An intelligent person’s guide to the panic of 2008

LIAQUAT AHAMED

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THE current financial and economic crisis – which has yet to acquire its own catchy moniker, but which I like to call ‘The Panic of 2008’ – began like so many other crises before it with a bubble. Such bubbles are nothing new – the word was first used to describe an out-of-control financial boom in 1721 at the time of the South Sea Company. Bubbles seem to be such an inherent part of a vibrant capitalist economy that by one count there have been over fifty different episodes in various markets across the world since then.

Financial booms all differ. Some originate in the stock market, some in the credit markets, some in real estate or in commodities; often they occur in many markets simultaneously. They all, however, share a common pattern. It usually begins innocently enough with a surge of optimism among investors which at some point, human nature being what it is, becomes transformed into overconfidence. As prices of assets rise the general public, fearful of missing an opportunity to get rich quickly, scrambles to get on board. A frenzy of buying ensues. Suddenly a shock occurs, perhaps a big bankruptcy or a large fraud. This jolts the public and provokes a dramatic shift in sentiment, leading to fear, mass selling and eventually panic.

While financial bubbles are ultimately driven by elemental forces of mass psychology, they can almost always be traced back to periods of excessively easy credit.

In the early part of this decade the Federal Reserve System, which by virtue of the size and power of the U.S. economy sets the pace for world monetary conditions, made a major error in the conduct of its monetary policy. As inflation fell to post War lows, the Fed under Alan Greenspan became concerned that the U.S. might be sinking into the sort of deflationary funk that had characterized Japan after its stock market bubble burst in the early 1990s. It, therefore, reduced short term interest rates to a very low level and kept them there for an unusually extended period of time.

 

It turned out that the low inflation of those years, which the Fed had mistakenly read as a symptom of inadequate demand, was in fact a reflection of a remarkable transformation in the world economy emanating from Asia, for it was during those years that the Chinese export boom really took off. It was also at this time India entered the world economy as a major supplier of services. Moreover, many East Asian countries, shaken by the turmoil of 1997, embarked on a strategy of undervaluing their exchange rates in order to generate foreign exchange to pay down their short term debts and build up a war chest as insurance against a recurrence of another crisis. The confluence of all these factors put downward pressure on prices. Low inflation was thus not a reflection of a stalled U.S. economy that had run out of steam but of an astounding, once-in-a-generation, expansion in the supply of low cost goods and services from Asia.

The effect of the Fed’s easy credit policy during those years was exacerbated by the capital flows coming out of Asia. Gigantic sums of money accumulated in the hands of Asian central banks were then invested in the U.S. bond market, driving down real interest rates around the world. Thrifty Asians thus provided the fuel for the credit boom in the U.S. and European countries.

While cheap financing and easy credit provided the initial impetus to the real estate boom in the U.S., as house prices began to rise, the bubble developed a life of its own. An army of amateur investors – doctors and lawyers, civil servants and car salesmen – speculated on the side in real estate by buying condominiums on credit in order to flip them for a profit. Consumers borrowed against their homes to finance a spending spree in the expectation that the value of their houses would keep rising. Banks reduced their credit standards by providing so called ‘sub-prime’ mortgages to those who could least afford them but who were afraid of missing out on the American dream. These sub-prime loans were pushed by mortgage brokers who had an incentive to do as much lending as possible with little regard to how much would or could be paid off.

The real estate boom was not restricted to the U.S.; it was a worldwide phenomenon. House prices in much of Europe and the Middle East, from Ireland to Spain, from Britain to Dubai, went crazy. Nor was India immune with house and apartment prices in New Delhi and Bombay soaring to ridiculous levels.

 

The bubble psychology infected not only real estate but a whole series of other assets. Stock markets in the U.S. and Europe remained reasonably priced, rising only in line with earnings. Emerging markets, however, became highly speculative as equity prices went up much faster than earnings. In India the market went up four fold from 2003 to 2007, while in China the market went up almost six fold.

During a bubble almost everyone makes money, which they invariably attribute not to luck but to their superior wisdom and investment skills. There are always a few doubters who keep predicting a disaster. But bubbles tend to go on for much longer than anyone expects and as the forecasts of these Cassandras keep being proven wrong, they end up being completely discredited. When something is too good to be true, however, it usually turns out not to be true. Bubbles always burst. This one began deflating in early 2007.

The collapse of a bubble does not have to end up in a financial crisis. After the dot com bubble of 2000 was pricked the US stock market fell almost 50%, there were several high profile bankruptcies and many people lost a lot of money, but there was no run on the financial system. It is only when a large amount of borrowed money is at stake that the banking system is threatened.

 

Real estate happens to be the one area of the economy most dependent on borrowed money. In the US, for example, supporting a total housing stock of well over $20 trillion dollars stands the largest mountain of debt in the world: $10 trillion of mortgages. The U.S. has always prided itself on having the most efficient and deep housing mortgage market in the world – where else can someone get a fixed rate mortgage for 30 years that can be paid off without penalty at any time? But the truth is that the authorities have never really figured out how to fund this mortgage system. Historically, mortgages used to be financed by savings and loan companies, also known as thrifts, equivalent to ‘building societies’ in the UK. The thrift industry, however, went belly up in the 1980s and mortgages found themselves, as it were, homeless.

Over the last decade much of this mortgage debt was packaged into bonds known as ‘mortgage backed securities’. The hope was that these securities would be spread around to lots of different investors, allowing risk to be shared across the system. Some of this did happen. These bonds found their way into the hands of French money market funds, German banks, Norwegian municipalities, and Australian public hospitals. But a lot of it – far more than anyone expected – was put on the books of ‘the shadow banking system’.

 

This ‘shadow banking system’ – money-market funds, the mysteriously named conduits, the various off balance sheet ‘special-purpose investment vehicles’ located in Luxemburg or the Cayman Islands, investment banks and hedge funds – had been allowed to develop over the last decade as a legal way to bypass the heavy regulations that governed the banking system. On the eve of the crisis, this shadow banking system had grown to $10 trillion and had become as large and as important to the workings of the economy as the banking system proper. But in contrast to banks whose capital was policed, these mysterious and often very risky institutions were supported by only a sliver of equity capital – many of them relied on borrowed funds for up to 98% of their assets, much of it short term money that could easily evaporate at the first hint of trouble.

Thus when problems in real estate emerged in 2007 they hit a financial system that was unusually fragile, though no one foresaw the extent to which the whole edifice had become a house of cards. The first sign of trouble – the canary in the coal mine – was an increase in delinquencies on sub-prime mortgages. As losses on these mortgages rose, exceeding analysts’ worst expectations, investors deserted the market for mortgage backed bonds and suddenly it became impossible to sell these securities at any price.

In August 2007 it turned out that a money market fund run by the French banking giant BNP had a high percentage of its assets invested in illiquid mortgages. Institutional investors, who had assumed that their funds could be accessed at any time, to their great surprise found themselves blocked when they tried to take their money out. As news of this hit the wires, investors across the board rushed to pull their cash out of all money market funds indiscriminately just in case they too were blocked. Suddenly the world faced a massive run on its financial system.

Finance as a business has always been especially vulnerable to such attacks. Banks and ‘shadow banks’, like money market funds, take deposits from investors and, promising to let them have their cash whenever they want, lend it out. If more than a small fraction of depositors actually tried to exercise that right, banks would collapse. It is a business that depends on trust and confidence – some would even say a giant bluff. Bankers rely on the assumption that not everyone giving them money will pull their cash at the same time.

 

In contrast to the infamous bank runs of the 1930s when panicked individuals lined up outside banks to take their money out physically, this time round the financial system was hit by a ‘digital run’ fuelled by a panic among large investors who were able to siphon their money out of these ‘shadow banks’ with the click of a mouse. Ever since the banking panics of the 19th century, the formula for dealing with bank runs has been well known: inject so much money into banks that depositors, reassured they could get their money whenever they wanted to, stop withdrawing their funds. And so, from August 2007 through to the Spring of 2008, the Fed, the European Central Bank and the Bank of England lent several hundred billion dollars to banks and through them to money market funds in an effort to reassure depositors that their money was safe.

This strategy was called into question in March 2008 with the run on the investment bank of Bear Stearns. Until then, central bankers had operated on the assumption that they were dealing with an irrational panic – a massive liquidity crisis in which banks faced a temporary shortage of funds and which could be cured by short term loans from central banks. With Bear Stearns it became apparent that the panic was not irrational. The losses on ill-conceived mortgage loans had been so great that a large part of the banking system was in effect insolvent.

 

The nature of the problem can best be illustrated by the details of the Bear Stearns case. It was one of the smaller investment banks with assets of a mere $400 billion. Supporting this giant portfolio of securities, it had barely $12 billion in equity – that is, its own money. The remaining $388 billion was all borrowed, including about $200 billion in short term borrowings that had to be rolled over on a weekly, sometimes daily, basis. As doubts about the true value of Bear Stearns’ assets began to circulate, its short term lenders decided quite reasonably that it was not worth the risk for them to renew their lines of credit.

Bear Stearns suddenly found itself having to scramble for cash and liquidate several hundred billion dollars of illiquid securities in a falling market at fire sale prices. If it had tried to do so it would have realized less than $350 billion on its assets, thus wiping out all of its equity and big chunks of its unsecured debt. To prevent Bear Stearns from going under, taking some of its creditors with it, and starting a full scale financial panic, the Fed arranged for J.P. Morgan to take over Bear Stearns, smoothing the way by guaranteeing to foot the bill for any potential losses.

Even after the fall of Bear Stearns in March 2008, however, the U.S. authorities failed to appreciate the magnitude of the problem. Though they now recognized that they were dealing with a problem of insolvency that could not be solved by temporary loans, but which required the injection of new capital into banks, they believed they could still deal with it on a case by case basis – what one commentator has called the ‘finger-in-the dyke’ approach.

 

In late September the two giant government-sponsored mortgage companies, Freddie Mac and Fannie Mae, faced trouble rolling over their short term debt and had to be taken over by the government. The following week Lehman Brothers, another investment bank, faced a similar run. The authorities decided not to bail out Lehman. This provoked a generalized run across the whole U.S. and European financial systems. AIG, the largest insurance company in the world had to be bailed out two days later. The two largest investment banks, Morgan Stanley and Goldman Sachs each with over $1 trillion faced a run from their lenders. The Belgian and Dutch insurance and banking behemoth, Fortis, had to be taken over. There were runs on the two largest regional banks in the U.S., Wachovia and Washington Mutual.

When one airplane crashes it is reasonable to attribute the problem to pilot error. When many airplanes of the same make crash in the same month, something more systemic is obviously at work. In late September the U.S. and European financial authorities finally and very late in the game recognized that they were dealing with a systemic solvency problem that cut across the whole financial system and that could only be cured by massive injections of public money.

Since then the authorities have thrown everything they could at the problem. In the U.S., in addition to over $2 trillion in loans from the Fed, the government has earmarked $700 billion for equity infusions and the buying of bad assets; the government has provided a guarantee on all new bonds issued by banks; interbank deposits and money market funds are now insured by the government; and most recently the government agreed to underwrite the losses on $300 billion of Citibank’s most impaired assets. Similar packages of measures have been introduced in Britain and in Europe.

Though the authorities have had some false starts, gone down some blind alleys and at times given the impression of making things up as they went along, this was inevitable. We are in uncharted territory and no one yet knows what will work.

 

As of early December (the time of writing this essay), it looks as if the world has now passed through the eye of the storm. A full scale panic and meltdown in the system has been avoided. There is still likely to be a need for more government money into the financial system – in Washington the talk is of another $1 trillion in addition to the $700 billion dollars that has so far been approved by Congress. The amounts are gigantic, but at 12% of GDP they are roughly in line with the experience of other banking crises in other countries over the last decade.

The steps to inject money into the banking system were necessary to stabilize the situation and forestall a financial catastrophe. They will not be enough to stop the economy from sinking. A corollary of the excess lending by banks is that households and businesses have borrowed too much over the last twenty years and will cut their spending. Thus, for all the enormous sums of money that were thrown into the banking system, a recession, perhaps even a deep one, is unavoidable.

The crisis, which emanated from the U.S. and Britain and infected Europe early on, has gone fully global since the summer. Until then, emerging market countries had convinced themselves they would be immune. Trade linkages were not large enough and everyone believed they had ample foreign exchange reserves. But as hedge funds and other investors lost money in the U.S., they were forced to contract their balance sheets and sell their positions in many emerging markets. Capital flows have come to an abrupt halt and money has flooded back into the U.S. One country after another, from Iceland to Kazakhstan to Hungary to Argentina to South Korea has been caught by a widening global credit crunch.

 

India is an especially interesting example of these channels of contagion at work. When the crunch hit, Indian multinational companies with operations abroad suddenly found their access to credit curtailed. They immediately resorted to borrowing in their domestic market. Simultaneously, foreign institutional investors with significant portfolio positions in India, facing redemptions from their own client, began liquidating their positions in the Indian stock market and repatriating the capital home, creating a squeeze in domestic liquidity. The result was the Indian edition of the credit crunch with interest rates spiking to 20% despite an easing by the RBI.

One positive over the last year is that the mechanisms to dampen the transmission of crises around the world have functioned pretty well. Countries such as India, side-swiped by an external credit crunch, have dealt with it by drawing down foreign exchange reserves, letting their currencies fall, and borrowing from the IMF. That is as it should be, though I suspect that IMF resources will need to be expanded. Open capital markets are here to stay and few countries have resorted to capital controls as a way of insulating themselves from swings in international credit conditions.

What is now to be done? Going forward, economic officials around the world face two issues: How to jumpstart the world economy and how to ensure that we don’t get into a similar mess again.

 

The main difficulty in getting the world economy moving is that in the U.S., which accounts for 25% of global output, monetary policy has lost its traction. Official interest rates have been cut about as much as they can be. For all the enormous sums of money that have been injected into the financial system, banks, scarred by their losses, are understandably reluctant to lend out any more and are likely to use all the extra liquidity and capital to build up their own reserves. While monetary policy may have stopped working in the U.S., there are large parts of the world – for example Europe, China and India – which can afford to cut interest rates further.

Since monetary policy will not be enough, fiscal stimulus to offset the collapse in consumer spending that is taking place will be required. This has now become accepted as conventional wisdom. The incoming Obama administration is planning an unprecedented fiscal package of 4% of GDP, roughly $600 billion dollars. Even the IMF, which in the past has given the impression of believing that budget deficits are invariably a bad thing, has endorsed a generalized global fiscal stimulus.

As for avoiding a repeat of this crisis in the future, there are two things that need to be done. First, central bankers and other regulators have to accept responsibility for acting against asset bubbles while they are in progress rather than waiting until they burst before stepping in. The whole Greenspan philosophy of doing nothing to deflate asset prices preemptively because it is difficult to distinguish between a rise that is warranted by fundamentals and a bubble, has been finally and completely discredited.

Second, whatever central bankers and regulators do and however prescient they are, they will never completely eliminate the boom and bust cycles that give rise to bubbles – these seem to be an inevitable by-product of the animal spirits that drive a dynamic capitalist economy. But central banks can do a better job of protecting their banking system from the consequences of those cycles, especially from the effects of bubbles bursting.

 

The right way to do that is through more effective regulation to curb leverage and ensure that all financial institutions, whether they chose to call themselves banks or not, are well capitalized. Any institution that is too large or central to the system to fail and that would therefore be bailed out, should be governed by these regulations. Designing a system of regulation for a globalized financial system will not be easy. Banks have become so large relative to the size of their countries of origin, that some form of supra-national regulator and lender of last resort seems inevitable.

The French statesman, George Clemenceau, once said, ‘War is too important to be left to the generals.’ The lesson of the last year is that banking is too important to be left to the bankers.

 

* Liaquat Ahamed is the author of Lords of Finance: The Bankers Who Broke the World, Penguin Press, New York, 2009 (forthcoming).

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