After 40 minutes of explanations, it still made no sense. It was January 2007, and a slick young investment banker from Lehman Brothers had just decoded the mechanics of “sub-prime” lending. Handing money to one person with a patchy credit history who was constantly in and out of work was obviously risky, he said. But giving loans to 100 such people at the same time was much safer.
Statistically, there was a negligible possibility that all 100 people would lose their jobs at the same time — especially if those people were spread all over the country. Therefore, risky loans could be magically transformed into safe ones by packaging groups of them together.
THE CRISIS IN NUMBERS
- 0.33% The percentage of sub-prime bonds in Europe that actually lost money
- £110m The amount of profit the government made nationalising Northern Rock
This financial alchemy was widespread. As much as 25% of the British mortgage market was being funded through the sale of these bonds. Investors wanted to buy more and more of them.
“If the market stops buying these bonds, that will be the least of our problems,” he said. “There will have been a nuclear war or something.”
Seven months later, the financial equivalent of a nuclear war began. Investors started to worry that maybe these bonds were risky after all, particularly in America. The Federal Reserve had been steadily raising interest rates and sub-prime borrowers were feeling the strain.
The merry-go-round of the international financial markets stopped, suddenly, on August 9, 2007 — the “day the world changed”, as Northern Rock boss Adam Applegarth famously declared.
There are times when transparency is really not in the interests of the common good
There had been a run on some hedge funds controlled by the French bank BNP Paribas. Smelling fear among global traders, the US Federal Reserve and European Central Bank started pumping money into the system at unprecedented levels. The Bank of England ignored pleas from Britain’s banks to follow suit, tutting about the “moral hazard” of intervening.
A month later, a catastrophic run started on Northern Rock, which led to its nationalisation. A year after that, RBS, HBOS, Lloyds, Bradford & Bingley, Alliance & Leicester and even Dunfermline Building Society were also rescued by the taxpayer. There was no financial lifeline for Lehman, which went bust.
A decade on, a huge volume of reforms has been implemented. Banks are unquestionably more secure. The regulatory system is undoubtedly smarter. Yet there remain some huge misunderstandings about what went wrong, and a welter of unintended consequences has sprung from the new regulations.
What follows is based on interviews with senior financiers, politicians and regulators who were in and around the crisis. The points made are intended to be provocative — to improve the debate before we sleepwalk into a new cataclysm. Much of what we think about the credit crisis is wrong.
“Anyone who thinks problems can’t happen again is fooling themselves,” said Lord (Alistair) Darling, who was the chancellor during the dark days of the crisis.
Hardly any ‘toxic’ loans lost money
Banks around the world lost billions on sub-prime loans, wiping out their capital bases and forcing taxpayer interventions. Yet those losses were, to some extent, illusory. “Almost every ‘toxic credit instrument’ turned out to be fine in the end,” said a senior financier who served on the front line of the credit crunch.
Almost 92% of the 81,002 AAA-rated structured finance securities issued between 1993 and 2016 repaid their investors in full, without missing a single interest payment, according to a recent report by the credit agency Moody’s. In Europe, only about 0.33% of supposed sub-prime bonds actually lost money.
While sub-prime loans sparked the crisis of confidence, the biggest source of problems in Britain was old-fashioned bank lending — risky corporate loans and commercial property deals, in the main.
Oddly, Northern Rock was an exception to this. Although its racy mortgage deals were widely criticised in the wake of its collapse, those loans were mostly repaid in full. The government made a £110m profit from the nationalisation when the bulk of the Rock’s loans were sold off in 2015. Where the Rock went wrong was in relying on the international financial markets for 40% of its funding.
There is a caveat to this point. The main reason that sub-prime loans “turned out fine” is that governments and central banks propped up the global economy, printing vast amounts of money to do so. Nonetheless, it is interesting. Many of the sub-prime court cases brought against banks have been settled by the lenders simply buying back the bonds at face value.
Blame a different Scottish accountant
While fingers always point at Fred Goodwin for his role in creating the world’s biggest and riskiest bank in the shape of RBS, there is another Scottish accountant whose part in the crisis should not be underestimated. As head of the International Accounting Standards Board, Sir David Tweedie, a jovial Church of Scotland elder, oversaw the implementation of “mark-to-market” accounting. His idea was that everything on a company’s books should be listed at the current clearing price. Tweedie was reacting to earlier scandals at Enron and WorldCom.
While that sounds sensible, it was only once buyers fled the credit market that everyone realised the flaw: sometimes there is no price for an asset. On peak days of the liquidity squeeze, when the world’s banks were in a Mexican stand-off, trying to second-guess whose losses would be greatest, nobody would buy or sell anything. The market price was zero. Yet the asset was still worth something. Transparency is a good thing, but mark-to-market accounting helped to turn transitory, uncrystallised losses into pounds, shillings and pence. “There are times when transparency is really not in the interests of the common good,” said one veteran City banker.
Banking’s chief regulator is not a trained banker
Before the crisis, most of Britain’s bank bosses were not trained bankers. For example, HBOS chief Andy Hornby, a marketing guru, was hired from Asda. Rules were put in place to ensure this mistake could not be repeated.
Under the new regulatory set-up, however, the individual with arguably the most responsibility for determining how much banks lend and to whom has no banking qualifications at all.
Sam Woods, chief executive of the Bank of England’s Prudential Regulation Authority (PRA), is a McKinsey-trained former civil servant with an MBA from Insead. He served as secretary of the Independent Commission on Banking and is widely considered a sharp, intelligent man. Yet he is not a banker.
Lenders are now heavily incentivised over whom they do and do not hand money to, based on the capital rules applied and interpreted by the PRA.
“The basic thing a bank does is measure risk,” said the chairman of one bank. “The way this new system works, a lot of the decisions being made flow from the regulators.
“We are heavily incentivised to lend against property, which is why most of the money printed during the central banks’ quantitative easing programmes has washed into the housing market. Did they mean for that to happen?”
New regulations are creating another bubble
Banks are much safer. If there is a new crisis, the system is much more resilient. However, the new rules have also made banks less profitable. The average return on equity for bank shareholders has dropped from about 25% to roughly 10%. “That is pushing banks to make riskier loans,” said a senior financier. “There is a new quest for yield. In principle, this is not dissimilar to what happened in the run-up to the crisis. Banks are struggling to make sufficient returns, so they are creeping out along the risk curve.”
Concentrations of risk are another by-product of the capital rules. With all banks incentivised to make the same types of loan, risks are accumulating in more specific places.
“The banking system is better placed, there is no doubt about that, but whether the consumer is better placed, I’m not so sure,” said an investment banker who worked on the bailouts. “Banks will turn off credit much more quickly in any future crisis, which tends to exacerbate the problem.
“The Bank of England is in a difficult spot. It wants to restrain bad lending, but if you restrain it too much, previous lending goes bad.”
Experts did predict the last crisis — and are worried again
As the seeds of the credit crunch were being sown, the name on the lips of worried City analysts was Tony Dye. As chief investment officer at stockbroker Phillips & Drew, he predicted the bursting of the dotcom bubble five years before it happened. Dye was nicknamed Dr Doom for his insistence that markets were overvalued, which cost his clients billions in lost gains. He was pushed into “early retirement” just as his predictions came true.
The Queen asked in November 2008 why no one had seen the crash coming. Many people did, but they did not know precisely when it would happen.
“When the music stops, in terms of liquidity, things will be complicated,” said Chuck Prince, the soon-to-be-ousted Citigroup chief executive in July 2007. “But as long as the music is playing, you’ve got to get up and dance.”
Hedge fund gamblers such as John Paulson had started to bet on a fall in US house prices. It was their strategy that precipitated the crisis of confidence.
Many of the analysts who warned of doom a decade ago are now getting twitchy about Britain’s consumer debt. Those who play down the risks offer exactly the same rationale as bankers before the crisis. Everything is backed by bricks and mortar, they argue. Maybe they are right. Maybe not.