The Global Financial Crisis

Rather than justice for all, we are evolving into a system of justice for those who can afford it
We have banks that are not only too big to fail, but too big to be held accountable
Joseph Stiglitz

The global financial crisis was the result of a boom in subprime mortgages in the US, where an oversupply of money and exceptionally low-interest rates resulted in loans being granted to people who would not otherwise have been eligible. This included some highly dubious lending practices, such as the so-called NINJA loans, made to people with no income, no job, and no assets. The low interest rates also encouraged homeowners to extend mortgages to finance personal consumption, leaving them with little equity in their homes.

Economists claimed they could not have predicted the GFC, but they should have seen it coming because a similar thing happened a couple of decades earlier. Some people did see it coming and made millions of dollars betting on it. Hollywood then made millions of dollars from a movie about the bets called The Big Short.

The earlier collapse came about after the US government deregulated the savings and loans industry, which led to reckless lending and a real estate boom and bust. From 1986 to 1995, 1,043 savings and loans companies went out of business, $160 billion was lost, and protecting depositors cost US taxpayers $132.1 billion. As is often the way with our global economy, if a problem does not get sorted out when things go pear-shaped it happens again on a larger scale. A 2009 IMF report estimated that the financial cost of the GFC to high-income countries was $10.2 trillion, and a further $1.7 trillion to low and middle-income countries.^{1, 2}

Another reason why economists should have known the GFC was coming is because of the work of Hyman Minsky, Professor of Economics at Washington University, St. Louis, from 1965 to 1990. Decades before the GFC Minsky had posited the theory that the free market is inherently unstable. He called his theory the ‘financial instability hypothesis’ because the primary area of instability was the financial sector.

Minsky’s theory asserts that financial stability is itself destabilizing. After an episode of financial stress that has caused a contraction in the money supply, banks will only lend to businesses that can readily service their debts. This provides stability to the economy and confidence to the business community. This leads to economic growth, which in turn leads to financial institutions having more money to lend.

With more money to lend, more borrowers must be found. Eventually banks are forced either to loan money to high-risk borrowers or rein in their lending. High-risk loans attract higher interest rates and higher returns, so any financial institution that fails to make these loans will see its profits stall, and its share value fall. Reining in lending, then, is not an option if a bank wants to keep up with the pack (economists call this the prisoner’s dilemma). Some of the high-risk loans will inevitably default, and when defaults reach a critical mass it will trigger a financial collapse, the money supply contracts, and the process starts again.

A key reason the banks had surplus equity in the mid-2000s was an increase in their allowable leverage. The leverage ratio is the amount a bank can loan out relative to its assets. New regulations allowed the banks to leverage up to 30 to 1. This not only permitted the banks to lend more, it meant that just a small number of loans needed to go bad for them to be insolvent. This would be okay if the banks only lent to sound businesses and people who can pay back their loans, but not if they are making NINJA loans.

Minsky’s work had been mostly ignored before the GFC, and his 1986 book ‘Stabilizing an Unstable Economy’ was out of print when the GFC hit. Shortly after the crisis copies of his book were fetching hundreds of dollars on eBay.³

In addition to the problem of the prisoner’s dilemma was the enormous incentive packages being paid to banking CEOs. In 2006, Charles Prince, the CEO of Citigroup, was paid $25.98 million; Kenneth Lewis, the CEO of Bank of America, was paid $27.87 million; James Cayne, the CEO of Bear Sterns, was paid $33.85 million; Richard Fuld, the CEO of Lehman Brothers, was paid $40.5 million; John Mack, the CEO of Morgan Stanley, was paid $41.41 million; Stanley O’Neal, the CEO of Merrill Lynch, was paid $48 million; and Lloyd Blankfein, the CEO of Goldman Sachs, was paid $54.72 million. With their salaries being tied to profits it is hardly surprising the CEOs of these banks all stayed on board the juggernaut.⁴

One of the more pernicious aspects of the GFC was the credit default swaps developed by JP Morgan & Co. These are effectively an insured loan, where a third party takes on the risk of a loan defaulting yet does not own the loan. The bank passes on some of the interest gained from the loan, but keeps some of it, safe in the knowledge that its investment is protected from default.⁵

Another dodgy tactic the banks used to offset their high risk loans was to package them with low risk loans as collateralized debt obligations. These were given AAA or AA ratings by the rating agencies, which were paid by the banks to rate their products, before being sold to investors.⁵

When financial institutions are allowed to separate risk from lending they have no incentive to ensure the loans go to people who can repay them. In theory the people who insure the loans or buy the collateralized debt obligations will not do so if the risk is too high, but they base their decisions on the ratings made by the agencies that were paid by the banks.

Free market ideology is based on the idea that competition will ensure customers get the best deal. For many goods and services this is fine, but when companies want their products rated they don’t want the most accurate rating, they want the most complimentary one. This encourages them to employ any agency that is willing to fudge the figures in their favour. And if one starts doing it the others must follow suit or they will go out of business.

In the aftermath of the GFC 46 European bankers were jailed for their role in causing the crisis, yet only one American banker went to jail, and he was an Egyptian-born American who worked in London for Credit Suisse.⁶

References

1. Curry, T. Shilbut, L. ‘The Cost of the Savings and Loan Crisis: FDIC Banking Review, 2000, vol. 13, no. 2, p. 26-35; Financial Audit: Resolution Trust Corporation’s 1995 and 1994 Financial Statements, US General Accounting Office, July 1996, p. 8, 13, table 3.
2. Cassidy, J. ‘How Markets Fail’ Penguin Books, London, 2009, p. 332; www.telegraph.co.uk/finance/newsbysector/banksandfinance/5995810/IMF-puts-total-cost-of-crisis-at-7.1-trillion.html – GFC costs $11.9T, IMF.
3. Cassidy, J. 2009, p. 207-10.
4. Cassidy, J. 2009, p. 289.
5. Cassidy, J. 2009, p. 264, 279-80.
6. https://ig.ft.com/jailed-bankers/