The making of a recession

Sometimes it feels as though major market events come out of nowhere, bursting on to your TV screen (or the front page of the Financial Times) all at once. But recessions are made up of thousands of tiny triggers, which might take place in boardrooms, oilfields or at rampant parties.

In Gillian Tett's account, the key to the 2008 recession lay, in part, with the creation of complex financial products that enabled risk to mushroom throughout the financial system. Ms Tett pinpoints the moment of fevered innovation at JPMorgan when the monster was born. In the 1990s, the tight-knit derivatives team at the American bank began working on the audacious aim of removing one of the bank's major risks - that its borrowers would not repay their loans - using derivatives. Derivatives are swap contracts in which a buyer compensates a seller if an underlying loan goes into default. They were typically used in the bond market, but the steely Blythe Masters, a rare woman in the testosterone-fuelled world of investment banking, was the first to use the instruments to take major corporate loans off bank balance sheets. "For the first time in history, banks would be able to make loans without carrying all, or perhaps even any, of the risk involved themselves," says Ms Tett.

This landmark deal - the first ever credit default swap - revolved around a loan to energy giant Enron. JPMorgan paid a third-party bank to take on the risk of Enron defaulting in return for an annual fee. In one fell swoop JPMorgan believed it had erased any risk of its loan to Enron going sour. The team were ecstatic. Next they borrowed a practice called securitisation, already used in the mortgage market, in which bankers and brokers would bundle up a large quantity of mortgage loans then slice them into chunks to sell to investors, products known as asset-backed securities (ABSs). Because of the large pool of homeowners involved, it seemed highly unlikely that all of them would default on their payments and, in return for buying a chunk of risk, investors were rewarded with a regular income stream from the mortgage repayments. Ms Masters and her team used the same logic for corporate credit, chopping up the big company loans on the bank's books and dicing them into tranches. Finally they took it to a new level, carving up the securities into different levels of risk, with those taking the lowest level of risk paid out first in the case of any defaults and setting up a shell company to play the part of the third-party bank in the Enron deal. The beauty was that the company, a special purpose vehicle (SPV), was not regulated like the banks so didn't have to hold large reserves to insure the risk it was taking.

"The team was jubilant. They felt they had stumbled on a financial Holy Grail. At a stroke, they had managed to remove credit risk from the bank's books on an enormous scale," writes Ms Tett. The final product, given the catchy title the 'broad index secured trust offering', or Bistro, launched in 1997, would morph into the most complex kind of financial instrument, known as collateralised debt obligations (CDOs). "Five years hence, commentators will look back to the birth of the credit derivatives market as watershed development," said Ms Masters at the time. And so it was.

Financial contortionism reached new levels in the early 2000s. Global banks went on a rampant binge, dealing in ever more complicated financial products. The mad science soon reached the mortgage market and pretty soon banks and brokers all around the world were knee deep in bundling up, packaging and repackaging loans in ever more opaque ways and caring less and less about whether the borrowers at the end could pay them back. To top it off, they stopped holding anything like the amount of capital at risk in reserve.

Sitting in a sweltering café on 9 August 2007, Robert Peston realised just how much trouble we were in. The UK was in the midst of a feverish property boom, though in the US the subprime mortgage bubble was bursting. Mr Peston, flicking through his BlackBerry, stumbled on an email from BNP Paribas. The French bank was announcing that it could no longer value the assets within several funds it held. It said that the lack of trade in derivatives linked to subprime "has made it impossible to value certain asset fairly regardless of their quality or credit-rating". In other words, the bank had no idea what it was really holding or just how toxic the risk was. And in contrast to the bankers' earlier theories, it was not possible to tell what risk was held where.

It was the first major signal that something had started going seriously wrong. "Could it be that it fears that the assets it holds are toxic garbage that defy rational valuation? Is there reason to believe that may of the securities manufactured out of subprime loans are worse than ordure? I'm afraid so," wrote Peston in a blog that day.

By the end of the day markets had spiralled into panic mode. Investors were indiscriminately heading for the exits. The crisis had begun.

The collapse of Northern Rock

Those moments might not be etched into the public's memory, even if they were major events for these writers. But the queues of panicked savers lining up to pull their money out of Northern Rock in 2007 will be more familiar. Ms Tett remembers seeing Mr Peston's report as the start of the end for the bank.

"At 8.30pm on 13 September Robert Peston, the gangly business editor of the BBC, appeared on its news channel. Until that point, the BBC had given only cursory coverage to business dealings. On that Thursday night in December, however, Peston had electrifying news to report. In breathy, dramatic tones, he declared that Northern Rock, the fifth-largest British lender had gone to the Bank of England and asked for emergency support. 'Although the firm remains profitable,' Peston declared, 'the fact it has had to go cap in hand to the Bank is the most tangible sign that the crisis in financial markets is spilling over into businesses that touch most of our lives'".

"The story felt momentous to me," says Mr Peston, "although the extent of the public reaction took me by surprise." The next day, savers withdrew £4.9bn from the bank in a single weekend. "There has been no equivalent panic by retail bank customers in living memory," says Mr Peston. And things would only get worse.

Why did it happen and who can we blame?

Talking about the financial products behind the crisis sounds a little like reeling off the alphabet. From ABSs to CDOs of ABSs to CLOs and RMBSs you could be forgiven for not understanding how the products worked or what they stood for. Even the bankers who created them seemed a little at sea about what exactly they were peddling when crunch time came. But these were the clever instruments that caused a crash.

"What kind of monster has been created here?", a former JPMorgan employee wrote in a heartfelt email to another, according to Ms Tett. "It's like you've known a cute kid who then grew up and committed a horrible crime," exclaimed another.

Mr Peston says: "CDOs are tradable debt fabricated out of lots of other bits of tradable debt. They are investments manufactured out of the offcuts and offal of other investments, which when minced together are supposedly non-toxic." Add in some leverage and you get "debt that has become even more indebted - a concept that would have stretched the paradox-manufacturing power of Lewis Carroll".

Even fund managers are scornful of the clever instruments that brought down markets. Nick Train, co-founder of asset manager Lindsell Train, says: "It should never, ever be forgotten that the first hedge fund to blow up at the start of the crisis was called - High Grade Structured Credit Strategies Enhanced Leverage Fund. You almost feel that people who invested in such a product deserved what they had coming to them."

The bankers

So should we blame the bankers? Were they deliberately selling toxic products in the 1990s, naively optimistic or wilfully ignorant? Mr Train says: "Ms Tett is convincing that an elite corps of bankers willingly fostered a taboo or 'social silence' about credit derivatives - CDOs were too technical, too boring for the layman to understand - and this suited the bankers well. In her words: 'The situation was almost akin to that of the European medieval church: although almost nobody in the congregation really understood the financial Latin in which the service was being conducted, few rebelled because they were receiving blessings.'"

The regulators

And where were the regulators when these situations exploded and why hadn't they foreseen the risks? Like the bankers, at the start of the decade regulators believed that the banks really had performed the greatest trick of all, getting rid of risk.

A key part of that was regulators' failure to rein in the shadow banks. So called because they operated in a murky, unregulated sphere, the shadow banking industry turned out to be more deeply connected to the beating heart of the mainstream banking industry than anybody realised. When the blood stopped flowing into shadow banks, it was the high-street banks that needed life support.

But that was not the only issue. The litany of flaws raised by Ms Tett and Mr Peston include letting the banks come up with their own risk measures, rolling back requirements for how much capital they had to hold and decentralisation of UK regulation.

And according to Robert Aliber, author of the sixth chapter in Kindleberger's tome, policy response was just as much to blame. Stephen Wilmot says: "For students of the 2008 banking crisis, a chapter was added in the sixth edition focusing on the policy response. Mr Aliber's unequivocal view is that letting Lehman Brothers go bust was a major error, as a result of which 'a market adjustment cascaded into the most severe crisis in one hundred years'.

"In his view - following the lead of the internationally minded Kindleberger - the pilloried banks of Wall Street were merely responding to cross-border investment flows that made money cheap. He rails instead against the political and central banking elite who looked on in the face of surging house prices and made no contingency plans for a crash. As a result, they flitted indecisively between policy responses in the crucial days of September 2008, letting Lehmans fail only to bail out AIG and Citibank, sparking panic without sparing the taxpayer."

Blame globalisation

There is also the view that we are all to blame for what happened. Alex Newman, companies writer at Investors Chronicle, says: "According to Mr Peston 'this mess' turns out to be a product of globalisation just as it is a story of bad bankers and indebted consumers. Elsewhere, Mr Peston examines Europe's permanent state of crisis and stagnation, the unsustainable dynamics of international trade, the often destructive role of central banks, and the unparalleled rise and rise of China. Pan out, and an awful number of actors bear responsibility: lazy politicians, Greeks living beyond their means, credit-drenched UK consumers, risk-addicted traders and the saver economies of China, Japan and Germany.

"If there is a unifying theme to this book, it is the way consumers, governments and countries have essentially lived on credit, thanks to unerring support for the magic of a ballooning financial services industry. In the UK, property speculation has been incentivised over production and R&D. Meanwhile, China has risen on a debt-fuelled economic boom on a scale history has never before witnessed."