Triggers of the Crisis

Chapter 2
Triggers of the Crisis


Introduction


The triggers of the current economic and financial crisis continue to attract much attention and publicity. There have been a number of theories or explanations that have been put forward concerning the possible causes that have led to the greatest financial crisis since the Great Depression. It has been suggested that one key catalyst for the crisis was the aggressive build-up in many developed economies in household debt that was channeled into unproductive and speculative investments such as residential housing. The build-up in risk led to a bubble initially in the US housing market, which contributed significantly to the build-up of risk within the US economy and later spread to financial markets globally.


When US household debt was repackaged and securitized in the form of collateralized debt obligations (CDOs) and sold off to international investors, government entities, municipal councils, equity funds, pension funds, banks and investment banks, what initially commenced as a US problem spread globally to become truly international. The bursting of the US housing bubble was no doubt a significant contributing factor in explaining the current financial crisis. However, to simply assert that the US housing bubble caused the global financial crisis (GFC) would amount to an oversimplification of the current crisis. As is discussed in Chapter 1, previous crises have occurred throughout the world, including in the US, which have had various causal factors.


Perhaps a somewhat unique feature of the current crisis was the speed at which the Western world appeared to be engulfed by a catastrophic series of interrelated events. There is little doubt that the apparent dislocation of global financial and credit markets manifested themselves in the creation of an almost perfect storm. What is less clear is whether the dislocation of financial markets contributed to the current crisis or whether financial markets were merely symptomatic of a deteriorating global economic cycle that had already commenced.


Some commentators have suggested that financial markets are responsive to economic events, whilst others are of the view that financial markets have a more profound effect on the world economy. In any event, it is clear from the lessons of previous crises that economies that are confronted with recessions and downturns which are coupled with damaged or stressed financial systems ordinarily take a long time to heal. Certainly this was the case with the Great Depression in the 1930s and it appears to be the somewhat dismal conclusion of analyses of the current crisis. Described by the International Monetary Fund (IMF) as the “Great Recession,” this downturn will take a considerable time and sustained effort to unwind.


The United States Financial Crisis Inquiry Report


In the immediate aftermath of the GFC, a number of enquiries, public and private, were established to investigate, analyse and provide considered responses to the crisis. These enquiries have included some set up by international bodies such as the Group of Thirty (G30);1 the Financial Stability Forum;2 the Center for Financial Studies;3 the International Monetary Fund;4 and the US Treasury.


Perhaps one of the most influential commissions set up to investigate the causes and consequences of the GFC was the Financial Crisis Inquiry Commission, which was established to “examine the causes of the current financial and economic crisis in the United States.”5 The Final Report prepared by the Financial Crisis Inquiry Commission was delivered to the President of the United States, the US Congress and the American people in January 2011.6


A key finding of the Financial Crisis Inquiry Commission was that the GFC could have been avoided.7 According to the Commission, the GFC “was the result of human action and inaction, not of Mother Nature or computer models gone haywire.”8 This was an interesting finding from the Commission because it appeared to be concluding what was obvious. Yet despite this, suggestions had been made that human error was not the only cause of or contributing factor to the current crisis. Some believed that the crisis had been made worse because of computer modeling and the over-reliance by financial markets on the use of mathematical algorithms.


The suggestion that computer modeling and limitations associated with algorithms contributed to the crisis may sound far-fetched and lack substance. However, the former Chairman of the US Federal Reserve, Alan Greenspan, did express a view that the current crisis may not have been anticipated because of limitations in the risk management paradigm that was in place during the global crisis.9 Greenspan further asserts that reliance by market regulators as well as the US Federal Reserve on little or no meaningful data meant that authorities could not make informed decisions regarding the potential consequences and fallout resulting from a major corporate collapse, including the collapse of Lehman Brothers.10 So-called “tail risks” from a large-scale corporate collapse were not properly analysed or readily quantified.


Indeed, there is much force in the argument that the failure of market regulators to appreciate the fallout arising from the collapse of the Lehman behemoth did in fact make the crisis worse than might otherwise have been the case. As is discussed in Chapter 4, a key challenge for market regulators in dealing with the Lehman Brothers collapse and other large-scale corporate disasters concerned the issue of moral hazard. Market economics informs us that investment losses lie where they have fallen and are part of the risk return paradigm. If governments were to intervene and compensate investors for losses every time a company went broke, an unfair burden would be placed on taxpayers. Hence, it was not unsurprizing that taxpayer-funded bailouts in the form of the Troubled Assets Relief Program (TARP) in the United States proved controversial to say the least.11


The key finding from the Financial Crisis Inquiry Commission that the GFC was caused by human error and not by Mother Nature or by artificial means raises a number of interesting possible triggers. Importantly, there is no single factor or trigger that can explain the cause of the GFC. Instead, the GFC had a number of triggers, and while contributory factors on their own may have been insignificant, when combined they had widespread and long-lasting effects on the international financial markets and the global economy.


Trigger 1: The United States and the Global Housing Bubble


There is little doubt that the housing bubble in the US and other economies had a sizeable adverse impact on the crisis. Years of relatively cheap money channelled into largely unproductive and speculative housing investment contributed to inflated residential house prices. As interest rates remained low through the monetary policy settings of the Federal Reserve in the United States and in central banks in other countries, investment and construction in residential housing began to take off. This led in turn to higher residential real estate prices, which attracted the attention of investors and lenders worldwide.


The era of low interest rates at the beginning of 2001 in the United States and other parts of the developed world coincided with the 9/11 terrorist attacks in New York. Concerned that the terrorist attacks would induce a recession in the United States, the US Federal Reserve aggressively reduced key benchmark interest rates 11 times, so that the official cash rate stood at 1.75% at the end of 2001.12 According to the Financial Crisis Inquiry Commission, at the end of 2001 the United States had the “lowest [cash rate] in 40 years.”13


The US Federal Reserve was not alone in aggressively reducing interest rates in the immediate aftermath of the 9/11 terrorist attacks. Central banks in the United Kingdom, Australia and the European Union reduced interest rates over the same period. In the UK, the Bank of England reduced the official interest rate from a high of 6.00% in February 2000 to a 30-year low of 3.50% in May 2003.14 There was a similar aggressive reduction in interest rates in Australia, with the Reserve Bank of Australia reducing the official cash rate from a high of 6.25% in August 2000 to a 30-year low of 4.25% in December 2001.15 The European Central Bank cut its official bank rate for EU member states from 3.75% in 2000 to 1.00% in 2003.16


Before the Financial Crisis Inquiry Commission, former US Federal Reserve Chairman Alan Greenspan testified that he had expressed his concerns about the state of the US housing market as early as 2002 in the Federal Open Market Committee.17 The current Chairman of the Federal Reserve, Ben Bernanke, also raised similar concerns regarding the excessive growth of leverage and household debt in the United States and its consequential adverse effect on house prices.18


As is discussed in Chapter 1, the current crisis has interesting parallels with previous economic catastrophes, particular with the Great Depression of the 1930s. With the Great Depression there had been a large build-up in household debt in the period leading up to the Great Crash of 1929. Most household borrowings had been channelled into speculative and largely unproductive investments in stocks on Wall Street. As stock prices continued to rise, an increasing number of investors with higher debt levels were required to continue to propel stock prices higher. When the great bull run of the 1920s ended, the stock price bubble also ended and precipitated the Great Crash on Wall Street in 1929 and then again in 1932.


Both the Great Depression and the current crisis were underpinned by excessive leverage and speculation in unproductive assets. The lure of higher prices led investors and lenders into a dangerous feedback loop whereby asset prices (stock prices in the 1920s and house prices between 2000 and 2007) were pushed ever higher, with alarming levels of debt. We know from our history that asset bubbles do not always go in one direction – upwards. By definition, a bubble must deflate at some point in time. The Great Depression followed the Crash of 1929 on Wall Street, which deflated stock prices suddenly in one day. Similarly, the equally spectacular sub-prime mortgage implosion in the United States in 2007 and 2008 led to a great crash in residential house prices in most developed countries.19


The current US Federal Reserve Chairman, Ben Bernanke, investigated the link between US house prices and easy monetary policy.20 Other economists have also explored the link.21 According to Bernanke, US house prices rose strongly in the 1990s in the period prior to the easing of monetary policy. Similarly, house prices rose in other countries over the same period. Hence, when previous periods are taken into account, the link between house prices and monetary policy is less convincing.22 Bernanke suggests that a much stronger relationship may in fact exist between US house prices and capital inflows from emerging markets, which may well have been channelled into US housing and residential construction, and this might provide a better explanation for the rise in US house prices.23


What we also know from our history of previous crises is that not all deflating bubbles lead to, or contribute to, economic recessions or depressions. Sometimes a bubble will burst and asset prices deflate over time, or remain flat, and the economic consequences tend to be somewhat benign or inconsequential. Economists often refer to such occurrences as a “soft landing.” The corollary to a soft landing is a “hard landing,” which by its very nature conjures more severe consequences, often leading to recessions, higher unemployment and bouts of deflation. The severity of the ensuing recession following a deflating asset bubble varies from mild – as is evidenced by the dot-com bubble bursting in early 2000 – to the more severe, such as the Great Depression of the 1930s and the current Great Recession.


It is not known for certain what makes a bubble burst, nor is it clear why some deflating bubbles lead to inconsequential outcomes for the wider economy, whilst others lead to significant, widespread and systemic downturns. The supporters of Keynesian theory have suggested that government intervention can smooth out erratic business cycles through expansionary fiscal policy. Taking this one step further, expansionary monetary policy can also aid in providing additional stimulus to a depressed economy. Supporters of this approach have argued that through expansionary measures the economy can overcome the debilitating effects of a deflating bubble.


As is discussed in Chapter 5, the use of scarce taxpayer funds to prop up or bail out investors, entities and public and private pension funds is not without controversy. Arguments that are used in support of such strategy usually involve considerations of balancing the needs of society on the one hand with the desire to maintain appropriate moral hazard standards on the other. If governments become too liberal in their support of investors and provide full or partial compensation for their current losses, investors can lack sufficient discipline to properly scrutinize future investments. In this sense a hazard is created, because investors could take excessive risks with their investment decisions, comfortable in the knowledge that if an investment does not turn out as they had expected, governments would subsidize any losses they incur.


The ongoing debate as to whether the US Federal Reserve, the US Treasury, or any other governmental authority should step in to bail out distressed entities, or purchase toxic assets from private banks and investors, further contributed to unnecessary delay. Delay, and even inaction, in turn exacerbated the crisis. As is discussed in Chapter 3, the decision by the US Treasury and the US Federal Reserve not to bail out Lehman Brothers was possibly the single largest contributory factor undermining confidence in financial markets.


Trigger 2: The Collapse of Lehman Brothers and the Global Credit Freeze


The collapse of Lehman Brothers was, in a word, enormous. In the early part of 2000, Lehman Brothers epitomized the Masters of the Universe analogy. The firm appeared to be successful, profitable and engaged in developing and actively participating in innovative financial products and markets. The firm delivered to its clients sophisticated financial solutions and, at the same time, delivered itself significant windfall gains. What was not clear at the time was the inherent build-up of risk the firm was absorbing, a situation most likely made worse by rising asset prices fuelled by low interest rates.


At the time Lehman was on the brink, the US Federal Reserve and the US Department of the Treasury frantically worked on a strategy to prevent the firm from filing for bankruptcy.24 Part of the strategy involved Barclays Bank in the UK purchasing the net assets of Lehman Brothers; with this buyout Lehman Brothers would avoid filing for bankruptcy. Initially it appeared that Barclays and Lehman had both agreed to the buyout and as a result Lehman would avoid filing for bankruptcy. However, the buyout between Lehman Brothers and Barclays did not occur. It appeared that Barclays was required under UK law to obtain the approval of the market regulator, the Financial Services Authority (FSA). The FSA refused to approve the deal allowing Barclays Bank to acquire Lehman Brothers. According to the Financial Crisis Inquiry, the main stumbling block to the prearranged deal concerned the issue of a guarantee. The Federal Reserve required Barclays to “guarantee Lehman’s obligations from the sale until the transaction closed.”25 According to UK law, Barclays was required to seek shareholder approval before it could proceed to acquire Lehman Brothers and provide the necessary guarantee. In any event, the FSA did not want Barclays to take on the guarantee, fearing that Barclays could be burdened with Lehman’s debts and future repayment obligations for years to come.


Instead of providing approval for the buyout, the FSA proposed that the US Federal Reserve provide the guarantee as a necessary precondition for the deal to go ahead. With the US Federal Reserve guaranteeing Lehman’s future obligations Barclays and, more importantly, Barclays shareholders, would be provided with greater financial certainty regarding Lehman’s outstanding obligations. The US Federal Reserve and the US Treasury refused to take on the guarantee. As there was a stalemate between the FSA, the US Federal Reserve and the US Treasury, Lehman was left with no choice but to file for bankruptcy. And file it did.


On 15 September 2008 Lehman Brothers issued a press statement announcing that it intended to file for bankruptcy under Chapter 11 of the United States Bankruptcy Code with the United States Bankruptcy Court for the Southern District of New York.26 Lehman’s bankruptcy was the largest in US corporate history, with estimated debts of over $US600 billion.


Lehman’s bankruptcy was felt immediately on stock markets all over the world. The Dow Jones Industrial Index fell by over 500 points in a single day. Similar falls were recorded on bourses all over the world, including in Europe, Asia and Australia. What would be less clear at the time of Lehman’s collapse was the effect it would have on credit and debt markets and, in particular, the effect its collapse would have on the availability and supply of credit all over the world.


Almost immediately, from the time Lehman collapsed, credit and debt markets began to seize up. The freezing of credit markets worldwide resulted in devastating consequences in the real economy. What began as isolated events now had systemic implications. As the German Chancellor, Angela Merkel, remarked in early 2009, there was now a vital need to restore trust and confidence in the world’s financial markets.27


The freezing of credit markets at the beginning of 2009 continued unabated throughout the first half of 2010. The functioning of credit markets was distorted because lenders restricted and in some cases refused to lend money, on the basis that the borrowers might not have the ability to repay their loans. Following the decline in real estate and asset prices, collateral had become next to worthless as banks tightened lending standards. Confronted with the spectre of significant losses, lenders withdrew from credit and debt markets and tightened further their lending standards. This, in turn, restricted lending to many businesses and investors began to panic, bringing a number of businesses, including investment banks and other financial institutions, to the brink of failure.28


In a speech delivered in 2009, the US Federal Reserve Chairman, Ben Bernanke, attempted to give proper meaning to the extraordinary events in 2008, including the collapse of Lehman Brothers and its dramatic effect on global markets.29 Bernanke asked “How should we interpret the extraordinary events of the past year, particularly the sharp intensification of the financial crisis in September and October?”30 He essentially answered the question by describing the events as reminiscent of a “classic panic,” which can be described as “collectively irrational,” but “entirely rational at the individual level.”31 As Bernanke correctly pointed out, the actions are rational at the individual level because “each market participant has a strong incentive to be among the first to the exit.”32


According to Bernanke, the world’s financial markets, including those in the United States, exhibited features of panic. The crisis following Lehman Brothers’ collapse led to a freezing of credit markets. Financial markets had become dislocated. Without proper functioning of credit markets, the availability of short-term credit began to dry up. The rapidly reducing supply of credit led to even larger declines in asset prices. As asset prices began to fall, banks were reluctant to lend, which in turn affected short-term liquidity. Hence, a feedback loop had emerged with diminishing available credit and reduced liquidity causing ever-greater declines in asset prices.


Trigger 3: Systemic Market Failure


There is little doubt that the GFC demonstrated significant market failure. This was especially the case at the time of Lehman’s collapse. Financial markets all over the world became dislocated. Credit markets were frozen, lenders withdrew funding and tightened lending standards, short-term liquidity dried up and asset prices continued to fall.


There are several strands of market failure that epitomized the GFC. First, there was the initial US and global housing bubble, which resulted in significant house price rises, particularly during the 1990s and up to 2007, culminating in the formation of a formidable bubble. Second, the collapse of Lehman Brothers, as well as other notable collapses (or near collapses) in the United States, including mortgage originators Fannie Mae and Freddie Mac, AIG, Bear Stearns, Washington Mutual, Wachovia Bank and other regional US banks. In the United Kingdom, the collapse of Northern Rock undermined consumer and investor sentiment. In Australia the collapse of Babcock and Brown (the second largest investment bank) and Allco Finance Group (the third largest investment bank) adversely affected market sentiment.


Third, the creation of exotic and opaque financial products, including credit default swaps and CDOs, all continued to make the financial crisis much worse. The markets for these products were largely non-transparent, confusing and perhaps even misleading, especially for ordinary retail investors. Even sophisticated institutional investors fell victim to the complexity of such instruments.33