The queues that formed in Britain’s high streets on the morning of Friday 14 September 2007 were orderly but subdued. If there was tension, it was not the anticipation of success – the feeling that comes from, say, being in the front of the queue for Wimbledon’s centre court. Rather, it was the tension of entitlement that might be denied; the worry of how to cope with the anger that would well up with the injustice of being told you could not have what was yours.
As it happened, those who queued – across the country at least a few thousand – need not have worried. All got what they wanted – their savings back from Northern Rock, the UK’s fastest-growing bank that was experiencing the first run on a British bank since the 19th century.
Ten years on, those scenes outside most of Northern Rock’s 76 branches still seem slightly surreal. A run on a bank was something that happened in inflation-ridden Argentina or in the dustbowl towns of mid-west America in the 1930s; certainly not in the towns of middle England in the 2000s. Was it that Britain’s financially naive Mr and Mrs Average had panicked when rumours of Northern Rock’s difficulties came over the BBC news that morning? Or was it that the sophisticates – the ones who were supposed to know a CDO from a CDS and who had the pinstripes and the cuff links to prove it – had messed up big time?
More the latter than the former. By mid September 2007, Northern Rock had been in the doo-doo for some while and long before its bosses realised it. In the summer, they still imagined they were in clover. In late July, they released first-half results for 2007. These claimed a 27 per cent rise in underlying profit, a 24 per cent return on equity and – maybe most amazing in the light of what was developing – promised a 30 per cent rise in the dividend, made possible because Northern Rock had convinced its regulators that it needed to hold less capital. Had they paid more attention to what was happening in the US, Northern Rock’s bosses might have been more cautious.
In the eight years to 2006, US house prices had risen on average by 67 per cent and home ownership had reached an all-time high of almost 70 per cent of households. Simultaneously, mortgage indebtedness had almost doubled to $10.5 trillion (£8.1 trillion). Americans had taken advantage of this by extracting over $1 trillion in cash from their homes via second mortgages, including $330bn in 2006 alone.
But by early 2007 it was becoming clear that house prices had peaked. Despite this, the machine that kept generating new mortgages, packaging them into mortgage-backed securities then parcelling those of the lowest quality into collateralised debt obligations (CDOs) remained on full throttle. However, the lack of stability at the base – the point where borrowers actually made their mortgage payments (or, increasingly, didn’t make them) – was beginning to show.
The first clear pointer that non-payments were infecting Wall Street’s wholesale money markets on which Northern Rock depended for its funding appeared in June 2007. Bear Stearns, a New York investment bank, froze redemptions on two in-house hedge funds that bet on the value of CDOs. In response, Merrill Lynch, another investment bank that had lent to the funds, seized $850m-worth of CDOs that had been posted as collateral and attempted to auction them. It only found buyers for $180m.
In July, it got worse. IKB Deutsche Industriebank, a small German lender, was using an off-balance-sheet vehicle, Rhineland, to buy CDOs, which it funded by selling commercial paper (essentially, post-dated cheques) in the money markets. New York’s investment banks had happily stuffed Rhineland full of CDOs but were becoming increasingly loathe to market its commercial paper. IKB felt the need to reassure its investors that ratings downgrades of mortgage-backed securities would have only a limited impact on its business; that was on 20 July, five days before Northern Rock announced its happy-go-lucky half-year results. But no one believed IKB. Within days, Goldman Sachs, Wall Street’s most powerful investment bank, told IKB it would no longer touch Rhineland paper. In response, on 27 July Deutsche Bank, IKB’s major lender, cut off its credit lines to IKB. Without a bailout from its major shareholder, IKB was as good as dead.
The moral of IKB was the same as whenever a bank goes under. It is killed by what happens on the liabilities side of its balance sheet regardless of the quality of the investments – good or bad – on the assets side. It’s what can happen to any business that borrows short to lend long. Whether or not toxic mortgages lurked somewhere in Rhineland’s assets or whether the assets were pure gold was neither here nor there. Investors didn’t want to stop to find out. They had lost their faith in mortgage-backed securities. They weren’t going near them. So they left Rhineland high and dry without funding. As a dress rehearsal for what the markets would do to Northern Rock a few weeks later, IKB’s near-death experience was spot on.
And by August even Northern Rock’s bosses could see it coming. Put simply, the bank was running out of money. Its previous capital raising had been in May when it tapped the US wholesale markets by selling bundles of securitised mortgages. The next fund-raising was due in September, but it was obvious it wouldn’t happen.
In mid-August, Northern Rock’s bosses confessed the company’s troubles to its chief regulator, the Financial Services Authority (which no longer exists). The question arose whether it would need emergency funding from the Bank of England, acting in its role as ‘lender of last resort’. Yet that possibility floundered because at that time the Bank of England’s responsibility for the stability of the UK’s financial system was not clear cut and the bank was being run by a governor – Mervyn King – who was a monetary economist from academia with no experience of banking or the City.
Mr King’s response was that of the theoretician, fearful of the ‘moral hazard’ that could spread through the system by lending to a bank that had taken too many risks. It would be better if Northern Rock could fall into the arms of a bigger bank.
In desperation, Northern Rock hawked itself around and came close to finding a buyer in the shape of Lloyds TSB (now Lloyds Banking). But Lloyds would only deal if Northern Rock were lent £30bn by the Bank of England. The UK’s financial regulators ruled that out as “inappropriate to help finance a bid by one bank for another”. Yet the ironic consequence was that the Bank of England had no choice but to give Northern Rock the emergency funding it had been so reluctant to offer.
Even that was messed up. News of the impending rescue leaked out so the government dashed out a statement on 14 September whose meaning Mr and Mrs Average mistook. Rather than grasping that Northern Rock had been – belatedly – saved by the Bank of England’s support, they thought it meant the savings bank was in real trouble. It did not help that, back then, the UK’s deposit insurance scheme only guaranteed 90 per cent of the first £35,000 of a deposit account. Mr and Mrs Average didn’t wait to find out more. They were on that bus to the high street. To join the queue.
The real significance of Northern Rock
The tale of Northern Rock is a dramatic story in its own right. It’s the tale of a little building society that became a big bank, whose shares were in the FTSE 100 index, and a power house in its native north-east of England. It’s the story of dramatic growth based on an innovative business model that relegated the tedious and expensive necessity of running a branch network to a subsidiary role. Its growth was such that, just as Northern Rock was about to crash, it was funding almost one in every five new mortgages arranged in the UK. But Northern Rock is also a tale of hubris; of a bank being run by people who weren’t as clever as they thought, who did not really understand what they were doing, who had conveniently ignored the warning signs that had pressed up against their operations three years earlier and who were legged over by the most brutal market that Anglo-Saxon capitalism offers – the New York fixed-interest market.
However, the real significance of Northern Rock is that it is emblematic of much that was wrong with the developed world’s financial systems, the consequences of which are still with us today. So there is a bigger question: what is the explanation of the financial crisis that took Northern Rock as its first victim but which proceeded to find bigger prey, not stopping at banks but gorging itself on almost every aspect of the developed world’s economic systems? Answer that and we can understand many anomalies that are both baffling and dangerous: why growth remains so elusive; why interest rates remain so low; why capital assets have performed so well.
In a way, there are two explanations. There is the academic explanation and the popular one; the intellectual explanation and the one with a human face. Of course, that’s a simplification and, besides, the two overlap. But let’s start with the popular explanation.
This focuses firmly on the US housing market in the early 2000s – how home ownership expanded, how house prices rose and, most of all, how purchases were financed. It is the story of how a laudable aim – raising the level of home ownership, especially for the poor – was achieved by the brilliance of financial innovation – the process of securitising loans – but became corrupted by greed and human frailty.
The corruption took the form of financial regulators failing – and even conniving – in the creation of mortgage-backed securities that were supposedly low risk but which, actually, few people either studied or understood. It took the form of collapsing standards for mortgage lending such that, when the US housing bubble had inflated to its fullest extent, two-thirds of loans made by the country’s two biggest mortgage lenders were so-called ‘liar loans’ – ie, they required little or nothing in the way of back-up documentation. And most dramatically it took the form of a mad, bad and dangerous securitisation machine, which generated a momentum of its own as it created collateralised debt obligations (CDOs), followed by CDOs squared (CDOs that invested in other CDOs) and then synthetic CDOs (CDOs that bet on the performance of CDOs).
The popular explanation has its fullest and arguably its best account in an unlikely source – the official US government report into the crisis, called – appropriately enough – the Financial Crisis Inquiry Report. Published in 2011, the report is fast-paced and reads more like a financial thriller than the deliberations of an eight-man commission chaired by Phil Angelides, a Democrat politician from California. It rubbishes the notion that the crisis was unavoidable and incapable of being predicted – “the crisis was the result of human action and inaction, not of Mother Nature or computer models gone haywire”, it says.
Its genesis was aided by “more than 30 years of de-regulation (that had) stripped away key safeguards which could have helped avoid catastrophe”. It was abetted by “dramatic failures in corporate governance and risk management” where “too big to fail meant too big to manage”. And it was stimulated by a “systematic breakdown in accountability and ethics”.
The report reserves special criticism for “stunning instances of governance breakdown and irresponsibility”. Those include the conduct of the bosses of AIG (American International Group), prior to the crisis the world’s biggest insurance company. AIG was colloquially known as ‘the golden goose of Wall Street’ thanks to its willingness to underwrite ‘credit default swaps’ (CDS), derivatives that paid out if CDOs went into default. Yet it turned out that its bosses had little knowledge of the $79bn exposure to this risk on its books.
Similarly reckless was the conduct of Wall Street’s leading investment banks, which operated with “extraordinarily thin capital” and so much leverage that “less than a 3 per cent drop in net asset values could wipe out a firm”.
In the case of two firms – Bear Stearns and Lehman Brothers – that’s pretty much what happened. However, Bear Stearns was fortunate enough to collapse first. That meant that, after a fashion, it was rescued. Lehman was not so lucky. It failed in September 2008 and by then the US central bank had decided that saving Bear Stearns had actually been a bad move – it stimulated the moral hazard that had so exercised the Bank of England’s Mervyn King a year earlier. Therefore, reckoned Ben Bernanke, Mr King’s friend and counterpart at the US central bank, Lehman should be allowed to fail. Bad move. Sorting out the 900,000 derivatives contracts on Lehman’s books was the sand in the engine – the global financial system ground to a halt.
Not that it should have been too much of a surprise that Mr Bernanke made such a bad call. The commission reckoned that “senior public officials did not recognise that a bursting of the bubble could threaten the entire financial system”. Through the summer of 2007 both Mr Bernanke and the Treasury Secretary, Henry Paulson – formerly the boss of Goldman Sachs – “offered public assurances that the turmoil in the subprime mortgage markets would be contained”. Then their decision to rescue Bear Stearns but to let Lehman sink “increased uncertainty and panic in the market”.
Yet there were those who spotted what was coming – and made shed-loads of money. To meet them, you need to read Michael Lewis’s brilliant book, The Big Short. There, you will encounter the likes of Michael Burry, Steve Eisman, Gregg Lippmann and the kids from Cornwall Capital.
The big short
Michael Burry was the boy with the glass eye and Asperger syndrome who became a neurologist but was obsessed by numbers and the stock market. He quit medicine to become a full-time investor and could not believe the madness he found in the US housing market. He pretty well invented credit default swaps – a way of betting on the failure of CDOs – to profit from the insanity.
Steve Eisman, a hedge fund manager for JP Morgan Stanley, was deeply disposed to find tragedy in all he saw following the sudden death of his baby son. Thus the potential tragedy within the sub-prime housing boom came easily to him. He met and somehow teamed up with his antithesis, Gregg Lippmann, a Deutsche Bank salesman who, according to The Big Short, “was a walking embodiment of the bond market, which is to say that he was put on Earth to screw the customer”.
Then there was Cornwall Capital, a hedge-fund start-up run from an artist’s studio in New York’s Greenwich Village. If Goldman Sachs were The Rolling Stones of investment banks, Cornwall Capital was the garage band that made even The Ramones sound accomplished. Yet – relative to their size – they profited the most because they were predisposed to make the most outrageous bets. In the crisis, they bet not against the lowest quality CDOs, which were likely to default even if the market just got shaky, but against the triple-A rated securities that were supposed to be able to withstand a flood. As such, they captured returns where risk was most badly priced.
The great merit of both The Financial Crisis Inquiry and The Big Short is that they remind us that financial markets – like all economic systems – have people at their centre. Thus the crisis was caused by people, chiefly those who responded to bad incentives framed by other people.
Michael Lewis's book, The Big Short, made into a film of the same name (pictured), reminds us that financial markets have people at their centre
As for the intellectual explanation, this deals with the global forces that were at work in the early 2000s and which, to an unnerving extent, are still with us today. In that sense, these forces are both the cause of the crisis and the reason that its consequences remain so difficult to shake off.
Explaining them begins with a “conundrum”; at least, that’s the famous word with which Alan Greenspan, the head of the US central bank, described the behaviour of the world’s bond markets in early 2005. What especially puzzled Mr Greenspan was that his central bank, the Federal Reserve, had just raised short-term interest rates yet long-term rates continued to fall. This was perverse – long-term rates should have been rising to reflect the move in short-term ones. And this wasn’t just happening in the US. Throughout the developed world, the yield curve – the pattern of interest rates across the spectrum of maturities – was inverted (ie, long rates were lower than short ones).
As to the cause, Ben Bernanke, then a board member at the ‘Fed’, came up with the theory of a savings glut. This idea focused on the way some nations were saving hard. The proof was that they were running big surpluses on their current account balance of payments, which indicated that domestic demand was insufficient to absorb domestic output. Therefore there was nowhere for the surplus money to go but to be saved.
The really odd feature was that many of these nations in surplus – and especially China – were still in their development phase when, according to conventional wisdom, they should have been running a trade deficit as they imported lots of goods and services to help propel their expanding economy. The explanation for their trade surpluses was to avoid the successive crises that developing nations got themselves into during the 1990s and early 2000s as they expanded too fast, ran up deficits, then found themselves prisoners of developed-world interest rates and financial markets.
This oddity – that poor nations were lending to rich ones – neatly explained Mr Greenspan’s conundrum. But it had further, perverse, consequences. It meant that rich nations were able to – and, in a sense, had to – run current-account deficits, which also meant that they were able to – had to – borrow cheaply. That persuaded players of all sorts in the financial markets to behave with “irrational exuberance”, to use a phrase that Mr Greenspan had coined a decade earlier in connection with the dot-com boom.
The irrationality was characterised by the response to falling interest rates. These signalled lower future returns, which should have told punters and investors to take less risk since such risks would be less well rewarded. Yet the punters did the opposite. As rates fell – and, implicitly, the reward for taking risks dropped with them – they responded by taking more risks, partly because it was so easy for them to do it. The raw material was abundant and cheap in the form of low-cost debt. So punters did what they have done throughout history when the going got intoxicating – they added leverage to their bets using other people’s money. The hope – even the expectation – was that leverage would gear up returns from respectable to wonderful.
This would more easily be achieved in a world where regulations were fewer and innovation was greater, Happily, the trend towards less regulation had been a feature of financial markets since the early 1980s and reached its high-water mark in 1999 with the scrapping of the last remnants of the Glass-Steagall banking laws that had separated racy-and-risky investment banking from dull-but-worthy commercial banking. This released a wall of capital that could surge into sexier products than five-year fixed-interest loans.
Cue the innovation that would conjure up the products. Wall Street’s tool of choice became ‘securitisation’, the process of bundling up lots of small loans into securities. These were then sold, chiefly to institutional investors who could use the interest they received, via the coupon on the securities, to match their own liabilities, usually the money they owed on insurance and pension policies.
At its core, securitisation was a brilliant idea. Not only did it meet the needs of investing institutions but it reached from Wall Street to the suburbs of middle America where it began by doing good. Since pretty well any form of consumer debt could be securitised, securitisation enabled consumers to get rid of their expensive unsecured debt – the loans that funded credit-card spending, buying a car, putting the kids through college – by swapping it for cheap debt that was secured on the collateral of their homes. In other words, they took out a second mortgage whose interest rates was less than half the rate on their consumer loans.
Then those mortgages were bundled into securities and sold to institutions. So far, so good. Almost needless to say, however, the process got out of hand. Egged on by salesmen responding to perverse incentives all the way from Wall Street to Main Street and emboldened by a cocktail of cheap debt and rising house prices, consumers took to mortgages that were used to punt on property prices.
Even by the late 1990s it was ending in tears. One area that saw excessive speculation was Cleveland, Ohio, deep in America’s rust belt. In the 1990s, house prices in Cleveland outstripped the rise in prices nationwide by a third even while the unemployment rate tagged the national average. Yet in the five years to 2000, the rate of foreclosures in Cleveland doubled to 7,000 a year. James Rokakis, the treasurer for Cleveland’s local authority, summed up the whole sorry tale when he told the Financial Crisis Inquiry Commission: “Securitisation was one of the most brilliant financial innovations of the 20th century. It freed up a lot of capital. If it had been done responsibly, it would have been a wondrous thing because there’s nothing safer than the American mortgage market. It worked for years, but then people realised they could scam it.”
As we know, that process wasn’t confined to the US. An imitation of what was happening Stateside propelled Northern Rock into oblivion. It did almost the same to other former building societies, most notably HBOS and the Royal Bank of Scotland, which – driven by the ferociously ambitious Fred Goodwin – smashed into the pile-up of broken banks created by Lehman’s crash.
As we also know, the factors that contributed to the financial crisis linger. As Chart 1 shows, China’s trade surplus remains substantial; although it has been overtaken by Germany’s, both as a fraction of national output and, more important, by size. Simultaneously, the US and the UK remain in current-account deficit. This may not matter so long as enough foreign investors are willing to own US or UK government debt and/or invest in the US and the UK.
Clearly both countries have advantages – the status as the world’s reserve currency for the US dollar; smoothly functioning markets and well-defined property rights for the UK. Even so, it’s not a happy state for either country. They are – as the governor of the Bank of England, Mark Carney warned (adapting a famous line from Tennessee Williams) – dependent on the kindness of strangers.
Meanwhile, it has taken exactly 10 years for employment levels in the US to return to where they were before the financial meltdown. About 8.5m jobs were lost by the time the recession reached its pit and – taking into account expansion of the US labourforce – it took the creation of 10m new jobs to make good the loss. That mark was reached in July, according to the Hamilton Project, a US thinktank.
Yet not all jobs are created equal. A disproportionate number of the new ones are low paid, a fact that is revealed in Chart 2, which shows real growth – ie, after deducting inflation – in per capita output for the US, the UK and Germany since 1985. The data are expressed as the five-year rolling average so as to emphasise the trend, which is downhill. True, it has bounced in 2014-16, but it is still below the growth rates of the 1990s, which themselves were heading downwards. Especially in the UK, where inflation is shifting upwards, consumers in the developed world continue to get poorer.
Michael Lewis addressed this issue in The Big Short with the rhetorical question: “How do you make people feel wealthy when wages are stagnant? You give them cheap loans.” That response was at the heart of the financial crisis and it’s still not far away today. Chart 3 shows that US consumers continue to fund debt obligations that are just one percentage point below their average for 1980-2016 – 15.5 per cent of disposable income compared with 16.5 per cent. That difference almost entirely comprises the drop in monthly mortgage payments. But it is a function of lower interest rates, not lower indebtedness. In other words, such stability as there is, depends heavily on interest rates staying at rock bottom. Ten years on, those in the US and the UK have to pray that the savings glut does not run dry and that Chinese consumers remain happy to lend to them. Not a happy prospect.
