The Crisis Goes Global
Chapter 3
The Crisis Goes Global
Introduction
The GFC has already proved itself a truly global and historic event. Although its genesis may well have been the US housing bubble, the GFC affected both developed and emerging nations. The crisis did not discriminate on any basis. Put simply, the consequences of the crisis have been devastating. The GFC has been responsible for destroying financial systems and government budgets, undermining market confidence and security in financial markets, and ushering in one of the most severe recessions since the Great Depression.
The GFC destroyed economic growth and real wealth. Unemployment rose to double-digit proportions in the United Sates and parts of Europe. Worldwide industrial production plummeted, bankruptcies rose and deflation began to take hold. The credit crisis that led to a freezing of short-term credit in money markets led to further home foreclosures and corporate collapses in the United States. The damage was not limited to the United States but spread to other parts of the world. The collapse of investment banks in the United Kingdom and Australia began to take their toll on investor sentiment, which was reflected in substantial falls in equity markets.
Banks and thrifts (retail deposit-taking institutions) also collapsed as the crisis moved from the shadow banking system and the sub-prime mortgage market to the mainstream banking sector. In the United States, mortgage originators Freddie Mac and Fannie Mae defaulted and required immediate government assistance to prevent their complete demise. Global investment banks Bear Stearns and Lehman Brothers collapsed under the weight of debt and investor uncertainty. Banks and thrifts, including the Wachovia Corporation, AIG and the Washington Mutual, all suffered a similar fate and were acquired by other major banks for a fraction of their previous market values.
The story of collapse, demise and rationalization was repeated in other developed countries, including the United Kingdom, Australia, Iceland, Ireland, Spain and Portugal. Neither were emerging economies spared the effects of the GFC, nor nations with large sovereign debt risk such as Ireland, Greece and Portugal. All of these events served to highlight the destructive nature of the global crisis.
The United States
US Sub-prime Mortgages: Freddie Mac and Fannie Mae
The United States was the epicentre of the GFC and the genesis of the crisis. Subprime mortgages that were sold to unsuspecting consumers were later repackaged and relabelled as “investments,” and sold to investors through the use of OTC swaps and synthetic derivatives. Sub-prime mortgages largely operated in the shadow banking system, with credit providers supplying mortgages to consumers who could ill afford the repayments. The sub-prime loans were essentially non-recourse, which meant that consumers could literally walk away from their mortgage by simply allowing the mortgagor to foreclose on the borrower’s home when the borrower fell behind with repayments.
Once defaults began, the house of cards that had been built on the sub-prime fault line began to unravel. Corporate collapses followed soon thereafter. At first, the giant mortgage originators Freddie Mac and Fannie Mae collapsed. These two entities alone accounted for over $US2 trillion worth of mortgages. Both Freddie Mac and Fannie Mae were highly active in the sub-prime mortgage market. As Wall Street investment banks began selling sub-prime mortgage-backed securities, Freddie Mac and Fannie Mae, along with other investors, were highly active in the market, purchasing billions of dollars of mortgages.1
Both Freddie Mac and Fannie Mae were no strangers to controversy. In 2007, following an investigation by the US Securities and Exchange Commission (SEC), Freddie Mac2 agreed to pay a $US50 million penalty for alleged securities fraud and related alleged violations in connection with misstating earnings,3 including alleged accounting irregularities.4 According to the SEC, the alleged securities violations were a direct result of a corporate culture at Freddie Mac “that placed emphasis on steady earnings, and a senior management that fostered a corporate image that was touted as ‘Steady Eddy’ to the marketplace.”5
Further, The US Financial Crisis Inquiry Commission reported that the Office of Federal Housing Enterprise Oversight (OFHEO) had also called Fannie Mae into question for alleged violations and accounting irregularities.6 The OFHEO prepared a very detailed report into an investigation that it had initiated into the earnings announcements made by Fannie Mae and filed with the SEC between 1998 and 2003.7
According to the specially commissioned report, “a large number of Fannie Mae’s accounting policies and practices did not comply with General Accepted Accounting Principles (GAPP).”8 Further, the OFHEO report found that “the Enterprise also had serious problems of internal control, financial reporting, and corporate governance.”9 The OFHEO also reported that Fannie Mae had taken on significant risk related directly to its operations and reputation.10 The build-up in risk, in turn, ultimately weakened both entities and exposed shareholders and taxpayers to considerable financial losses at the time of their collapse.
Banks and Thrifts: Wachovia and Washington Mutual
The demise of US banks Wachovia and Washington Mutual also served to highlight the damage brought about by the GFC. The liquidity crisis that emerged from the collapse of Lehman Brothers in September 2008 led to a funding crisis for both Wachovia and Washington Mutual Bank. Both banks were exposed to the toxic assets resulting from the acquisition and supply of sub-prime mortgages to its retail borrowers. In the final week of September 2008, both banks experienced a run on their deposits from anxious customers who were concerned about their potential collapse.
Wachovia and Washington Mutual were also placed under additional liquidity stress when their unsecured and secured borrowing capacity was further restricted.11 Market conditions for both banks deteriorated when investors and bondholders withdrew their support in financial markets, which led to considerable falls in their market value. The falls in the value of their securities led to a corresponding rise in their credit default swaps as lenders demanded higher returns for the banks’ higher expected risk.12 Meanwhile overnight funds and counterparties involved in short-term money markets and OTC swap markets demanded greater collateralization from both banks before they would resume lending.13
On 25 September 2008 Washington Mutual closed its doors. The FDIC organized a transfer of Washington Mutual’s retail deposit book, including its other assets, to JP Morgan Chase.14 On 26 September 2008 Wachovia approached the Federal Deposit Insurance Corporation (FDIC), claiming that it was unable to secure additional liquidity from the short-term money market to operate its business or loan book. The FDIC approached the US Treasury, requesting authorization for the FDIC to provide assistance to Citigroup, in order to enable Citigroup to purchase the net assets of Wachovia.15 The terms of the sale of Wachovia’s assets and its branches required Citigroup to provide an asset guarantee. The asset guarantee required Citigroup to cover $42 billion in initial losses and the FDIC to cover for any further losses beyond that amount.16
The collapse and subsequent asset transfers of both Wachovia and Washington Mutual underscore the gravity and systemic ramifications flowing from the GFC. Both banks were victims of the liquidity crisis that existed in short-term money markets. The GFC had now become systemic, moving initially from the US sub-prime mortgage market to infect the broader US financial sector, claiming mainstream banks as its new victims.
Investment Banks: Bear Stearns, AIG and Lehman Brothers
Bear Stearns was a global investment bank with its headquarters in New York. Founders Joseph Bear, Robert Stearns and Harold Meyer established the bank in 1923. Bear Stearns survived the Great Crash on Wall Street in 1929 and the Great Depression in the 1930s and became a global giant in merchant and investment banking in the 1980s and 1990s.
At the beginning of 2002 Bear Stearns became an active participant in the securitization of sub-prime mortgages. All appeared to be well for a while, as US house prices continued to rise and investors poured more of their capital into residential mortgages. However, like Lehman Brothers, Bear Stearns began to suffer a liquidity crisis in 2007. At the time the US bubble popped, investors, bondholders and counterparties in Bear Stearns became nervous and began to demand greater collateralization from the investment bank, threatening to restrict lending if their demands were not met. Swap spreads on Bear Stearns’ debt began to rise as concerns were raised that the investment bank would not have sufficient liquid assets to repay creditors in the case of default.
With heightened default risk, creditors demanded greater security as well as higher returns on the firm’s credit default swaps in OTC markets. Bear Stearns held vast sums of toxic sub-prime mortgages, which ran into billions of dollars. As the markets became nervous of sub-prime mortgages following the housing bubble meltdown, investors turned their focus to firms, which held potentially large write-downs of toxic assets.
In March 2008, Bear Stearns began to feel the acute pressure of the short-term money markets, with credit default swap spreads rising sharply. Its short-term liquidity position also deteriorated as the firm’s counterparties withdrew or restricted the provision of credit lines. Bear Stearns approached the Federal Reserve Bank of New York (FRBNY) for assistance. On 16 March 2008 the FRBNY released a statement,17 announcing that it would establish a Primary Dealer Credit Facility (PDCF),18 which was “intended to improve the ability of primary dealers to provide financing to participants in securitization markets and promote the orderly functioning of financial markets more generally.”19
Under the facility, announced on 24 March 2008, the FRBYN provided short-term financing to JP Morgan Chase for the purpose of facilitating JP Morgan’s purchase of Bear Stearns. The FRBYN would acquire a portfolio of assets from Bear Stearns valued at $US30 billion and the portfolio would be used as collateral to secure $US29 billion in short-term financing. Under the proposed acquisition agreement between J.P. Morgan and Bear Stearns and facilitated by the New York Federal Reserve, J.P. Morgan would absorb the first $US1 billion of any losses associated with the portfolio of Bear Stearns assets and any realized gains would accrue to the New York Fed. The portfolio of Bear Stearns assets, which included the toxic sub-prime mortgage-backed securities, would be managed by BlackRock Financial Management under strict guidelines administered by the FRBYN.20
American International Group (AIG) was another global financial, investment and insurance giant which would have suffered a similar fate to Bear Stearns had it not had assistance from the Federal Reserve Bank of New York. From about late August to early September 2008, the FRBNY considered that AIG’s short-term liquidity position had deteriorated as a result of volatile market conditions. The FRBNY quickly decided to act and on 16 September 2008 the US Federal Reserve announced that with the support of the US Treasury, the FRBNY would lend $US85 billion to AIG.21 The loan would be secured against assets belonging to AIG so as to provide protection to the US government and the American taxpayers in the case of any default by AIG.22
According to the Federal Reserve, the loan to AIG was necessary given the current circumstances, and to avoid “a disorderly failure of AIG, which could add to already significant levels of market fragility and lead to substantially higher borrowing costs, reduced household wealth, and materially weaker economic performance.”23
On 23 September 2008 AIG signed the loan agreement with the Federal Reserve Bank of New York to obtain access to the $US85 billion credit facility. The terms of the agreement allowed AIG access to the credit facility for a two-year period and interest would be at the LIBOR rate plus an additional 850 basis points (8.50%).24 Under the credit facility the New York Federal Reserve would borrow up to $US37.8 billion in investment-grade securities from AIG in return for providing cash under the facility.25
The actions of the Federal Reserve Bank of New York and the US Treasury in providing the much-needed line of credit to AIG were absolutely necessary given the circumstances at the time. Without these support measures, AIG would have faced considerable liquidity stress. The credit facility helped to stabilize AIG, providing the organization with sufficient short-term liquidity and enough time to enable AIG to sell assets in an orderly manner. The actions of the Federal Reserve and the US Treasury were designed to prevent the spread of systemic risk26 flowing from any further market-related disruptions that would undermine the stability of AIG.27
Lehman Brothers, a giant in the global investment bank arena, was also in major financial difficulties following the volatile market conditions in 2008. Concerns started to emerge after Lehman announced a $US2.8 billion loss in the second quarter of 2008.28 The earnings loss came after Lehman Brothers had attempted to strengthen their liquidity position by offering a $US4 billion public sale of its common stock in June 2008, as well as a $US2 billion public offering of preferred stock. In June 2008, the FRBYN undertook liquidity stress-testing of Lehman Brothers and concluded: “Lehman’s weak liquidity position is driven by its relatively large exposure to overnight CP, combined with significant overnight secured funding of less liquid assets.”29
As is discussed in Chapter 2, the attempts by the Federal Reserve and the US Treasury to prevent Lehman Brothers from filing for bankruptcy failed. Following the breakdown in talks with Lehman’s suitor, Barclays, Lehman Brothers filed for bankruptcy on 15 September 2008. As the Vice President and General Counsel of the Federal Reserve Bank of New York described the events leading up to Lehman’s bankruptcy:
By Monday, 15 September, Lehman faced a total erosion of market confidence, and so the Federal Reserve would have been lending into a classic run. Had Lehman not filed for bankruptcy on September 15, but opened as if it were business as usual, creditors and counterparties would have rushed to protect their positions, using all legal remedies, causing the liquidity crisis to spread throughout Lehman’s organization.30
One of the main sticking points for a successful deal for Lehman’s net assets with Barclays concerned the provision of a guarantee. The day immediately preceding Lehman’s bankruptcy, Barclays informed the Federal Reserve that it could not provide a guarantee for Lehman’s trading obligations without first obtaining a shareholder resolution. The shareholder vote was a requirement under UK law. Obtaining such a resolution could take considerable time, which Lehman and the Fed could ill afford. The Federal Reserve then enquired whether the UK market regulator, the Financial Services Authority (FSA), could waive the requirement that a guarantee be provided so as to facilitate the merger transaction between Lehman and Barclays.
The FSA refused to waive the requirement for Barclays to obtain shareholder approval for Lehman’s liabilities and continuing contractual obligations. Barclays suggested that in order for a deal to be completed the Federal Reserve would have to guarantee all of Lehman’s current and future liabilities. The precedent had been established for providing assistance with the rescue of Bear Stearns and AIG. With the bailout of Bear Stearns and AIG the Federal Reserve had provided significant financial resources to both entities in the form of loan agreements and the provision of credit facilities.31
However, as was pointed out by Baxter from the Federal Reserve Bank of New York, the Federal Reserve Board of Governors did not have the legal authority to provide a “naked guarantee.”32 As Baxter further pointed out, even with the passage of the Emergency Economic Stablization Act 2008, US law provides only the US Treasury with the legal authority and capacity to issue a guarantee.33 The Act does not provide the Federal Reserve with such powers.
The United Kingdom
The United Kingdom was not spared the fallout from the Lehman Brothers’ bankruptcy, nor was it immune from the economic consequences of the bursting US and global housing bubble. In September 2007, the UK began witnessing the first runs on the retail deposits of a UK bank since the reign of Queen Victoria.34 The run commenced on the British building society, Northern Rock plc.35 Northern Rock had started from humble beginnings in the 1990s to become a substantial player in the UK residential mortgage market. At the end of 2006, Northern Rock’s balance sheet recorded the value of its assets at over £100 billion sterling, with over 89% of the bank’s assets in residential mortgages.36
The large number of residential mortgages held by Northern Rock created a perception in the minds of investors and customers that Northern Rock could potentially collapse. With the issue playing on the minds of customers, a run on Northern Rock’s retail deposits began on the morning of 13 September 2007. As was described by the Parliamentary Enquiry into Northern Rock, the day had witnessed long queues of Northern Rock customers anxiously waiting for the branch doors to open so they could withdraw their deposits.37
Despite the run by depositors, evidence tendered before the Parliamentary Enquiry suggested that the asset book of Northern Rock had been of high quality. The problems experienced by Northern Rock were not caused by its asset book but, rather, its liabilities as represented by the way the bank had chosen to fund the purchase of its assets. Northern Rock had relied heavily on borrowings from wholesale markets to finance its aggressive growth in its asset base, including its market share of UK residential mortgages.38
The proportion of Northern Rock’s assets that were funded by wholesale markets instead of through retail deposits meant that Northern Rock had become increasingly dependent on funding through money markets.39 When the wholesale credit markets became dislocated as a result of the US sub-prime mortgage market, Northern Rock suffered a liquidity crisis because it faced increased difficulty in sourcing sufficient funding and credit in Britain’s money markets.40
The Parliamentary Enquiry concluded:
The directors of Northern Rock were the principal authors of the difficulties that the company has faced since August 2007. It is right that members of the Board of Northern Rock have been replaced, though haphazardly, since the company became dependent on liquidity support from the Bank of England. The high-risk, reckless business strategy of Northern Rock, with its reliance on short and medium term wholesale funding and an absence of sufficient insurance and a failure to arrange standby facility or cover that risk, meant that it was unable to cope with the liquidity pressures placed upon it by the freezing of international capital markets in August 2007.41