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November 20, 2008

Anatomy of a Breakdown

By Spear's

Stephen Hill on the causes and chronology of the credit crunch — in which the blind avarice on the part of central bankers played a key role.

‘It’s impossible to foresee a crisis,’ asserted ‘Sir’ Alan Greenspan in a Bloomberg TV interview, unconvincingly, on Friday 12 September. Even George Dubya, the one with the problem with the ‘vision thing’, had called for greater regulation of Fannie Mae and Freddie Mac as long ago as 2002, six long years before their $700 billion US government bail-out.

Old men forget, all right, and then their eyes get so weak that they can’t see what’s right there in front of them. Yes, this is the same beknighted Alan Greenspan, we promise you, who as the Federal Reserve chairman cautioned the markets in 2005 about their ‘irrational exuberance’, and then did nothing about it for the next two years, except leave interest rates at the catastrophically low level of 1 per cent.

Then came the inevitable credit crunch on 9 August 2007, as gung-ho banks had borrowed short at low rates and shovelled out the money long-term to wannabe homeowners and consumers and then sold these debts on all neatly sliced and diced and at a tidy profit. But the new breed of sub-prime borrowers didn’t have enough dosh coming in to pay off their debts, and so the music stopped.

The central bankers then accused the retail banks of having ‘mispriced the lending risk’, rather than admit to their own folly of letting the party roll on past midnight and into the wee small hours: remember Chuck Prince, the ex-CEO of Citigroup, who said the music was still playing and that his bank was still dancing? Well, he soon discovered he was the only one standing in the last-dance saloon.

The real crisis came a year later, however, when it broke over the weekend that began with that interview. Lehman Brothers was bust: it had assets of $639 billion and liabilities of $613 billion, implying debt leverage of around 25 times, an absurdly risky multiple, but $88 billion of the assets were unsold toxic sub-prime mortgages, so bankruptcy was inevitable. Lehman also had total derivatives bought and sold of $729 billion with a fair net value of $16.6 billion credit, which will probably be uncollectable in the course of its bankruptcy.

As a major issuer of CDSs (credit default swaps, or insurance for a bond or debt that goes bust), Lehman’s sudden collapse immediately hit the solvency of the biggest insurer of the world, and the biggest insurer of the $55 trillion — that’s $55,000,000,000,000 — CDS market, namely the mighty AIG, with $1 trillion assets but with exposure to $441 billion of mortgage-related CDSs. Systemic risk was now a contagion blowing dangerously in the wind: on the morning of Monday 15 September, AIG needed $20 billion cash, then $75 billion by Monday evening and $85 billion by Tuesday morning and another $38 billion a month later.

Amid the din, confusion, noise and dust, however, an old cowhand of a banker — ‘I’ve had all the fun I can stand in investment banking,’ he said as he walked away from a possible move for Lehman last year — spotted that the ailing Merrill Lynch was unhappy at the immediate prospect of the financial abattoir that had so readily butchered Lehman overnight. The ‘Thundering Herd’, now dubbed the ‘Blundering Nerd’, was quietly rustled west by Bank of America’s Kenneth Lewis, sensibly offering not cash, but $50 billion of BofA paper.

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In the space of six months, Bear Sterns (leveraged 33 times), Lehman Brothers (leveraged 25 times) and Merrill Lynch (leveraged out of sight), had all gone, leaving just Goldman Sachs (leveraged at 20 times, down from a 28 times peak) and Morgan Stanley (leveraged at 17 times, down from a peak of 33 times) as the last outposts of a beleaguered so-called investment-banking community. ‘Geared jobbers’ would be a more accurate description of them.

This crisis had been building for three years already, and the man in charge couldn’t foresee it? Well, this magazine did, admittedly as late as February 2007, when it was already as clear as mud that the central bankers had lost control. But then Greenspan was always a friend of the market and the market-makers, which is not where a central banker’s sympathies should best lie.

Over in the UK, Gordon Brown had restricted the Bank of England to tracking inflation by reference to a misleading EU index, while the commercial banks trespassed all over the Bank of England governor’s ‘moral hazard’ territory of his own front lawn and he had to write inconsequential letters to Number 11 about inflation targets being missed.

Back to that interview: the Greenspan solution was for investment banks to be owned by the much larger commercial banks with their huge retail deposit bases, because in a crisis these banks have access to the Fed’s lending window. This would mean that the high-risk, high-reward investment-banking subsidiaries would automatically qualify in a crisis for what is in effect taxpayer support, which brings us right back to the current conflict of interests, where the self-styled ‘masters of the universe’ take all the profits and leave the rest of us to pick up the pieces and the losses.

This is a road to ruin in more ways than one: it points to yet more nationalisations à la Northern Rock and to more costly and ineffectual regulation — did any of these regulators see what was happening, and if they did, was there anything they could do to avert this crisis?

In other words, the Greenspan solution is a recipe for long-term, over-regulated, sclerotic capital, the worst of all worlds, as he seeks to argue that the taxpayer should shoulder the risk as depositor and not as taxpayer, neatly letting Uncle Sam off the hook and putting commercial banks firmly on it.

Then events took control and put the US government firmly back on the hook anyway, as it was forced to conjure up an $850 billion bail-out fund to buy the toxic mortgage waste from the banks. And then Greenspan’s idea of commercial banks owning investment banks was shown to be ‘nonsense on stilts’ as Goldman and Morgan simply signed some forms to become deposit-taking holding companies, allowing them access to the Fed’s support if the need should ever arise. And it arose, all right, within a month.

Greenspan’s view of the future is totally asymmetric to a simple structure that worked well for 66 years: the Glass-Steagall Act of 1933 separated the ownership of investment and commercial banking, separating high-risk/high-reward from low-risk/low-reward, and deposits from investments. It was successful and required no regulation, as it was simply on the statute book and was the law.

There was a rationale to this: commercial banking is really a utility, like a water company: you turn on a tap and, provided you have paid your last bill, water comes out; you put your card in the ATM and, as long as you are in credit, out comes liquid readies. You want a mortgage or car loan or overdraft, it can be arranged at a cost that wouldn’t interest an investment banker enough to get out of bed, let alone pick the phone up.

Society and the economy need liquid and sound commercial banks that don’t go bust, and those who want to adopt higher-risk/reward strategies can try their luck, or expertise, as hedge funds do, but don’t call on us taxpayers if you go broke. There is room for both models, but let them be separate businesses, please.

President Clinton did away with Glass-Steagall and the laws against predatory lending in 1999 in the name of banking freedom, just as Thatcher had done away with staid old building societies in the 1980s, which then became ‘banks’, before they went bust or were bailed out — Northern Rock, Alliance & Leicester, the Cheshire, the Derbyshire, Bradford & Bingley and now the biggest of them all, the Halifax. The idea was that banking and regulation and technology had moved on and Glass-Steagall was an anachronism, but hold on, haven’t hedge funds come along since then, and they are not part of any commercial banking or regulated structure, are they? Their mortgage assets, quite rightly, are not covered by the planned US bail-out.

And yet perversely, the humdrum commercial bankers hanker after the glamour, excitement and the greater profits of investment banking, but do they know the greater risks? Barclays Bank owns the so-far successful Barclays Capital, but what does the main board do when John Varley, running the commercial bank, wants to buy ABN, while Bob Diamond, running the investment bank, wants to buy Lehman? The risks and rewards are simply miles apart, so where does the capital best get allocated?

Fortunately, Varley missed out on ABN (but RBS did not and now rues the day!), while Diamond, equally luckily, managed on the first day of its bankruptcy to buy valuable Lehman assets, namely its investment-banking, fixed-income and equities sales, trading and research desks employing 10,000 executives, along with the Seventh Avenue headquarters, for just $1.75 billion — fortuitous for Barclays on three big counts, but it highlights the dilemma of the inherent problematical structure of this new banking combination. Incidentally, $1.25 billion in that price was for bonuses of the Lehman bankers who had just bust the bank.

No doubt Bank of America will discover all this for itself with its new herd of bulls, who won’t fit naturally into the twice-daily milking-parlour routine, and that’s before the thorny issue of vastly differing rewards for the two very different types of bankers under the same corporate banner. On the other hand, the shotgun-rescue takeovers of Washington Mutual by JP Morgan Chase and of Wachovia by Citigroup (deals that involved four out of America’s top five banks) and Lloyds TSB’s takeover of HBOS make perfect sense as combinations of two commercial banks with similar products and services and with duplicated costs that can now be slashed.

In America, JP Morgan is looking for $1.5 billion savings in the first year and in Britain the overlapping branch networks and the 70,000 headcount at Lloyds TSB and the 72,000 headcount at HBOS should yield similar cost savings. Lloyds TSB will now control over 44.4 per cent of the British mortgage market, will be number two in Scotland and will still have all its operations sensibly in the UK. Banco Santander/Abbey National’s acquisitions of A&L and B&B will give it 27.5 per cent, meaning that 72 per cent of the mortgage market is controlled by just two players. And there is nothing the competition authorities can do about this whopping concentration, given the current crisis!

So why did the US Treasury let Lehman go to the wall? Various commercial banks had carried out due diligence and had passed, not least as the price demanded was far too high. So the principle that public capital should not bail out private capital prevailed on the day, as did the notion that the systemic risk appeared an acceptable risk, albeit incalculable.

Lehman’s failure, however, immediately set off a fireball from 745 Seventh Avenue to One Pine Street, triggering the AIG crisis. So why did the US Treasury save AIG? Because it was just far too big to let it go bust, and anyway the Treasury took 79.9 per cent of the company on terms that might even see a profit over the medium term.
In the short term, the crisis has cratered stock markets around the world and the dash for cash is now on in earnest, led by insurance companies and mutual and hedge funds.

The first signs of a global recession are clearly visible, and in the most unlikely sectors such as minerals and oil, where the price of crude has dropped by 50 per cent in just months, and in the most unlikely places, such as Iceland, Hungary and Ukraine. There are even reports of billionaires losing billions, of Russian monopoligarchs retreating from the London property market faster than Napoleon did from Moscow, and with greater losses.

The banks have so far written off $550,000,000,000 of toxic mortgage debt, and now the US government bail-out fund is set to provide $850,000,000,000 cash, but other commentators believe another $1,000,000,000,000, a cool trillion, or even two trillion, will have to be written down or bailed out. On 27 October, the Bank of England estimated that losses on toxic assets were $1,577 billion in the US, £123 billion in the UK and €785 billion in the EU.

‘Hank the Hunk’ Paulson must have questioned his own judgement since throwing Lehman to the wolves, but Lehman’s top management had made appallingly bad misjudgements over the past three years and nobody liked the aggressive style of the CEO. In appearance and behaviour, Dick Fuld had all the charisma and instincts of Damien Hirst’s shark, but on the same day that Lehman Brothers finally went belly-up, at least the shark snagged a buyer at Sotheby’s for $17.2 million.

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