dissertation on financial crisis 2008

7/28/2019 Dissertation on Financial Crisis 2008

1/115

The Fight of the Century

An Exploration of the Great Credit Crash of 2008 and of Political and Economic Ideologues.

15088065

SUBMITTED IN PART FULFILMENT OF THE DEGREE OF LL.M. IN LAW AND

INTERNATIONAL COMMERCE AT QUEENS UNIVERSITY BELFAST

SEPTEMBER 2011

1


2/115

ACKNOWLEDGMENTS

To the academic faculty at Queens University Belfast who taught on the Law and

International Commerce LLM, to them I extend my most sincere appreciation for first stoking

my interest in this area, for sharing their expertise and for reassuring me that this work is a

road worth traveling.

To Doctor Dieter Pesendorfer for his pertinent and helpful advice and guidance.

To Andrew Entwistle and Vincent Cappucci, the founding partners ofEntwistle and

Cappucci LLP- a securities and class action law firm situated on 280 Park Avenue and

within the heart of the New York legal arena - who so generously granted me a five month

work placement, my gratitude is immeasurable.

My time at the firm has bestowed upon me unrivalled experience and exposed me to some of

the most topical and pertinent cases, such as the representation of the New York State

Common Retirement Fund in the pursuit of loses as a result of the Merrill Lynch and Bank of

America merger in September 2008.

Certainly exposure to the intricacies of such litigation granted me with new and insightful

perspectives which have heavily shaped my views and comments herein.

And likewise to all the staff at Entwistle and Cappucci, who were so good to me, I extend my

most sincere appreciation.

To my parents, John and Christine, for their unwavering support.

To all those involved in the wider discourse on the causes of the financial crisis I pay my

thanks and respect for they have shaped my views within.

I would highlight that this is an academic position seeking to advance a healthy discussion

that can go some way to helping suggest a route towards a future of long term, stable and

inclusive economical growth.

2


3/115

ABSTRACT

This study offers an exploration into the contentious causes of the financial crisis as well as

considering the principle ideologues of our time, Friedrich Hayek and John Maynard Keynes,

who have so extensively shaped financial markets over the past century. In this context this

discussion argues that whilst the ideology that advocates free and competitive financial

markets (Friedrich Hayek and neoliberalism) has been dealt a heavy blow in the wake of the

Great Credit Crash of 2008, the damage is not terminal.

Indeed since the causes of the financial crisis are not limited to the failings of Wall Street andhigh finance, but rather the precipitating factors were wide and multifarious, this paper argues

that liberal financial markets, albeit with more sensible oversight, will remain a routine aspect

of 21st Century life.

Beginning by providing an introduction that chronicles the rising and falling of the great

housing bubble of the 2000s, this discussion will then outline and explain the 5 deadly shots

that came together to cause the deadly asset bubble. It will then consider the ideology that has

underpinned finance over the last number of decades, after which this paper will highlight

that in spite of the current state of international finances, Frierich Hayek and his ideology of

individualism and liberated markets will prevail.

This paper will argue that in going forward and exiting from the crisis it is important that

policymakers recognise that there are important lessons to be drawn from the actions that

were taken in response to the Great Depression of the 1930s. It is also important that they

take insights from the proper consideration of the strong cultural context in which modern

America - which so extensively shapes global affairs - was born.

From the above and with a number of other considerations it will be demonstrated that

despite the deleterious failings of high finance, man and his primal desire to push the

boundaries of human endeavour will ensure a long future for free markets and neoliberalism.

3


4/115

4


5/115

Which way should we choose?

More bottom-up or more top-down?

The fight continues.

Keynes and Hayek third round.

Its time to weigh in.

More from the top or from the ground?

Lets listen to the basics

Keynes and Hayek throwin down.

Fight of the Century: Keynes vs. Hayek, Round 2.

INTRODUCTION

The return of John Maynard Keynes in the wake of the most damaging financial downturn

since the Great Depression has sparked a debate that challenges the legacy of the GreatModeration and the 20 years of calmness that prevailed over the vast plains of global

financial markets. Indeed voices have risen from the fallout of the financial crisis that

continually clammer that Friedrich Hayek, neoliberalism and free markets, that which has

defined the last three decades of Western economics, is not theEnd of History.

The debate has entered mainstream media as epitomised by the financial lyricism ofFight of

the Centuryas seen above, an ideological sparring match that stages a rap battle between the

two political and economic ideologues of the 20 th and 21st Century. One, Friedrich Hayek the

5


6/115

exemplar of libertarian economics, the other, John Maynard Keynes the man of the big state,

government spending and interventionary economics.

Indeed prompted by the Fight of the Centurythe purpose of this monograph is to consider

financial markets and the changes that are necessary in order to bring decorum to a world of

finance sailing over choppy ideological waters, battered by a raging gale of populist anger.

In order to do so it is necessary first to understand what in fact caused the worst financial

contraction since the Great Depression. Fittingly the syllables, words, paraphrases and

metaphors from henceforth will be the tools at hand as this paper starts on an archaeological

dig that seeks to unearth the causes and enter the substratum of the Great Crash of 2008.

However, a crisis that was caused by a morbid mix that included a fast and loose monetary

policy, a fanciful federal housing policy, widespread irrational exuberance amongst

consumers on Main Street, rampant excess by the financial alchemists on Wall Street and

recklessness amongst credit rating agencies, this paper wants to dig deeper, down into the

cultural form of modern society and into the ideological rhetoric that has shaped modern

finance.

Ultimately the goal of this paper is to navigate the tempestuous ideological currents and to

consider the future of free markets and to pose an answer to the ideological uncertainty.

6


7/115

7


8/115

PART 1

THE GREAT CREDIT CRASH OF 2008

8


9/115

CHAPTER 1: THE TELLING OF A CLASSIC TALE OF

BOOM AND BUST

Innumerable jeremiads have been written, told and screened throughout academia, the

popular press and the wider media telling a classic tale of boom and bust. Fittingly the

following section shall attempt to capture the mood and chronicle step by step the rise and

fall of the global economy.

i. A Five Shot Deadly Cocktail Fuels a Housing Bubble

The housing bubble that started inflating in the mid 1990s and carried on until 2006, teetered

in 2007 and eventually burst spectacularly on September 15th 2008. A day that witnessed

history in the making (Thain, 2009) and an event that saw a billowing real estate bubble

spew its toxic financial contents across the globe. Indeed the contents were a cancerous

financial contagion that spread across global capital markets in systemic and stratified waves

of destruction crippling credit lines, halting interbank lending, freezing assets and setting the

fate of the global economy on a knife edge.

However how did the lethal housing bubble form in the first place?

For over forty years house prices in the post-war period moved in tandem with the overall

rate of inflation, but from the middle of the 1990s the two variables diverged and house

prices took off on a steady upward trajectory in the absence of any discernible inflationary

pressure. Indeed the new trend that saw housing prices outstrip the rate of inflation ensured

that real estate prices in the U.S. rose by more than 70 percent between 1995 and 2007.

9


10/115

Figure 1

Source: (Baker, 2010).

The 70 percent hyper appreciation of real estate had no correlation to core fundamentals,

happening in a world in which income growth averaged just 1.8% annually from 2001 to

2007. In fact, the increase in house prices created more than $80 trillion in additional housing

wealth compared with a scenario in which house prices had continued to rise at the same rate

as inflation (Baker, 2007).

However the causes of the housing bubble and resulting crisis are complex and multifarious.

Indeed Gillian Tett (2011) captured the mood and confusion that surrounds the causes of the

crisis when she stated that the anger keeps festering, like a boil that cannot be lanced. Yet

all too often people and the popular press flog the greed and ruthlessness of Wall Street,

international finance and of free markets.

But to arrive at such a solution is too facile. Rather the coming together of the housing bubble

was a copious blend of a plurality of factors as it is right to say that most historical events,

from wars to revolutions, do not have simple causes (Shiller, 2005)

Despite the difficulties associated with locating the causes of the financial crisis this paper

proposes five principle phenomena behind the housing bubble, a hit list of five deadly shots

that came together to produce a lethal cocktail that created the environment for a speculative

and deadly asset bubble.

10


11/115

Firstly, the short-term interest rate policy of the U.S. Federal Reserve helped to nourish an

asset boom. Indeed the expansive monetary policy of the Fed that ran from 2001 until 2006

ensured a liquid and free flowing marketplace that facilitated a plentiful and cheap source of

credit for the consumer, business and banking.

Secondly, it is well documented that increasing homeownership was an explicit goal of the

Clinton and Bush administration. Thus this paper will seek to explore the U.S. governments

fanciful housing policy that forced banks to loosen their traditionally rigid mortgage lending

standards in order that the benefits of homeownership could be enjoyed by the less-than-

credit-worthy.

Thirdly, increased debt-to-income ratio for consumers and households was a central

protagonist in the tale of the Great Crash. Indeed with real estate prices skyrocketing

consumers were caught up in the market psychology that house prices would rice ad

infinitum and as a result they feel infinitely wealthier and consumed credit at a rapacious

pace. It was in the words of Alan Greenspan and later Robert Shiller (2005), irrational

exuberance.

Fourthly, the modern science of financial alchemy that financialised homes and homeowners

as carried out by investment banks on Wall Street converted worthless mortgages into

investment grade products that in the end exported the ills of modern finance worldwide and

deepened the crisis exponentially.

Fifthly, credit rating agencies played a starring role in the warped drama of finance pre-2008

and their actions merit timely consideration. Indeed these independent and wholly

unaccountable agencies helped Wall Street banks to complete the process of modern financial

alchemy by giving their actuarial stamp of approval to fixed-income securities that were in

reality worthless junk.

This paper stands by the five crisis causing proponents outlined above. Indeed they came

together in a morbid mix and created a reaction that caused the American and global

economy to go on overdrive, ensuring a voracious upward inflation of real estate that had no

correlation to basic economic indicators. As the bubble grew it spurred on the very factors

that caused its genesis in a dangerous and mutually reinforcing positive feedback loop.

11


12/115

These five factors will be considered later on in the paper as it is first necessary to outline the

fall of global finances.

ii. The Great Unwind

The 9th August 2007 is often cited as the day that the financial crisis announced its presence

to the world as the aftershocks from the collapse of the subprime mortgage market spread to

the world of high finance (Bernanke, 2010a). However it remains that the hazy days of

August and September 2007 were only the start of a downward economic spiral as the world

would later find out.

Indeed things got dramatically worse and by December 2007 the onset of the global recession

was official as 73 months of damaging speculative expansion that had been built almost

entirely upon fictitious housing wealth, came to an end (The National Bureau of Economic

Research, 2008).

Thereafter the financial chaos from the collapse of the U.S. subprime mortgage collapse

gathered pace and swept throughout global capital markets with devastating effect, hitting

Wall Street at the beginning of 2008 and pushing Bear Stearns - the fifth largest investment

bank in the U.S. - towards bankruptcy

Bear Stearns recorded a loss of $854 million largely attributable to heavy subprime exposure

and only survived through a forced marriage to JP Morgan Chase in March 2008 thanks to an

emergency $30 billion loan and a deal pushed through by the Federal Reserve and U.S.

Treasury. However the market chaos continued as IndyMac, the seventh largest mortgage

issuer in the U.S. collapsed under the weight of huge subprime losses in July 2008.

And as the page turned to September 2008 one found that life got a whole lot choppier on the

high seas of high finance. Indeed the market currents stirred violently on the 6 th September

2008 as the U.S. government took control of the two federally chartered and government-

backed mortgage bond issuers Fannie Mae and Freddie Mac, who like others had suffered

monumental losses associated to subprime loans.

Around the same time Merrill Lynch - the third largest investment bank in America -

announced record losses due to heavy exposure to the subprime mortgage market, prompting

12


13/115


14/115

largest bank in the U.S. and only four days after, Wachovia, the seventh largest bank in the

U.S. was sold.

By the 30th September 2008 the Federal Deposit Insurance Corporation had placed 171 banks

with combined assets of $116 billion on their problem list (Congressional Oversight Panel for

Economic Stabilization, 2008) and on the 3rd October 2008 the U.S. Congress enacted the

$700bn Troubled Asset Recovery Program (TARP) in order to stave off a collapse of the

banking industry and later brought into law the Term Asset Backed Security Loan Facility

(TALF) in an effort to ensure the survival of capital markets.

Citigroup got a rescue package in November and Morgan Stanley and Goldman Sachs whose

share prices halved, were effectively guaranteed by the Treasury and transformed into bankholding companies - entities which are subjected to far stiffer regulation. Indeed their new

status guaranteed that they would have access to the full menu of the Federal Reserves

lending facilities, including the central banks discount window which would ensure that they

would not go down a destructive Lehman path.

Bank of America and JP Morgan were shielded from the worst of the depressed capital

market conditions thanks to their strong liquidity profile and lower capital ratios. Indeed their

survival could be accredited to their large commercial banking presence and stockpile of

traditional retail banking deposits which acted as a buffer against the worst that the crisis had

to offer.

Without the heroics of the bank holding companies JP Morgan and Bank of America, it

remains that in all likelihood Bear Stearns and Merrill Lynch would have done a Lehman for

which the repercussions would have been unthinkable.

In the end the policy activism of the U.S and other governments, with emergency liquidity

provision, globally coordinated low interest rates and fiscal stimulus, were successful in

stabilising the global economy and went some way towards filling the demand hole.

Nevertheless the autumn and winter of 2008 was a time that will always be remembered as a

period of unprecedented economic intervention - essentially a period in which governments

subsidised where they did not nationalise.

14


15/115

However the activism of the U.S. and other governments which saved the global economy

from extinction ensured the transference of billions of dollars of toxic private debt onto

public sector balance sheets. In fact the U.S. Federal balance sheet had begun to look like that

of a giant hedge fund. Indeed the U.S. governments budget busting bailouts and fiscal

packages, enacted in order to shore up the American and global financial system, left the

federal government $7.7 trillion out of pocket.

Governments worldwide socialised the toxic losses of private sector actors and in doing so

the seeds were sown a sharp and stinging economic contraction, the European sovereign debt

crisis as well as the global angst surrounding the levels of U.S. federal debt. Contentious

issues that truly threaten the future of the global economy, and moreover contentious issues

that continue to sound the death knell of libertarian economic policies.

Thus having outlined the rise and fall of the housing bubble and the collapse of international

finance it is now appropriate to consider in more detail the 5 deadly shots and precipitating

causes of the financial crisis. Only later will it be appropriate to consider the Keynes, Hayek

and Eucken and their role in the future of economic policy making.

15


16/115

16


17/115

CHAPTER 2: SHOT 1, (SADO) MONETARY EXCESS

A Fast, Loose and Dangerous Monetary Policy

The canonical narrative of the Great Crash of 2008 underscores the primary role played by

the U.S. Federal Reserves fast and loose monetary policy. Indeed the respected Professor

John B. Taylor, an expert on monetary economics, stated that monetary excesses were the

main cause of the boom (Taylor, 2009).

Rather ironically it was the Feds monetary policy that was a central cause of the Great

Depression. Indeed prior to the collapse of the stock market in 1929 the Federal Reserve had

increased the money supply from 1921 through 1927 by around 60 percent (Niskanen,

2009).

Such an increase in money supply eerily mirrors the expansive policy of the Fed in the years

between 2001 and 2006. Indeed for a sustained period both before 1929 and 2007 the federal

funds rate was below the general inflation rate and in both instances an asset bubble followed.

In 1929 it was a stock bubble and 80 years later in 2007 it was real estate bubble.

However what prompted the U.S. Federal Reserve in the early 2000s to take interest rates to

such lows? Well the story goes as follows. It is well documented that the start of the twenty

first century provided a challenging macroeconomic environment for the markets.

Indeed following the rise and collapse of the internet bubble from 1995 until March 2000

stocks plummeted, investor confidence vanished and the markets suffered a mild recession. In

addition geopolitical tensions arising from the 9/11 attacks, the conflict in Iraq and the

dislocations that followed the Enron scandal further heightened market uncertainty.

Fearing that the geopolitical tensions and market turbulence would spill into the real

economy the U.S. Federal Reserve made the move to lower the target federal funds rate the

interest rate at which banks lend to one another - set by the Federal Open Markets

Committee.

Thus fear prompted the Fed to drastically cut the target federal funds rate from 6.5 percent in

late 2000 to 1.75 percent in December 2001, and down to 1 percent by June 2003, a record

17


18/115

low. Then in June 2004 the Federal Open Markets Committee started to raise the target rate

until it reached 5.25 percent in June 2006 (Bernanke, 2010a).

Moreover it must be recognised that the U.S. government had a strong influence over the

Feds monetary policy as Congress pushed its affordable housing mandate. Indeed the Fed

found itself under sustained pressure from the government to maintain low interest rates, as

will be discussed later.

Inflation vs. FFR Graph, (2010).

In any case the most telling aspect of the target federal funds rate is that it directly impinges

on consumer and market confidence. Indeed interest rates are a central tool used to control

economic activity and a principle tool of macroeconomic stabilisation and by lowering or

raising the target rate the Fed can dictate the general ambiance of the marketplace and the

direction of the economy.

However the Feds laxity from 2001 to 2006 ensured a rich vein of money supply which

impinged heavily on the global economy. Indeed John Thain the former CEO of Merrill

Lynch was expressing popular sentiment when he stated that there was too much money

available for too long at too low a cost (Thain, 2009).

By lowering the target rate so extensively and holding it low for so long the Fed ensured that

global credit markets were supple, liquidity was ample and the consumer and the marketplace

were ready for the taking as they were prompted to buy houses, which in turn raised house

prices and led to a surge in housing investment (Rajan, 2010, pp.5).

18


19/115

The rise in housing demand was also a notable symptom of the tech stock bubble of 2000, for

after the collapse the flight to survival and profits went into real estate (Rydstrom, undated).

Indeed housing starts jumped to a 25 year high by the end of 2003 and remained high until

the sharp decline began in early 2006 (Taylor, 2007). The huge surge in housing demand

ensured that there was an incredible inflation in real estate which encouraged further demand

which caused an encore of price hikes and a deadly upward spiral as price increases beget

further price increases (Shiller, 2005, pp.xvii).

Few can deny the repercussions that stemmed from the overly expansive policy of the Federal

Reserve and the fact that it was a major factor fueling the increase in housing prices prior to

the onset of the current U.S. recession (Lothian, 2009).

In any case the writing was on the wall for the global economy when Raghuram Rajan (2005)

stated in his now infamous 2005 paper,Has Financial Development Made the World

Riskier? that persistent low interest rate can be a source of significant distortions for the

financial sector. Likewise Friedrich Hayek had long since written that increased money

supply and artificially cheap credit is a recipe that ultimately ends in a boom and bust.

However it is quite unsettling to think that the actions taken by the Federal Reserve in 2001

in order to avoid a recession led to the creation of an asset boom and bust that far outstripped

that of the tech bubble and its aftermath. Indeed William Fleckenstein (2008, pp.3) stated that

Greenspan bailed out the worlds largest equity bubble with the worlds largest real estate

bubble.

Ultimately it turned out that the Feds crisis averting and accommodative monetary policy

was nothing more than a form of sado-monetarism.

i. European Monetary Policy

The creation of a single currency in Europe in 1999 unleashed an age of creativity in Europe.

Indeed the common currency heralded a move away from traditional stodgy banking

practices and a move towards profitable investment banking and the world of high finance as

high financiers from London, Paris, Frankfurt and Edinburg linked up with New York and

other centres of international finance.

19


20/115

Most tellingly by modernising finance Europe aligned its economic and monetary policies

considerably with the hegemonic presence of America.

Indeed the landscape of low interest rates that reigned in America from 2001-2006 was

largely mirrored across the Atlantic as ten European Member States pegged themselves to a

single monetary policy from the beginning of 1999.

Ekkehard A. Kohler and Andreas Hoffmann (2010, pp.234) observed that the lowering of

interest rates was not localised to the U.S. but rather it was a global phenomenon and

certainly as Europe unveiled its common currency it followed that European monetary

policy became more closely allied with U.S. monetary policy (ibid.)

And whilst the European Central Bank (ECB) serves under a single mandate to control

inflation - the Federal Reserves role is to maintain price stability and control inflation -

Europes central bank allowed an asset bubble to inflate that had no correlation to core

economic fundamentals. Indeed just as happened in America from 2001 until 2006 the ECB

lowered real interest rates considerably and kept them low for some time. In doing so the

ECB and its monetary excesses allowed for housing in Europe to inflate to scarily high levels.

Indeed The ECBs loose monetary policy helped Portugal, Ireland, Italy, Spain and Greece(the PIGS) and other parts of Europe to go down a path of self destruction. These countries

were given access to cheap funding which ultimately fuelled hugely damaging housing and

construction booms.

The ECB needed to show more restraint for the weaker peripheral economies of Europe who

were like kids in an all you can eat candy store. Ultimately the crisis in Europe has shown

again the importance of monetary policy and that inaction on the part of central banks goes a

long way to fuelling devastating asset bubbles.

ii. Global monetary policy

Moreover from the start of the 2000s central banks all across the globe in a seemingly

concerted move lowered interest rates, causing a worldwide monetary expansion for which

real world interest rates remained near zero for a long time after 2001 (Kohler and

Hoffmann, 2010, pp.227). Indeed it wasnt just the U.S. and Europe that moved lending rates

20


21/115

close to zero; there was an international conversion to accommodative monetary policy

(ibid.).

In any case this simply confirms the global hegemonic status and influence of American

governance and economic policy. It is a country that has a global reach and when America

moves the rest of the world reacts. Indeed the U.S. Federal Reserve is worlds central bank

in all but name (Rajan, 2010, pp.227) and it is quite rightly the most important and least

understood force shaping the American and global economy (Grunwald, 2009).

Thus not only does the Fed control the money supply by setting short-term interest rates that

shapes national levels of inflation, employment, the strength of the currency, the spending

power of the individual and the outlook of the economy, but it also directly shapes the

policies of foreign central banks.

Indeed the lowering of interest rates and subsequent boom in housing prices was not

restricted to the U.S. and Europe and indeed the real estate euphoria manifested itself in other

nations around the globe. Rather the global blanket of low interest fuelled credit expansion

across the world and a commensurate housing bubble as asset prices, particularly house

prices, in nearly two dozen countries accordingly moved dramatically higher (Greenspan,

2010).

In particular Robert Shiller (2005, pp.11) noted that was a globally concerted increase in real

estate after 2000. Notably cities in Australia, Canada, China, France, Hong Kong, Ireland,

Italy, New Zealand, Norway, Russia, South Africa, Spain, the United Kingdom and the

United States (Iceland also) experienced housing booms.

Moreover, researchers at the Organization for Economic Cooperation and Development

provided evidence from that the greater the degree of monetary access in a country, the larger

the housing boom was (Taylor, 2009).

iii. Low Interest Rates Spur on Modern Financial Alchemy

The low interest rates of the U.S. Federal Reserve and of central banks around the world had

another gravely ill effect. Namely it pushed investors away from the traditional, prudent and

21


22/115

more risk-averse techniques of banking and investment, away from equities and towards

risky investments in search of yield, leverage and higher returns.

Indeed relatively low interest rates worldwide for much of the 2000s drove investors to seek

higher yields (Dunaway, 2009). Raghuram Rajan (2010, pp.109) echoed that statement when

he stated that low short-term interest rates pushed investors to take more risk. It pushed

normally cautious and circumspect investors such as public pension funds, mutual funds,

labour unions, insurance companies and foreign investors towards riskier exotic instruments

that offered yield enhancement and highly attractive returns, with seemingly little risk.

It was the great shift from equities to debt investment, and more specifically the shift en

masse towards high-yield and investment grade mortgage bonds. Indeed in order to satiate

investors institutional investment managers, normally judicious and conservative money

handlers, began to place their portfolios and cash reserves in MBSs and CDOs, moving away

from the traditional and prudent investment avenues such as U.S. treasuries, corporate debt,

municipal bonds government bonds, investment grade commercial paper and the like.

The distaste held by U.S., foreign and European investors for the low returns to be had from

traditional vanilla investments of government bonds and corporate debt ensured that once

prudent investors inadvertently took on subprime packed mortgage bonds.

Indeed it turned out that European and international investors who purchased AAA and

investment grade fixed-income securities in reality bought heavily into subprime mortgage

backed securities (MBSs) and credit default swaps (CDOs). In doing so they unwittingly tied

themselves inextricably to the fate of American subprime homeowners and as a result

suffered devastating losses.

iv. A Summation

The unspeakable damage of the Great Crash has taught us a few hard lessons about monetary

policy that we must learn from.

Firstly, to prevent future asset bubbles central banks need to work by the adage that interest

rates should be elastic as opposed to uniform, in that they should undulate, meander and

oscillate along the ebb and flow of the business cycle. They need flexibility and adaptability

22


23/115

as prescribed by the Taylor Rule which warns against the tendencies for interest rates to

remain low and stable over a prolonged period.

However this goal was not exercised and as a result, the non-elastic and uniformly low

interest rates that prevailed during the early 2000s fuelled a killer asset bubble and market

hysteria.

Thus it is necessary for central banks to continually assess asset prices and their correlation to

inflation, core fundamentals and intervene where necessary. Excess liquidity pre-2008 was

deadly and had central banks restricted money supply earlier during the asset inflation the

devastating highs of real estate would never have occurred.

Indeed Ben Bernanke (2010, pp.26) did admit that the Fed could have stopped the bubble at

an earlier stage by more aggressive interest rate increases. Certainly Nouriel Roubini (2005)

in his famous paper, Why Central Banks Should Burst Bubbles, advocated just such a method

in order to combat an asset bubble. In any case we have learnt the hard way that low interest

rates held low for a long period are deeply damaging.

Moreover Europe has learnt the hard way that European monetary policy is unsuited to the

rigours of a multitude of diverse economies. Indeed the ECB policy was found to be

appropriate or slightly restrictive for France and Germany, but too loose for Ireland and

Spain (Seyfried, undated).

Ultimately it is rather easy to conclude that the influence that the U.S. central bank holds on

the mood of the global economy is something that is hugely underestimated and in the end

the actions and inactions of the Fed between 2001 and 2006 played an integral role in

precipitating and maintaining the U.S. and global housing bubble.

23


24/115

24


25/115

CHAPTER 3: SHOT 2, FEDERAL HOUSING EXCESS

Democratising Finance isnt all its Cracked up to be

Having outlined the damaging role of low interest rates on the global economy it is now

appropriate to consider another major factor that helped to precipitate the Great Crash of

2008 and in this instance we will consider the failings of the U.S. federal government. Indeed

the financial crisis was one not only of market failure as we will see later but one also of

government failure.

Certainly the U.S government was guilty of two major financial crisis-inducing shortcomings

that contributed massively to the Great Credit Crash of 2008.

Firstly, successive presidential administrations sought to extend the American Dream by

pushing the benefits of private homeownership down market. In pursuing the goal of pushing

mortgages to the lower echelons of society the U.S. Congress forced the relaxation of

traditionally rigid credit issuing standards and in doing so gave birth to subprime and ARM-

mortgages (adjustable rate mortgages) and in doing so institutionalised the subprime

mortgage market.

Secondly, in an effort to push home starts the U.S. government kept a strong hand over the

Federal Reserves monetary policy in order to ensure that the central bank kept interest rates

low.

Both of these actions by the U.S. federal government had the most unintended of

consequences, rapidly distorting the economy and international financial markets and as such

it remains that government excess was one of the 5 deadly shots that came together to unleasha financial crisis of planetary proportions.

25


26/115

i. Reducing Loan Requirements to Palliate the Poor

Growing increasingly aware of the escalating inequality both in the standards of living and in

the levels of income among American citizens - a serious fault line in the American economy

the U.S. Congress sought to extend credit to the less than credit worthy in an effort smooth

out the disparities and to make the American Dream a reality for those on the bottom rungs of

society.

Raghuram Rajan (2010, p.42) pertinently discerned that the government policy that pushed

for the expansion of credit lines to subprime borrowers ensured that credit expansion was tobe used as a populist palliative. Likewise in similar tone Robert J. Shiller (2008, p.23)

observed that the extension of credit to subprime borrowers was an attempt towards

democratising finance.

Indeed the federal housing policy that sought to palliate the poor by democratising finance

was first initiated in the early 1990s by the Clinton administration and later carried on as

George Bush took office in the 2000s. Howard Bloom (2010, pp.30) was right to observe that

Clintons goal was messianic, as it was a goal that sought to lift (the) oppressed masses

into the middle class and to give them a stake in the stability of a vigorous, inventive

America.

Certainly George Bush had a rather ecclesiastical tone when he stated that we can put light

where theres darkness, and hope where theres despondency in this country. And part of it is

working together as a nation to encourage folks to own their own home (Bush, 2002).

Thus in order to meet the hallowed goals of Clinton and Bush, banks soon found their armwrenched by a wave of legislation, an assortment of policy measures and a number of

community organisations that applied heavy pressure in order that they lend to the poor.

Certainly banks had been accused for some time ofred-lining, or in other words of simply

having refused to lend to minorities and those in inner-city and low-income neighbourhoods.

However the divine intervention of successive presidents put an end to any such suggestions.

Indeed the Community Reinvestment Act of 1977 (CRA) which was revised by Bill Clinton

in the early 1990s stipulated that in order to obtain a bank charter from the federal

26


27/115

government banks had to lend to African Americans, Hispanics and other minorities. It was

thus a stick used to beat banks in order to drive up lending in neglected areas.

Above all it was a way to get around Americas historically and culturally rooted reticence

towards ideas of taxation and redistribution. Certainly for the large part it pleased Democrats

as it upped social justice and pleased some Republicans who saw the business and profit

aspect of the government program. A mix of big business and social justice interests were

thus merged in order to give the poor a taste of the American dream through buying houses

and starting businesses.

However the federal housing program which gave birth to adjustable rate mortgages (ARMs)

and subprime loans helped to extend loans to people that should never have been given

access to credit.

Indeed encouraged by the government-loosened mortgage standards many hundreds of

thousands of subprime borrowers took on loans, and with the wide spread assumption that

house prices would rise indefinitely many more joined them. Indeed over a trillion dollars

was channeled into the subprime mortgage market, which is comprised of the poorest and

least credit worth borrowers within the United States (Reinhart and Rogoff, 2008a).

However the idea that real estate values would rise forever was a raw economic fallacy and

once house prices began their decline in 2006, subprime, ARM and NINJA (no income, no

job or assets) borrowers all defaulted on payments en masse. This had the most severe

repercussions on high finance and international capital markets.

Thus due to the heavy involvement of government in urging the relaxation of loan standards

and the creation of subprime loans it is right to say that the subprime crisis lay right at the

heart of the American political system.

ii. Government Push for Low interest Rates to Kick Start Housing Starts

As a result of the federal housing policy the low interest rates of the U.S. Federal Reserve

between 2001 and 2006 had strong undertones of government intervention. Indeed such was

the desire of the U.S. government for increased housing starts that pressure (was) applied all

the time by Congress (Rajan, 2010, pp.108).

27


28/115

Whilst the disparities in the levels of U.S. income were hidden for a while under the world of

low interest rates and reduced lending requirement as well as the smoke and excitement of

rising real estate, in the end the credit rise and collapse was a huge fault of the fanciful

housing policy and the governments meddling in the affairs of the Federal Reserve.

iii. A Summation

Attempts to democratise finance and to palliate the poor in the U.S. by expanding credit to

citizens sitting on the periphery of society is commendable but history tells a story that

should warn against such economic policies. After all it was the massive extension of credit

by rural banks in the 1920s to farmers coupled with other extraneous factors which

contributed to the stock market Crash of 1929.

Indeed both the Great Depression of the 1930s and the Great Recession of 2008-2009 have

shown that populist credit expansion went too far (Rajan, 2010, p.43) and in the case of

mortgage issuance the US government has learnt a little late in the day that homeownership,

for all its advantages, is not the ideal housing arrangement for all people in all circumstances

(Shiller, 2008, p.6).

Certainly extending credit to the poor appeared a simple and effective way to address the

growing inequality. However such activity caused major distortions to the financial sector

and in the end the U.S. found out that it was an extremely costly way to redistribute (Rajan,

2010, pp.43).

The federal housing policy was one of good intentions yet it was utterly fanciful and what

started as a government effort to improve the prospects for home ownership through a policy

of easy money end(ed) up having unintended consequences that will leave many Americans

economically scarred for the rest of their lives (Thornton, undated).

And whilst it is right to say that there are plenty of culprits, it remains that the story the

global financial crisis was partly one of Bushs and (Clintons) own making (Becker et al.,

2008).

28


29/115

29


30/115

CHAPTER 4: SHOT 3, CONSUMER EXCESS

Irrational Exuberance

30


31/115

To pin the blame for the financial crisis solely on the backs of bankers, credit rating agencies

or the like is not the correct response nor is it constructive. As outlined earlier, such a

response would be too facile and indeed to take such a stance would be to absolve the rest ofus of our responsibility for precipitating the crisis (Rajan, 2010, pp.4). And rightly so as it

was your greed and mine (Bloom, 2010, pp.31) that contributed to the manic housing and

spending euphoria. Ultimately consumers were part of a morbid mix that caused a financial

catastrophe.

Indeed the coming together of the financial crisis was a subtle but deadly chemistry and the

role of the consumer on Main Street cannot be underplayed. At the end of the day people

decided to take out credit cards and home loans, monumental household debt was self-

induced. No one was forced to take on a mortgage or mortgages, credit cards or consumer

finance. Consumers willfully consumed huge amounts of credit before the crisis and thus

implicated themselves in the fall of global finances most seriously. Main Street was greedy

too and the greed was good, while it lasted.

Through their incessant consumption, consumers provided the foodstuffs that propelled the

activity on Wall Street and of high finance. Indeed by increasing their liabilities consumers

raised exponentially the flow of debt and structured products that wizzed throughout high

finance. And at the end of the day Wall Street could not have done what it did without the

raw material needed for the process of modern alchemy - the housing and debt liabilities of

consumers on Main Street.

However what is it that drove consumers to take on so much credit and to spend with such

manic euphoria? As was alluded to earlier, the consumer debt binge was in large part a

symptom of the low interest rates which made mortgages and the like so manageable andattractive. It was also a phenomenon that manifested itself as a result of the reduced loan and

credit requirements thanks to a government housing policy as well as the indifference of

mortgage originators who were pushed on by huge mortgage origination fees and the hunger

of Wall Street alchemists.

However a central and perhaps primary cause underlying the incessant activity of consumers

was the non-rational herding mentality that was driven by nothing more the infectious market

31


32/115

psychology ofirrational exuberance a term first coined by Alan Greenspan in 1996 and

later a central focus of academic research for Robert Shiller, an expert on consumer

behaviour, asset bubbles and their causes.

Robert Shiller (2005, pp.2) who has written voluminously on the matter of consumer

behaviour, market psychology and their bouts of market mania outlined that irrational

exuberance is the psychological basis of a speculative bubble. I define a speculative bubble

as a situation in which news of price increases spurs investor enthusiasm, which spreads by

psychological contagion from person to person, in the process amplifying stories that might

justify the price increases and bringing in larger and larger class of investors, who, despite

doubts about the real value of an investment, are drawn to its partly through the envy of

others successes and partly through a gamblers excitement.

Indeed in the early 2000s the media, rumour and social noise prompted consumers to take on

an unyielding faith in the real estate market. Reports of the doubling and tripling in value of

real stirred up consumers in a bout of investor enthusiasm and believing that house prices

would grow indefinitely - with few saying otherwise - countless consumers bought into the

real estate market with reckless abandon.

Certainly the globally spread and manic spending binge was driven by psychological factors

that (had) little to do with fundamentals (Baker, 2007) and as a result of the irrational

exuberance consumer demand pushed real estate prices far away from core economic

indicators.

The work of Robert Shiller which explores the non-rationality and herding behaviour of

consumers is something that overlaps rather fittingly with a new field that has emerged within

the wider study of economics, namely that ofsocionomics - a socio-economic theory that

considers the social mood and how its impinges on economic activity.

32


33/115

Much has been written within this nascent field of study, (cf., Nofsinger, 2001; Nofsinger,

2005; Olson, 2006; Parker and Prechter, undated A; Parker and Prechter, undated B; Prechter,

1999) however time and space constraints permit only a brief consideration of this fresh and

insightful aspect of modern academia.

Nonethelesssocionomic scholars hold that a social mood can be transferred through social

contact which can spread confidence or lack thereof far and wide. And since the mood is

collectively shared, and in a constant state of flux many simply follow the herd as individual

consumers base their purchase and investment decisions on rumour and social noise, devoid

for the large part of any sort of detailed knowledge of the insider dynamics of investment and

trading a scenario of the free rider investor.

Indeed it was the case that most homeowners did not care why residential real estate prices

rose; they assumed prices always rose, and they should simply enjoy their good fortune

(Roberts, 2008, pp. xvii). And as the prices rose the social noise stirred an ever stronger

public interest and indeed as the social mood reache(d) its peak, the level of optimism in

society (drew) more people into investment (Redhead, 2008) thus helping to feed the asset

bubble ever more.

Such a scenario highlights how emotion and perception are the core of economics (Bloom,

2010, pp.52) and in this instance the high prices were sustained only by the raw emotions,

confidence and perceptions of investors as well as a primal enthusiasm as opposed to any

correlation to real value. Indeed all too often humans have a chronic tendency to

overconfidence (Chancellor, 2011), and it remains that errors of human judgement can

infect even the smartest people, thanks to overconfidence (Shiller, 2005, pp.xv).

Certainly the psychological contagion of irrational exuberance crossed wide oceans and

stirred an unbounded confidence in the solidity of the housing market even amongst the

smartest and most market savvy people. However even though it should have been evident

33


34/115

to housing analysts that the housing market was experiencing a bubble (Baker, 2007), only a

select few took note.

It just goes to show in spite of all the advances in technology and knowledge, how something

as complex as the economy can be built up so high and brought down so low by something as

simple as the raw instinctive animal spirits of man and his desires. Indeed the economy is

shaped by the actions or inactions and the emotions of consumers and investors in low

finance and as such, if credit is the lifeblood of the economy, it goes that consumers and their

emotions are the pulse that can both set the economy both racing and plummeting.

Thus, much in the same way that man and other organic entities have a mood and an

emotional state, the economy - which is driven by the totality of man and the consumer can

likewise reach moments of acute pleasure or distress.

The end result was that the nature and character of household debt changed fundamentally

and throughout the early 2000s hyper leveraged household balance sheets became the norm.

Indeed coupled with the erosion of traditional loan requirements capital spilt over the

prudential banking levees and showered immense levels of credit over a wide and diverse

pool of borrowers who were all to willing to take it on. The graph below highlights the

increasing indebtedness of the consumer between 2003 and 2005 in particular.

34


35/115

Source: (Reidy et al., 2010).

Indeed the credit tsunami fed the investor enthusiasm and with an unyielding faith in asset-

based prosperity the wave of credit allowed consumers to buy their first, second, or even third

house. With the belief that house prices would rise ad infinitum and with fungible mortgage

debt consumers could liquidise their gains as prices rose or refinance their mortgage loans in

order to purchase widescreen TVs, sportscars, holidays, boats and innumerable other luxury

items.

However this way of life was but a mere mirage. American consumers on Main Street were

swimming in financial hubris, a financial fantasy land and an economic utopia where house

prices would never fall.

Such a mentality fuelled by irrational exuberance led to significant under pricing of risk and

in the end the consumer and wider finance who had so long danced with fire got severely

burnt. Indeed as prices began to align to economic fundamentals consumers suddenly woke to

find out that house price appreciation was not an infinite rationality.

35


36/115

And as prices reverted to core fundamentals and house prices depreciated the world learnt

that the same irrational exuberance that fed the real estate bubble could help to deflate the

economy in a most damaging manner.

Indeed consumer, investor and market confidence or lack thereof is the central tenet of the

modern economy and financial markets, and just as price hikes stir further price hikes in a

rolling wave of investor confidence, so it remains that any major negative price fluctuations

can cause market actors to take flight.

Indeed consumers and banks rocked the market with fire sell liquidations which drove down

asset prices in a devastating downward economic spiral, bringing to an end the credit-driven

super-cycle and unleashing a long and drawn out cycle of debt deflation that has continued to

this day.

The above analysis ofirrational exuberance lays bare the inefficiencies of man and the raw

perfunctory emotion and primal instincts of the consumer that shape the mood and direction

of the global economy.

Thus the goal of this section was to highlight the weakness of man and their tendency to

disregard traditional sensibilities when faced with the chance to access cheap and easy credit.

Indeed the greed was not limited to Wall Street but rather was manifested on Main Street and

throughout society both from low and high finance.

36


37/115

CHAPTER 5: SHOT 4, WALL STREET EXCESS

An Exploration of Modern Alchemy

37


38/115

The science behind mortgage backed securities (MBS), collateralised debt obligations

(CDOs) and credit default swaps (CDSs) is true modern day alchemy. It is a tenebrous

technique that involves the financialisation and commodification of everything. Indeed

modern financial alchemy has helped to transform static and illiquid assets into commodities

that can be bought and sold around the world. Anything from mortgage loans, commercial

real estate loans, corporate debt, credit cards, student loans, car loans and the like are

converted into tradable goods in a world gripped by financialisation.

For the purposes of this section we will consider in detail these esoteric tools of high finance,

the magna opera of 21st Century financial engineering, and in particular this paper will focus

on the financialisation of homes and homeowners as it stands that housing is a central aspect

of financialisation (Aalbers, 2008, pp.148).

However the financialisation of housing and the complex, opaque and baffling practices

involved played a central role in the Great Credit Crash of 2008. Indeed the world found out

that Wall Streets buying of credit default swaps and the trading of subprime mortgage bonds

and CDOs in the end did not distribute risk as was originally intended, rather they

disseminated the toxicity of subprime debt, industry malpractice and the foibles of man

worldwide. Thus for the purposes of completeness it is necessary to dive into the dark world

of 21st Century financial engineering.

i. Mortgage Backed Securities (MBSs)

The practice of selling and trading debt is hardly new. Indeed the trading of bonds is a

practice many hundreds years old that has paid for wars and bankrolled governments the

world over. It was after all securitisation that paid for the warships that allowed Britannia to

rule the waves (Braithwaite, 2005).

A process that was first invented in Naples, Italy in the 17th Century (ibid.), the

contemporary science behind mortgage bonds has changed little. In any case the

securitisation of mortgages bears witness to the liquidation of once long-term, illiquid and

balance sheet clogging liabilities into tradable assets. By removing the default risk off

balance sheets, remodelling loan books and tapping into the underlying value of housing

loans the modern mortgage securitisation process has revolutionised modern finance.

38


39/115

Indeed the development of modern mortgage securitisation, the establishment of the

secondary mortgage market and the emergence of a non-exhaustive nomenclature of exotic

financial innovations which have developed around the process of modern alchemy has

irrefutably signalled the birth of new capitalism (Finch, 2009, p.19).

However before the advent of new capitalism the mortgage business was entirely different.

Indeed banks funded their housing business through lending out customer deposits at interest,

retaining the original mortgages and receiving the monthly cash flow of repayments and

interest. This process was known as the originate to hold model and an all together simpler

business from modern mortgage lending. As a result of retaining the original mortgage loans

on their books the traditional lenders also retained the risk of default and consequently they

were astute arbiters and managers of risk.

However the traditional originate to hold model of mortgage lending started to be displaced

by the originate to distribute model as primitive forms of mortgage securities were

developed in the 1970s when banks began selling off single mortgage loans to outside

investors in a product known as mortgage-pass-through securities. Much of the early

business was carried out by Fannie Mae and Freddie Mac, the now infamous governmentsponsored enterprises (GSEs). These agencies had an implicit government guarantees and

generally adhered to strict underwriting standards, and as a result their products carried high

credit ratings.

Indeed they produced attractive and profitable products that allowed third parties to invest in

the mortgage business without the need to engage in the time consuming process of

scrutinising details and assessing default risk in order to originate loans. More importantly

this new secondary mortgage market provided an invaluable source of mortgage and

consumer finance and when exercised properly it provided an important tool for risk

management.

But what exactly is a mortgage security/bond and how does it come into being? First of all as

mentioned earlier a bond or securitised debt product can come in any form. Indeed it matters

39


40/115

not the nature of the primary underlying asset. The sole concern is whether a predictable cash

flow can be extrapolated from the pre-existing liability in order to back/securitize/

collateralise the original asset through the maintenance of regular repayment from the

borrower to the bond holder.

Indeed a bond is a contract whereby the investor will hold that, I, the bond investor, part

with my money now. You, the borrower, pledge that in return for receiving my funds now,

you will make specified, scheduled payments to me in the future (Sylla, 2001).

Mortgage borrowers make regular monthly repayments and it is for that reason that

mortgages are attractive and effective munition to subject to the financialisation process of

modern alchemy. Indeed following the financialisation and securitisation of a mortgage loan

the monthly repayments are then directed not to the mortgage originator but rather distributed

(originate to distribute) to the investor who bought the securitised mortgage product.

The investors who buy debt products are thus called bond holders. They receive promissory

notes that state their entitlement to receive a regular cash flow in the form of interest

payments and principle amounts loaned at maturity channelled from the original mortgage

borrower. The diagram below gives a competent explanation of the mortgage securitisation

process.

40


41/115

Source: Supreme Court of the State of New York representatives briefing in the case;

Allstate Insurance Company v. Merrill Lynch (2011).

However in the late 1990s and early 2000s the mortgage securitisation business soared

amongst investment and shadow banks on Wall Street who bought into the originate to

distribute model with reckless abandon. Indeed the banks on Wall Street who structured and

issued bonds with great efficiency ensured that mortgage securitisation quickly became a

routine aspect of modern finance.

Resultantly a technique that started out in life as a rather modest cottage industry in the 1970s

and 1980s, mortgage securitization was subjected to the full rigours of Wall Street as it was

transformed into a multinational business carried out on an industrial scale.

Moreover the once rather simple chemistry behind mortgage securities evolved into a vastly

more complicated science with techniques that involved the pooling of huge quantities of

debt liabilities into packages that created a range of assorted debt products. These were the

new sophisticated tools of high finance, known as collateralised debt obligations.

41


42/115

ii. Collateralised Debt Obligations (CDOs)

A Collateralised Debt Obligation is simply the science of mortgage backed securities on

steroids, of financialisation and modern alchemy on overdrive. It involves the pooling of an

assortment of debt liabilities which are then divided into slices and tranches of debt that each

carry a unique risk profile. Indeed CDOs can be made up of a rainbow selection of illiquid

assets - mortgage debt of the prime and subprime variety, student loans, credit card loans,

corporate and commercial loans, auto loans and even debt bonds can all be bunched together

within a CDO portfolio.

Thus the principle difference between a mortgage backed security and a CDO is that a CDOis a melting pot of debt, a giant pool of illiquid assets.

The construction of a CDO contract usually requires the involvement of a special purpose

vehicle (SPV) which includes assets, liabilities and a manager responsible for issuing notes to

institutional investors. The notes issued by the SPV are the obligations of the CDO which

entitles the note holder to regular payment from a tranche of their selection.

The financial engineering of funnelling the cash flow or income from the assorted pool of

debt into a wide range of tranches provides a multifarious menu of risk which caters to the

demands and diverse risk appetites of the modern sophisticated institutional investor.

The senior tranches have better credit ratings and as such the buyers of highly rated CDO

tranches are entitled to the first round of the available CDO cash. Conversely the lower

tranches of a CDO portfolio have a higher potential yield but are far riskier assets. Indeed it is

the tiering or water falling of the cash flow that thus seeks to protect those investors who

have taken on senior and more highly rated tranches.

This form of structured credit was first issued in 1987 and soon after Wall Street found outthat sponsoring a CDO and selling debt assets from a broad portfolio of risk was a highly

42


43/115

profitable business. Indeed debts of all kind were routinely secured in the 80s, 90s and early

2000s. However as the U.S. housing bubble inflated it became increasingly apparent that

housing debt was the collateral of choice for financiers stocking up a CDO portfolio.

Indeed as the housing bubble continued its upward spiral subprime MBS, ARM (adjustable

rate mortgages) and Alt-A (poorly documented loans) mortgages increasingly made up the

collateral held in the CDO pool of assets. In fact the issuance of residential MBS CDOs

roughly tripled over the period from 2005 to 2007 and RMBS CDO portfolios became

increasingly concentrated in subprime residential MBSs (Petersen et al., 2011).

Moreover statistics compiled by Bernstein Research (2011, pp.7) has shown that the annual

issuance volume of CDOs rose from $33 billion in 1999 to $229 billion in 2006. The growth

in the CDO issuance volume provided an estimated $361 billion in new capital to the

mortgage market and more importantly gave a supposedly permanent home for the subprime

and Alt-A loans being originated and packaged by financial institutions.

Indeed the short-sightedness and hubris of bankers and financial engineers drove them to

forge CDO contracts whose very structural foundations were assembled upon subprime loans

which rested on the ability of poorly or non-documented subprime borrowers to maintain

payment, a most unlikely scenario.

If the underlying debt liabilities packaged within a CDO go unpaid in large numbers the

entire integrity of the structured finance vehicle can collapse. Furthermore if CDO contracts

collapse en masse the very solvency of the buyers of CDOs and the integrity of the buyer-

seller network can be brought into question.

iii. A Boom in Modern Alchemy Pushes Subprime Lending

The originate to distribute securitisation process advanced wildly beyond its primitive roots

into a complex and convoluted beast that radically altered the economic incentives of

43


44/115

mortgage lenders and fundamentally warped the world wider finance. Indeed the desire of

high financiers for housing debt in order to financialise pushed bankers to further loosen loan

requirements.

However there were negative side effects of the most severe degree to be experienced from

the financial wizardry that fused subprime mortgages with rampant financial engineering.

For centuries banks and mortgage lenders had been astute assessors and arbiters of risk,

bastions of sensible money lending. However the financial engineering of mortgages had

seemingly made the longstanding issue of default risk defunct, infecting mortgage originators

and Wall Street with an insatiable appetite for mortgages of any kind to financialise and pass

onto end-investors.

Indeed since the original lenders were no longer required to hold home loans to maturity they

could quickly devoid themselves of the burdens and worries that a borrower would default. In

the new process of mortgage lending the original lender would originate the loan, take a

commission fee then pass on the loan and in doing so pass on the default risk. Thus the

creditworthiness of the borrower soon became irrelevant as in the event of default it would be

a matter for the investor.

It became standard practice that for as long as loans could be quickly dumped in the

secondary mortgage market, mortgage issuers had little concern about the ability of

borrowers to actually pay off their loans (Baker, 2007).

As such the high servicing fees and an incessant demand for structured debt products ignited

a parallel boom in the secondary mortgage market alongside the housing boom in the real

economy. Indeed the extension of mortgages simply could not keep up with investor demand

which further prompted myopic bankers to extend loans to the less than creditworthy.

44


45/115

It was becoming obvious that the mortgage business had developed into an assembly-line

affair (Tett, 2010, pp.112). A non-stop production line as loans were extended to retail

customers and quickly packaged into bundles of mortgages, labelled AAA and immediately

sold to pension funds, mutual funds, insurance companies, labour unions, foreign investors

and foreign banks worldwide.

The demand for both mortgages and mortgage bonds ensured that retail borrowers and real

estate loans of any kind were to become feedstock (Caulkin et al., 2010, pp.7) and fertile

fodder (Tett, 2009, pp.111) to mortgage lenders and the financial wizardry of investment

banks. Indeed it was becoming clear that mortgage markets were no longer strictly a

facilitating market for needy homeowners but rather a market that was increasingly feeding

global investment (Aalbers, 2008, pp.148).

In the end it was the warped incentives of mortgage lenders and those on Wall Street

combined with a federal housing policy and the widespread belief in the near economicimpossibility (Stiglitz, 2010, pp.86) that house prices would interminably rise which led to

the complete erosion of sensible lending practices and the normalisation of subprime loans.

Indeed with the abandonment of the customary ritual of risk assessment prior to the issuance

of credit it was ensured that mortgages would be made available to anyone and everyone.

And even though the underlying debtors were unlikely to make repayment Wall Street was

still ready to financialise the raw material in order to feed the market demand and by 2005

there was $625 billion in subprime mortgage loans and $507 billion of which found its way

into mortgage bonds (Lewis, 2008).

However Michael Lewis (ibid.) was very much right to state that such loans were built to

self destruct.

45


46/115

Indeed in the end it turned out that underlying the faade of a vast global network of MBS

and CDO contracts was a marketplace awash with toxic subprime debt, a ticking time bomb

strapped to the heart of global finances.

By February 2007 the 3 major credit rating agencies began to downgrade many MBSs and

CDOs from AAA to BBB and by the summer of 2007 the financial emperor was shown to be

wearing no clothes as the subprime crisis unleashed itself onto the world through a pandemic

of defaults on the underlying mortgages. It truly illustrated to the world that the chemistry of

financialising subprime loans was a lethal practice.

But how could the subprime lending of U.S. institutions affect banks in foreign nations right

across the globe? Quite simply the financial wizardry of modern alchemy (through the help of

credit rating agencies, as one will see later in the paper) transformed subprime housing debt

into highly rated structured finance products that foreign banks, investors, pension funds and

central banks were very willing to invest in.

Indeed Gillian Tett (2010, pp.116) stated that some American banks privately guessed that atleast half of subprime-linked CDOs were being sold not to Americans, but into Europe (Tett,

2009, pp.116).

Rather than diversifying and spreading the risk of default high finance had in the end simply

exported the horrors of subprime lending to most of the worlds economies, (and) none more

so than Western Europe (Datamonitor, 2008).

iv. Credit Default Swaps (CDSs)

Having probed into the contemporary world of mortgage bonds and the inextricably linked

cosmos of collateralised debt obligations it is now fitting to consider the science of financial

derivatives and more specifically that of credit default swaps.

Interestingly enough the science behind credit derivatives and CDSs is one that can trace itsprimitive roots far beyond those of debt and mortgage bonds. Indeed derivatives are as old as

46


47/115

finance itself and have been employed for thousands of years in order to limit risk as

rudimentary examples of futures and options contracts have been found on clay tablets from

Mesopotamia dating from 1750 BC (Tett, 2009, pp.11).

So what are derivatives exactly? Most simply a derivative contract is an agreement whose

value derives from an underlying variable and a tool that allows investors to shield or hedge

themselves from the risk of negative prices fluctuations or even to make wagers that may pay

off in the event of a future positive price swing.

Indeed derivatives have allowed financiers not only to hedge against risks but also to gamble

on the turnout of any number of market events including the rise or fall of oil prices, the

performance of foreign currencies as well as stocks and shares, interest rates, the solvency of

a company and even weather activity. The turnout of any given bet simply depends on the

behaviour of the underlying benchmark.

It is perhaps best to give a workable example. Say for instance that on a given day that the

pound-to-euro exchange rate is such that one British pound buys 1.30. Well someone who is

going to France for a few months in a years time is worried that by then the exchange rate

(the benchmark) will have swung wildly out of his favor. However a derivative contract

could hedge the buyer of the contract from an unfavorable fluctuation in the exchange

rate/benchmark. Indeed that person could buy a derivative contract that would ensure that he

could still buy euros at the rate of 1 to 1.30 just before his trip, thus rendering the

benchmark constant and unchangeable.

The buyer simply purchases an agreement with a bank stipulating that he can make a pound-

to-euro exchange of 1000 with a bank in 12 months time in which the buyer is guaranteed to

1300 regardless of what the actual exchange rate is in a years time.

47


48/115

A derivative agreement that stipulates that the above agreement had to happen is called a

future. Such an agreement locks the buyer into a contract to purchase euros at the pre-

specified exchange rate. However a derivative contract could be structured in another way

such that the buyer could agree to pay an extra fee of around 30 which would give him the

option to either make the exchange at 1.30 or in the case that the benchmark became more

favorable he would not have to exercise the exchange rate transfer at 1.30 but rather go with

the more favorable one.

For a long time futures and options have been traded on agricultural commodities in which

grain farmers would for example buy a future derivative contract in order to lock in at a good

price to hedge against the chance that a big crop would bring in low prices. This would leave

speculators to take on the losses in the event that a bumper crop drove prices down. At the

same time if the crop was poor and prices were driven far beyond that of what the farmer

expected, the speculators could hit a big pay day.

By the 1970s derivatives jumped from the realm of commodities and into the world of

finance. However credit default swaps as we know them today were not invented until the

mid-1990s.

It was Bill Demchak, his boss Peter Hancock, the illustrious Blythe Masters and a small

group of bankers at J.P.Morgan, inspired by the chaos of the Asian financial crisis of 1997,

who were responsible for the creation of a product designed to shield banking against the

troubles of bad loans.

Indeed the high financiers and financial wizards at J.P. Morgan had decided they could

defeat the bankers oldest foe the danger that borrowers will not repay their loans (Barrett,

2009).

So what exactly are credit default swaps? Well a CDS is simply a 21 st Century derivative that

often finds its value derived from an underlying asset such as a mortgage bond or another

form of debt liability as opposed to an agricultural commodity like wheat or an exchange rate

as outlined in the earlier example. Indeed not dissimilar from the exchange rate example

above, a CDS contract is an agreement chartered between two parties in which one buys

risk/credit protection from the other.

48


49/115

Rather appropriately it has been said many times that credit default swaps are complex

financial instruments whose primary purpose is to insure bond holders against the risk of

default. Indeed that is why it has been uttered countless times that a CDS is a form of debt

security or bond insurance. An insurance policy that covers credit risk by paying out in the

event of default much like an insurance deal taken out on a house or a car will cover any

losses in the event of damage or loss.

Indeed a credit default swap is a contract held between two parties in which the seller agrees

to compensate the buyer if a bond issuer defaults on his or her liability. It is a form of

structured finance that can be used to divert the credit risk borne by the investor (the

protection buyer) to another party who is willing and ready to take on that risk (the protection

seller).

Used sensibly, a derivative can provide a hedge against risk. For example, Bank A

(protection buyer) who is worried about some of the bonds that it holds on its books canmake a derivative deal to pay a fee to Bank B (protection seller) in exchange for Bank Bs

promise to compensate Bank A if the bond issuer defaults. By buying the credit protection

Bank A can rid itself of the worry and uncertainty related to the bonds that its holds and thus

free itself up to take on fresh debt liabilities and to make further loans. Bank B while

assuming some of the risk can immediately enjoy the fee income from the insurance

premium.

Banks on Wall Street and around the world saw the risk dispersion potential and it soon

became a household product. Indeed hedge funds, investment banks and insurance companies

all bought into the idea of bond insurance, buying and selling credit default swaps in

contracts that spanned the globe.

AIG however was the worlds biggest insurance company and largest issuer of CDS contracts

and before the crash AIG was the go to man for CDS contracts, selling bond insurance by the

lorry load to the modern alchemy factories on Wall Street who were mass producing exoticsubprime structured financial products.

49


50/115

However it was the fusing of bond insurance with subprime MBS and CDOs that brought the

financial world ever closer together, tied together in a world wide and systemic web of credit

and insurance agreements.

AIGs credit default swap portfolio stood at $517 billion according to a regulatory filing, of

which the giant insurance firm wrote some $79 billion in insurance on CDOs backed mainly

by subprime mortgages (Goldstein, 2008). Indeed AIG had sold swap contracts and made

obligations to investors across the globe and of the $441 billion in credit default swaps that

AIG listed at midyear, more than three-quarters were held by European banks (Andrews et

al., 2008).

Moreover since the fact that CDSs are traded privately by insurance companies, hedge fundsand investment banks as opposed to being orchestrated over a centralised public exchange,

financial institutions were basically allowed to get up to, buy and sell and strike whatever

deals they felt like. Indeed the Commodity Futures Modernization Act of 2000 had ensured

that derivatives would remain unregulated and to be traded as over the counter derivatives

(OTC), a term that is now largely seen as a byword for opacity and counterparty risk.

The lack of oversight allowed investment banks and hedge funds to take out CDS contracts in

order to take wild bets on the performance of the underlying benchmark. They were even

taking out CDS contracts in order to short and distort the market.

Indeed many market actors were packaging subprime debt, selling the product onto trusting

investors and then betting that the very product they had just assembled would default by

buying a CDS contract on the aforementioned deal.

And as the subprime mortgage market unravelled it rendered subprime MBSs and CDOs

worthless, ruining the banks and investors who had bought the subprime MBS and CDOs but

paying off handsomely for those who had bought the bond insurance.

Ultimately the collapse of the subprime mortgage market prompted investors all around the

world to call on their insurer, which for all too many was AIG. The rampant demand for AIG

to make good on its credit default obligations triggered the insurer to be forced to either

obtain emergency liquidity support or face bankruptcy.

50


51/115

In the end it turned out that credit default swaps which with the one hand can control risk, can

with the other if used irresponsibly and excessively, exponentially amplify risk.Indeed

Blythe Masters (2008a) who is lauded as the curator of modern CDSs stated that tools that

transfer risk can also increase systemic risk if major counterparties fail to manage their

exposures properly.

v. The Excesses of the Financial Wild West

The financial alchemists were modern day cowboys, pioneers, colonisers and speculators

pushing the boundaries of technology and modern finance. They were crossing into

unchartered plains and into a parallel world of finance riding high upon technological

advances on the crest of a wave; it was a true modern day gold rush.

However as we saw in the section above, financial alchemists were helping to sell AAA rated

debt all around the world. However the investment grade products was debt that was in

reality worthless debt. It was subprime debt buffed up and put in a fancy dress and gobbledup by large and risk-averse institutional investors.

Indeed Wall Street was straddling a wave that was built on subprime structured finance and

in the end that wave collapsed as their rampant use of chicanery brought the world to the

brink of economic Armageddon.

It is appropriate in this section to consider some of the worst practices indulged in by those

banks on Wall Street and the wider shadow banking network.

The band of Shadow banks were hedge funds, private equity funds, structured investment

vehicles and conduits, money market funds, broker-dealers and non-bank mortgage lenders.

51


52/115

But they were also the well known institutions like Goldman Sachs, Morgan Stanley, Merrill

Lynch, Lehman Brothers, Bear Stearns and other investment banks.

These banks had long abandoned the traditional techniques of banking, instead funding their

daily activities through the practices of modern alchemy and thus the unregulated creation,

servicing and trading of a plethora of exotic financial instruments that included mortgage

bonds, asset-backed securities, CDOs and CDSs.

However with hindsight it has become rather clear that such practices had turned global

capital markets and high finance into a great big national and not just national, global -

Ponzi scheme (Wolf, 2010).

The incessant competition and the unrelenting pursuit of profits and shareholder value pushed

Wall Street and shadow banks to push the legal limits of finance and to wildly distort any

sense of fair play on the marketplace. Goldman Sachs was perhaps the embodiment of all the

worst that Wall Street excess and trickery had to offer and it is perhaps appropriate to

consider some of their actions.

Indeed the questionable and immoral practices of Goldman Sachs had turned the bank into

nothing more than a big hedge fund (Cohan, 2009, pp.282) and such was the readiness of

Goldman Sachs to go against the interests of clients, shareholders, the market and global

economic stability in order to attain year-end profits that the firm had come to be seen as the

devil incarnate (Bernstein Research, 2011).

Traders in the mortgage betting rooms of Goldman Sachs went against their very own

customers by wagering that the worthless securities that they had just bundled together and

sold on would fail by taking large short positions on those transactions. Indeed in 2006 and

2007 Goldman churned out more than $40 billion in securities backed by at least 200,000risky home mortgages, but never told the investors that it was secretly betting that a sharp

52


53/115

drop in U.S. housing prices would corrupt the value of those very securities (Gordon, 2009).

In fact in the end Goldman made even more money than they anticipated from this practice as

the value of the junk mortgages fell further than they had expected.

Goldman Sachs bought into the worst that subprime lending had to offer, but then through

deception and raw deceit rid itself of its toxic assets before the subprime crash, and in doing

so exploited customers and clients around the world and more importantly exported their

evils and systemic risk worldwide.

The extent of Goldman Sachs corruption, deviousness and criminality was exposed by the

hearing held by the Senate Permanent Subcommittee on Investigations on April 27 th 2010

when Senator Carl Levin pulled out document after document which demonstrated the

systemic, sleazy criminality of the investment bank (Spannaus, 2010, pp.26).

Indeed Senator Carl Levin (

dissertation on financial crisis 2008

Documents