THIS ISN'T 2008 BUT IT'S STILL BAD
We are not facing a new 2008 financial crisis, instead this is a new one with its own unique challenges. That said, post-2008 responses are partly to blame for the inflationary pressures
Although we face new banks failing and central bank emergency funding being dished out, this isn’t a repeat of the 2008 financial crisis. The challenges this time are different, and circumstances quite unique in certain cases. That said, the inflationary crisis and the interest rate hikes to remedy it can party be laid at the door of the post-2008 financial disaster response. To understand what’s happening today and look forward we must first look back and understand.
Remembering 2008
Before launching into what is actually going wrong with some high profile institutions failing or needing bailed out today, it’s important to recap what actually triggered the 2008 financial crisis. This way we can easily see why today’s problems at Silicon Valley Bank (SVB), Credit Suisse and others is simply not the same thing.
So, let’s journey back in time.
The year is 2000, the USA is the global hegemon amid the supreme optimism at the turn of the century. The cold war has ended, capitalism and liberal democracy declared triumphant as Professor Francis Fukuyama penned his famous “End of History?” Bill Clinton is in the process of bequeathing an America with budget surpluses (can you imagine!) as it frolics as the only superpower left on earth.
If the politicians, academics and policy makers were increasingly filled with the complacency and hubris of a pre-9/11 world, so were the financial markets and banking sector. Investors in Wall street are hungry for new sources of financial return, and are eagerly searching for the next big thing.
The investors know stocks and bonds are popular, but the implosion of the 1990s tech bubble scares quite a few of them. They realise in the early 2000s just how hard it is to get your money back from a collapsed firm. So, they want big returns with minimalised risk.
All eyes began to swivel to…mortgages. Yes, that’s right, the good old fashioned mortgage. After all, to mortgage lenders, this is sort of like a bond…only with benefits. You get regular interest payments, and if the borrower doesn’t keep paying on time, you get to grab the house. But who doesn’t pay their mortgage, am I right? And even if they did stop paying, property prices just keep going up (this is the early 2000s remember), so repossessing some poor schmucks home for non-payment of a mortgage is fine. You get the money back.
But the big boy investors in Wallstreet really aren’t interested in buying the mortgages of individual working Americans. Nah, they can’t be bothered with one-on-one mortgages with Harry, Sue and James.
So, people get imaginative. More specifically, the huge investment banks get imaginative.
These giant investment banks decide to buy all these mortgages, pull them all together and sell tranches(shares) of the pulled together mortgages as ‘Mortgaged Backed Securities’ to eager, greedy investors wanting big returns for perceived low risk.
Quickly this becomes a massive business, and these massive investment banks are literally rolling in dosh as they bunch together mortgages of average Americans and sell shares of them all on as Mortgaged Backed Securities to investors all across the financial and investment world. Now average working American Harry, Sue and James are paying their interest on their mortgage to the investors. Everyone is delighted and the figures running the casino on Wallstreet are declared ‘masters of the universe’, allegedly having cracked open the walls guarding the golden goose.
This business is so incredibly lucrative the US Federal government gets in on the act (no, really) and they start having sponsored corporations Freddie Mac and Fanny Mae selling Mortgage Backed Securities too. All in an attempt to boost mortgage lending even higher. Money, money money! Everyone’s smiles grow even larger.
Lenders were facing huge demand for the mortgages, which they’re eager to part with as soon as humanly possible and at ever larger scales. After all, every single time these mortgage lenders sell their rights to the mortgage interest payments (to the big investment banks) they get their money back. Which they can then use to loan out again.
Mortgage lending and home buying then rocket into the stratosphere. Now we have the insurance boys enter this game, eager to cash in as well. These chaps start flogging ‘Credit Default Swaps’, which pays out if a mortgage payer defaults. But why stop at just selling one Credit Default Swap policy per property? You have greedy speculators desperate to buy too. So…the insurance giants decide: it isn’t too risky to sell, say, ten Credit Default Swaps per property…right?
Risky? Nah, this is all free money…remember…house prices always go up, yeah? And who doesn’t pay their mortgage? Real estate will just keep going up.
Soon the amount of credit being insured leaps up from $900bn to more than $62trn (yes, trillion). Sure, the insurance firms absolutely don’t have enough capital on hand to cover such an astronomical number…but who cares? Real estate will keep going up, right?
But, what happens if you run out of solid, reliable (credit worthy) average Americans whose mortgage you can buy and sell on as a Mortgage Backed Security? Here’s where the problems began. After all, the mortgage lenders have no longer got ANY incentive to avoid risk taking (they’re selling on their mortgage loans remember). Some mortgage lenders begin taking enormous risks to keep the conveyor belt moving from average American Harry, Sue and James trying to buy their little piece of the American dream via the lenders onto the investment bank casinos in Wallstreet (all backed up by insurance firms guaranteeing the mortgages in event of non-payment).
The lenders start peddling loans to ever poorer working class Americans with bad credit scores and low incomes; promising them they can actually afford to buy that bigger house with the extra two bedrooms. And the poor working American Joe, a steelworker perhaps not understanding all these things just takes the word of the ‘experts’. After all, they must know what they’re talking about! I must actually be able to afford to buy that dream home, the lenders assure me I can afford it.
All is right in the world. Suddenly everyone hopes they too can be apart of the thriving American middle class. Apparently nobody at any point ever stops to check to see if some of these loans to the average Joe are predatory lending. Everyone is making too much fucking money, and real estate prices always go up, house prices always rise…and who doesn’t pay their mortgage…right?
Nobody pays any heed to the fact that now suddenly the zone is being flooded by predatory loans which promise *one year low interest payments on the mortgage* (which then balloon sky high after that year). Why does nobody notice? Because we’re all making too much damn money - so shut it and don’t rock the boat!
Investment bankers keep devouring all these mortgages the lenders are chucking their way, creating a massive sea of totemic risk which like a terminal cancer flows through every single cell of US and eventually world finance and banking.
All these seriously bad mortgages lent out to Americans who will simply never have a hope of ever paying them off make their way into all the mortgage backed securities. A situation made worse since the banks are paying people to ‘rate’ their tranches of mortgage backed securities, and the ratings being written down become increasingly indecipherable. But these are the investment bankers, they must know what this all means - yeah? They’re masters of the universe remember.
Now a massive, enormous time bomb is burning inside the balance sheets of so many big banks, insurance firms and big money investors that we have a crisis of epic proportions in the making.
The banks take things even further, and start flogging ‘Collateralised Debt Obligations’ (CDOs). These are similar to the Mortgage Backed Securities only *even riskier*. But the investment bankers in their casino skyscrapers are telling everyone these CDOs are risk free (even though they’re filling up with all the toxic assets of bad loans lent out to poor schmuck American Joe still dreaming for his chance to be a little bit richer and own that dream house.
But almost nobody notices or cares. Why? WE’RE ALL MAKING TOO MUCH FUCKING MONEY! So shut up, smile and enjoy it. After all, house prices always go up, real goes up…so long as that happens and everyone keeps paying their mortgage the balloon will never burst…
The USA has designed a system heading into 2006 where lenders don’t care about the risk of borrowers paying their mortgages back, investment banks don’t care about risk, insurance firms guaranteeing ever riskier mortgage backed trades and ratings agencies set up *for the people* but paid by the investment bankers.
What a total disaster just waiting to happen.
Then it did.
October 2007, 3% of all US mortgages are in the foreclosure process. A further 7% are one month past due and close to foreclosure. Now the banks are flooding the system with foreclosed (or soon to foreclose homes). Supply outpaces demand quickly…
2008 house prices do the unthinkable. They start to fall. The one thing nobody prepared for, and would be entirely lethal to the whole conveyor belt of epic risk.
The 2008 dominoes fall
21, Jan 2008: As US markets are closed for Martin Luther King Day, the FTSE 100 in the United Kingdom tumbles 323.5 points (5.5%): the largest crash since 9/11
22, Jan 2008: Panic begins continues to grow so the US Federal Reserve opts to cut interest rates by 0.75% to stimulate the economy. This was the largest drop in 25 years and the first emergency cut since 2001. It doesn’t work as U.S. stocks suffer the worst January since 2000 over concerns about the exposure of companies that issue bond insurance.
13, Feb: in the UK the Labour government completes the emergency nationalisation of collapsing Northern Rock bank.
17, March: Bear Stearns, with $46 billion of mortgage assets that had not been written down and $10 trillion in total assets, face bankruptcy.
In response the the imminent collapse of the giant Bear Stearns and the catastrophic damage it would inflict on a financial system already showing signs of major deterioration the Fed Reserve does the unthinkable.
In its first emergency meeting in 30 years, the Fed Reserve agreed to guarantee Bear’s crap loans using taxpayer cash. It also works to facilitate its acquisition by JPMorgan Chase for just $2/share. (A week earlier, Bear stock was trading at $60/share and a year earlier it traded for $178/share)
August: the economy starts to grow increasingly darker as US unemployment hits 6%, amid rising human suffering.
7, September: As Fannie Mae and Freddie Mac suddenly collapse amid a sea of losses as the US housing market collapses, a Federal takeover is quickly implemented. Taxpayer cash again.
15, September: The Fed refuses to guarantee Lehman as it did with Bear. As this happens talks by Lehman fails to convince Bank of America or Barkley’s to buy it. It files for Chapter 11 bankruptcy. The 157 year old Lehman Brothers bank collapses in a sea of losses totally $600bn, the worst bankruptcy in US history.
Same day as Lehman goes to the wall, sending a heart attack across global finance, news breaks same day that giant Merill Lynch is on the eve of bankruptcy too (which would end the financial system as we know it. Panicking, the US Fed scrambles to facilitate the sale of Merrill Lynch to Bank of America for $50 billion.
16 September: AIG had been a leading insurer guaranteeing the dodgy Credit Default Swaps etc and now all the mortgages were going into default and they were on the hook for billions in insurance pay-outs. It simply couldn’t afford to meet the obligations it had put itself on the line for.
After a phone call to the Federal Reserve, AIG confesses it’s only days away from running out of money and also going bankrupt. The Fed panics, realising AIG collapse would be a nuke exploding under the US economy given its massive size dishes out a MASSIVE $85 billion two-year loan to AIG to prevent its imminent disintegration. Ultimately AIG would grab $180 billion of taxpayer dosh as the Fed bails AIG out from the mess it had created for itself.
17 September: As the financial world seems to be disintegrating, investors withdrew $144 billion from U.S. money market funds, the equivalent of a bank run on money market funds. The crisis gets even worse. Close to end of history territory now.
18 September: In what should count as the single most important moment in the history of modern finance and economics, the United States Secretary of the Treasury Henry Paulson and Chair of the Federal Reserve Ben Bernanke met with Speaker of the United States House of Representatives Nancy Pelosi. They warn her the credit markets were close to a complete and irreversible meltdown. Bernanke directly tells Ms Pelosi he needs $700 billion of taxpayer dosh to acquire all the toxic mortgages. He says to her: "If we don't do this, we may not have an economy on Monday”
20 September: Paulson formally requests the U.S. Congress authorize a $700 billion fund to acquire toxic mortgages. He tells the politicians of Congress: “If it doesn't pass, then heaven help us all”
26 September: Washington Mutual goes bankrupt and the Federal Deposit Insurance Corporation had to seize it after a bank run occurs when panicked depositors withdrew $16.7 billion in only 10 days.
29 September: U.S Congress shocks Wallstreet and pushes the global financial system to the brink of total disintegration after it refuses to pass the requested banker bailout Paulson had begged for. By a vote of 225–208, with most Democrats in support and Republicans against, the House of Representatives rejected the Emergency Economic Stabilization Act of 2008, which included the $700 billion Troubled Asset Relief Program.
Same day Wachovia nearing collapse too finally reached a deal to sell itself to Citigroup. But the deal would have made shares worthless and so once again government funding is called in. Yet more taxpayer cash.
30, September: President George W. Bush attempts to once again force his own Republican party in Congress to pass an emergency bailout to stave off catastrophe. He tells the world “Congress must act. ...Our economy is depending on decisive action from the government”
1 October: The U.S. Senate passed the Emergency Economic Stabilization Act of 2008. This begins the massive taxpayer bailout of the idiotic, reckless casino investment bankers. It does nothing for Harry, Sue, James or average Joe - they all lose their houses as the banks scramble to foreclose on any property they can in hopes of building up assets to avert their own collapse.
2022-2023: Old problems, new problems
So taxpayers bailed out the bankers, but many still lose their homes. In coming years, desperate to reflate economic growth huge ‘quantitative easing’ (GE) (i.e. printing money) by central banks occurs to provide liquidity to a financial system gravely weakened by the 2008 financial crisis heart attacks. This helps gin up the inflationary crisis we face today, which is contributing to the cost of living crisis.
Now central banks (2023) need to tackle the inflationary crisis so hike up interest rates (slowing the economy) despite insisting (2022) inflation was merely temporary. As a result of the sudden hike in interest rates sky high despite assurances to the contrary by the Fed Reserve many institutions are caught out. This also happens as QE taps are shut off, ending the ‘easy money’ era. Now many financial institutions face a new wave of crisis, not the same as the 2008 financial crisis instead caused by its own unique problems. But it definitely occurs in the shadow of the 2008 disaster.
Ending the easy money era
WHAT does the Liability Driven Investment (LDI) crisis under Liz Truss premiership have in common with the collapse of Crypto giant FTX? It’s the same thread linking it to the demise of Silvergate and Silicon Valley Bank. Welcome to the end of the easy money era as interest rates are hiked up and quantitative easing is put in reverse.
While all the aforementioned crises can be explained by individual circumstances, nevertheless they all have one thing in common. They were all caught out by the rapid raising of interest rates by central banks across the world.
Putting things simply, what we are seeing right now is the onset of a new longer term economic environment. When central banks from the Federal Reserve in the USA to the Bank of England in dear old blighty faced the inflationary crises post-pandemic, interest rates were sent sky high to solve it. But the thing about rising interest rates dramatically high and fast is that it inevitably sends bond prices crashing down.
The bond market remember has an inverse relationship to interest rates. When the cost of borrowing money rises (interest rates rise), bond prices usually fall, and vice-versa. The reason for this is easy to grasp, most bonds pay a fixed interest rate that becomes more attractive if interest rates fall, driving up demand and the price of the bond.
But we aren’t talking about an economic environment of falling interest rates, we’re dealing with the reverse situation. Instead if interest rates rise - as is now the case on steroids - investors will no longer prefer the lower fixed interest rate paid by a bond, resulting in a decline in its price.
At the same time the era of quantitative easing (which had kept Europe breathing after the consequences of the 2008 Financial Crisis) has ended. These central banks have begun winding down QE and in some cases pushing things hard into reverse gear. The end result? A lot of financial ripples are going to be felt and quite a few players in the economy are going to be caught on the hop.
Under Liz Truss brief premiership UK pension funds found themselves scrambling when left holding LDIs which had assumed bond yields would never rise. The panic forced the Bank of England to step in to rescue pension funds and along the way brought down Truss government as collateral damage.
It’s easy - and true incidentally - to blame Truss and Kwarteng for the chaotic LDI pensions crisis that briefly unfolded. Yes, their decision to unveil an uncosted mini-budget sparked things, but the reality is the LDIs market the pension funds were playing in were under stress long before Truss simply tipped things over the edge.
The bet the UK pension funds were engaging in with their LDIs is ‘borrowing short’ and ‘lending long’. Borrowing short means the interest you pay on your borrowing changes rapidly. For example, if interest rates rise fast you pay much more per month. ‘Lending long’ means buying with the borrowed money, assets that yield a fixed and initially higher rate than your interest costs (in this case the assets were government bonds).
Here we see the linking thread which triggered the UK LDI crisis under Liz Truss: rising interest rates. Likewise in the case of the Silicon Valley Bank (SVB) collapse we find the same story of rising interest rates causing massive economic damage to those caught out.
If we examine SVB’s problems they all started with the investment boom that followed the start of the coronavirus pandemic. SVB is the go-to institution for most California venture capitalists and start-ups. Thus it found itself literally flush with cash as billions of deposits from young companies holding investor cash ran to SVB. As the Financial Times described it,
“There was so much money — almost $130bn in new deposits in 2020 and 2021 — that SVB could not lend it all out. Instead, they invested much of the money in long-term US government-backed bonds. The bonds have no credit risk, and because SVB’s deposits cost almost nothing, they were profitable, too, despite paying only a few percentage points of interest”
Pay extra attention to that last point, ‘despite paying only a few percentage points of interest’. That’s the key reason why SVB has disinterested this week. Their whole approach could only work while rates remained low.
They didn’t.
In the USA under the Biden administration the new economic challenge became slaying the dragon of inflation. As a result the Federal Reserve battled the dragon by raising interest rates. Thus suddenly deposits became more expensive. In just the past year, SVB’s deposit costs rose from 0.14 per cent to 2.33 per cent. In just one year. At the same time their yields on long government bonds didn’t budge.
Result? A profit squeeze beckoned and SVB discovered investors and depositors weren’t going to wait around for the bank to take measures to resolve the problem it faced. SVB - as with the UK LDI crisis exposed the consequences ahead as the easy money era was being brought to an end. Rising interest rates, turning off the QE taps all resulting in a collapse in bond prices, catching our actors in the economy on the hop.
Things are no different with the epic downfall of crypto giant FTX earlier in the year. It too exposes the truth of my argument here. This draining of liquidity, and a return of genuine yields on real assets such as Treasury bills has served to crash the price of the flimsier alternatives such as Bitcoin. Suddenly people want the real deal. Bitcoin is to be found in the ‘toy town’ section of the financial industry. Bitcoin suddenly becoming less attractive by comparison to Treasury Bill yields triggered the crisis at FTX. Sure, I accept that circumstances vary in each three of the cases I’ve outlined but a common thread runs through all of them: tightening of monetary policy was the root cause of each crisis. And, dear readers, a tightening monetary policy is here to stay for the foreseeable.
The music has ended…again
Over the course of last year the music facing the global economy and financial markets has been slowing down. Not stopping, just slowing. As central banks slowly inched interest rates up, they expected everyone to be listening and paying attention. But quite a few were deaf to the changing realities and now the music has stopped and a lot of actors in the economy are scrambling desperately to find a seat. Many will fail, and the economic pain will be felt widely and for a long time to come.
What worries me the most is that I simply do not think very many of our political class in the UK or even Scotland in particular, really understand things. Truss mini-budget ridiculousness exposes a fundamental economic illiteracy lurking in our governing political class. We should all be concerned about that.
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