Would you pay £42,000 for a metal wall plate? You get a decent amount of metal for your money – the sign is 10ft wide – but even so. The significance is in the name: Lehman Brothers; the name that’s synonymous with – in a sense, even triggered – the credit crunch, the biggest financial meltdown in the lives of anyone reading this and from which the developed world has yet to fully recover. The depths of the fall and the timidity of the recovery make it all the more odd that someone would pay £42,000 – including buyer’s premium – for a name plate screwed to the wall of an unexceptional office block in the City, however infamous the background story.
So perhaps the sum involved was evidence of the success of a response tailored by the Bank of England – so-called ‘quantitative easing’. This aimed to liven things up by prodding punters to swap assets of good provenance – UK government debt – for those of doubtful worth, like this wall plate. That’s just being flippant. Besides, the sum involved probably surprised every one. When the sign was auctioned in 2010 – by Christie’s on behalf of PWC, which was liquidating the remnants of Lehman Brothers – the estimate was put at just £3,000.
True, the auction was expected to attract some interest. That was not just to satisfy morbid curiosity, but because Lehman’s London office could be expected to be the repository of some half-decent art. The US investment bank had got its foothold in London by taking over broking house L Messel, whose founder – the eponymous Leonard Messel – was born to wealth and was as much an art collector as a stockbroker. Sure enough, the auction contained some minor gems – a Freud sketch here (Lucien, not Clement), a Thomas Luny seascape there.
Yet only one item sold for more than the Lehman sign. Someone paid £73,000 for a piece by Gary Hume, one of the ‘brat pack’ of so-called Young British Artists, which included Damien Hirst and Tracey Emin. Interestingly, however, this piece sold for well below the auction house’s estimate, indicating, perhaps, that the effects were still being felt from the unbroken strand of financial virus that had produced its most dramatic moment on 15 September 2008 when Lehman Brothers filed for bankruptcy.
Of course, Lehman was allowed to go to the wall. Central bankers on both sides of the Atlantic thought it would actually be a good thing to kill off Lehman in much the same way that the British military once thought it was good to execute an admiral from time to time – “pour encourager les autres”, as Voltaire candidly explained. In 21st century economists’ speak, the equivalent is about purging ‘moral hazard’ from a system; moral hazard being the omnipresent threat that arises when people are inadvertently given the incentive to behave badly. As it turned out, moral hazard was deeply embedded within the developed world’s banking system. But that did not become obvious until the crisis. Besides, to recount the causes in roughly chronological order, we need to go back to the 1970s and gather factors from diverse sources.
● The Community Reinvestment Act. This US law – passed in 1977 – aimed to address decline in America’s inner cities by encouraging banks and mortgage lenders to include low-income borrowers among their customers. The charge was that various relaxations in the law persuaded banks to lower their lending standards, thus helping to fund the expansion of sub-prime mortgages that was a major contributor to the crunch. The extent to which the Reinvestment Act was responsible remains debatable. However, it is clear that the debt outstanding on sub-prime mortgages ballooned in the early 2000s. By 2006, they accounted for almost 24 per cent of all US mortgages, worth $600bn. By contrast, the figurers for 1996 were just below 10 per cent and less than $100bn.
● Financial markets liberalisation. In 1980, the UK government scrapped controls on the movement of capital into and out of the UK. In 1986, London’s securities market was liberalised by the ‘Big Bang’ where distinctions were scrapped between wholesalers and brokers of securities and restrictions on the ownership of securities firms was relaxed then scrapped. In 1987, the US central bank, the Federal Reserve, relaxed rules – enacted under the 1932 Glass-Steagall Act – that prevented commercial banks from dealing in securities. During the 1990s these rules were relaxed further and Glass-Steagall was finally scrapped in 1999. These moves, and others, encouraged innovation in the financial markets – new products; new economic models; new ways to match lenders and borrowers; new means of diversifying risk. They stimulated much activity and they demonstrated that finance could be socially useful. They also removed some of the checks and balances that helped to keep the finance industry grounded. It did not help that many were in awe of the financial markets and others, who should have, did not understand them. More of that below.
● The South American debt crisis. In August 1982, Mexico’s finance minister announced that Mexico would no longer be able to service its government debt, mostly borrowed from overseas commercial banks. This triggered a debt crisis throughout Latin America as lenders shied away and nations struggled to re-finance their – mostly short-term – loans. The significance was long term. As a result of being in hock to the International Monetary Fund and of experiencing the rise in unemployment that followed the crisis, developing nations switched their growth model away from ‘import substitution industrialisation’, which relied on overseas finance to fund industrial development, and towards export-orientated industrialisation, where goods were produced with the aim of building a current-account surplus. As Chart 1 below shows, the plan was hugely successful. For example, China’s trade surplus rose from just $1.6bn in 1995 to peak at $420bn in 2008.
That surplus – and similar surpluses, especially in oil-exporting nations – had to go somewhere and mostly ended up recycled into US government debt where they helped to push down interest rates and to stimulate mortgage lending on a gigantic scale (Chart 1 again). From 2001 to 2007 in the US, the amount of mortgage debt per household rose from $92,000 to almost $150,000 even while wages were stagnant.
If the sequence of events, outlined above in the barest form, created the conditions for a financial boom, other factors were needed to turn the boom to excess and then to bust. All of those factors can be viewed, in one way or another, against the backdrop of regulatory failure – the failure of finance company bosses to do their job properly; the failure of credit-rating agencies to do theirs; the failure of central bankers and treasury departments to understand what was happening.
That the most infamous bosses involved in the credit crunch – the likes of Fred Goodwin at Royal Bank of Scotland – failed is an understatement. They were among those lighting the blue touch paper. The more usual failure was of a duller sort – the bosses who didn’t really understand the complexity of their firm’s activities, let alone that of the financial system. This was epitomised by Chuck Prince, the chief of Citigroup, who insisted that his group was not “too big to manage” but whose testimony to the US Financial Crisis Inquiry Commission gave every indication that it was.
Meanwhile, the three major credit-rating agencies – Moody’s, Standard & Poor’s and Fitch – were failing on a gigantic scale. Without their seal of approval, the ‘securitisation’ – ie, bundling together – of mortgages could not have become a major industry. At the peak of their activity, the agencies were awarding mortgage-backed securities ‘triple-A’ ratings at hitherto unimagined rates. For example, from 2000 to 2007, Moody’s gave triple-A ratings to nearly 45,000 mortgage-backed securities; by contrast, in 2010 the securities of just six private sector companies in the US carried such a rating.
Arguably, however, the most egregious failures were reserved for the central bankers and those who ran the treasury departments and state-backed regulatory agencies. These were the ones who had convinced themselves they knew the pulleys and levers of the financial system even if they concluded that the operation of such metaphorical levers was usually best left to those in the system. Thus, central bankers speculated about whether they could spot an incipient bubble in the financial system and whether it would be worth bursting. They decided they couldn’t, but, even if they could, it wouldn’t be worth bursting because the financial markets were likely to do a better job at deflating it. Consistent with this, the Bank of England was completely caught off guard when depositors queued around the block to get their money from the failing Northern Rock bank in 2007. The following year, Ben Bernanke, chairman of the US central bank, and Henry Paulson, the US Treasury secretary, offered public assurances that the turmoil in the sub-prime mortgage markets would be contained, only to be proved wrong within weeks.
So there it is, a lightning tour of the causes of the financial crisis that lingers, as shown by Chart 2, which plots the UK’s faltering recovery and continuing longer-term decline in output.
Longer accounts of the causes of the credit crunch are 10 a penny, but few offer a better narrative than that of the Financial Crisis Inquiry Report of 2011, which, in effect, was commissioned by the US government. There’s plenty in its 660 pages about Lehman Brothers, though no mention of that wall plate. Unlike the wall plate, however, it’s free. Download it from https://www.gpo.gov/fdsys/pkg/GPO-FCIC/pdf/GPO-FCIC.pdf
