from country to country depending on the regulator, banks and governments have been trying to standardise this via agreements called the Basel accords. The act of lending out more than the core capital is called leveraging up.
The fundamental concept to understand is that banks take a finite amount of money and through careful control are able to invest it in projects or schemes whose worth is far in excess of the bank’s core capital.
About 20 years ago bankers realised that a new type of tier 2 capital could be used; Collateralized debt obligations (CDOs). Hundreds of thousands of mortgages were taken and packaged together. The idea was that by lumping these mortgages together the combined probability of failure was reduced; they could aggregate the risk across the entire package. Whilst some mortgages would fail most wouldn’t and as such the income from those mortgages would be relatively stable. This also worked in favour of the consumer, banks could be more lenient with the mortgages they loaned out because again the risk could be averaged out across the package. You may default on your mortgage but they were willing to offset the risk of you doing so across their entire package of mortgages.
The result was cheaper loans.
Because the income from these CDOs were meant to be relatively stable the banks included them in their tier 2 capital as something called subordinated debt.
The key concept I want you to clarify in your minds is that those CDOs were counted as part of the core capital and were then ‘multiplied’ (leveraged) up.
The largest source of these mortgage CDOs was the United States, and this is where the nature of government interference of the markets comes in. Fannie Mae and later Freddie Mac were government mortgage companies that were quasi-privatised. They were the biggest providers of mortgages in the US and they had implicit government backing which ultimately allowed them to skew the markets. The exact way they skewed the markets is hotly debated, the US government on both sides used them to make housing more affordable – both parties did this. There is a somewhat ugly argument now being made that this quest for affordable housing is what led to the downfall; what’s ugly about it is most of the people mentioned as examples of this need for affordable housing aren’t white â€“ this pretty much ignores the fact that until about 6 to 8 years ago Fannie Mae and Freddie Mac weren’t really in the so called ‘subprime’ sector. Another argument being made is that both companies acted as gorillas that drove the private sector in a particular direction and led to the private companies going a bit mad and essentially paying no attention to their own screening processes simply because they were trying to compete on an uneven footing with a quasi-government agency.
Regardless of how it happened a lot of people were not only given mortgages when they shouldn’t have been; they were given mortgages in the midst of a property bubble.
In a paragraph the current financial crisis is caused by the banks suddenly realising that part of the core capital that they leveraged from â€“ these CDOs – are haemorrhaging value, and because they multiply up their core capital the affects on the leveraged investments is multiplied; a small variation in their core capital leads to an amplified variation in their leveraged investments.
The banks are now in a mad rush to deleverage as fast as they possible can because their core capital has shrunk. As an example the Icelandic banks are getting rid of large swathes of their foreign investments in British businesses at dirt cheap prices because they’ve suddenly realised their core capital has shrunk and as such the ‘multiplication’ they used to invest in those businesses simply does not exist.
Whats called the ‘liquidity crisis’ (liquidity is like money in a till, its a short term flow of cash that that allows transactions to be completed) is caused in part by banks deleveraging and hence not having the ability to lend out even temporarily and in part by banks not trusting one another about the amount of these toxic CDOs they have.
The result of these banks not lending to each other as they concentrate on their own problems is an absolute collapse in banks which depended on interbank funding. Investment banks are a particular type of anglo-american bank that aren’t allowed to take deposits from the public or in the way conventional banks are, instead they borrow money just like any other businesses would from ‘conventional’ banks (or they go to their shareholders); in return they’re allowed to take much greater risks and leverage their capital far in excess of banks they borrow from.
The investment banks weren’t only exposed to these CDOs as other banks were but when what were really little more than businesses loans dried up because of the liquidity crisis they found themselves exposed in a manner they have never been; the net result is they’ve been wiped out. Massive wall street investment banking names have either been put through a government assisted and controlled suicide (Bear Stearns), or driven to the wall (Lehman Brothers), or merged with big retail banks (Merrill Lynch) or they’ve given up on the investment banking model (Goldman Sachs).
In the course of six months a business model that had existed for over sixty years was eviscerated.
As I said the investment banks essentially relied on businesses loans from other banks, their inability to get those loans as a result of the liquidity crisis as well as their problems with CDOs meant they were wiped out. The danger now is every other type of businesses that relies on loans and credit are in equal danger; some massive American companies â€“ the automotive manufacturers in particular are almost completely dependant on credit, are heavily in debt and have virtually no cash cushion whatsoever. GM and Ford are teetering, and if companies like them collapse it’ll reinforce the cascade of failed mortgages as their workers are made redundant.
And important side issue to this crisis, and potentially the most serious issue of all are so called Credit Default Swaps, its a type of pseudo-insurance. When the banks bought CDOs they decided they needed to offset the risk just incase they failed so they took out CDSs. These aren’t insurance in the manner you’d normally think of them rather its a type of bet. As the name suggests its literally a swap on the risk of a credit default. The banks would pay a premium to someone else to hold the risk of failure, the counter party to the bank would be betting that no default (no failure) would occur and as such the banks would be paying them regularly at no risk to themselves.
Well obviously the CDOs did fail and when everyone went to claim the CDSs from American Insurance Group (AIG) one of the major companies signing off on them, AIG simply couldn’t pay up. They went cap in hand to the ‘fed, and basically blew their corporate brains out. The company was transferred to the control of the US government.
So how the hell do we get out of this and what were the major blame areas?
Well the US bailout is intended to buy back the toxic CDOs at their maturity level. The important point of that is it would buy back those CDOs without leaving a hole in the core capital â€“ otherwise there’s really no point, they’d still have to deleverage and the problems would continue. What governments and central banks are trying to do is cut out the CDOs but simultaneously recapitalise the hole left when they’re taken out. The banks can then leverage up on the now secure core capital and everyone can focus on the economy (which is a completely separate issue).
The only problem is the US congress has a way of really making everything worse and the sorts of preconditions and nannying that they’re planning on implementing with any bank that takes part in the bailout is putting a lot of people off. Personally I think the government here should try setting up a special purpose vehicle, buy back the CDOs, then flog them back to the yanks via their own bailout plan. That way the banks don’t have to deal with hassle.
As for where to focus on making changes; traders at banks bought CDOs even if their own risk assessment colleagues advised against it. The important point for the trader was the rating agencies gave them AA or AAA status.
They were never that good an investment.
The relationship between the rating agencies (which have to be recognised i.e. authorised by the SEC) and the issuers of these debt instruments (as well as a whole host of other relationships) would be called corrupt were it to occur in any other industry.
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Filed in: Economics,Events