Ten Years After

9 August 2007 was the day that Adam Applegarth, then boss of Northern Rock, called "the day the world changed", marking the start of the global financial crisis when the financial markets stopped working.

Of course we all know why it happened, don't we? Those stupid NINJA (No Income, No Job, no Assets) sub-prime mortgages in the USA. Well, not exactly, though they were a big part of the loss of confidence that was the main driver. Why did those idiots think sub-prime loans made sense?

A young banker at Lehman Brothers explained how it worked to his bosses in 2007. Handing money to one person who was constantly in and out of work was obviously risky, but handing it to 100 such people at the same time was much safer. Statistically there was a negligible probability of most of them losing their jobs at the same time, especially if they were spread over the whole country, so bundling them together magically transformed risky loans into a safe portfolio. Investors rushed to snap them up and 25% of the UK mortgage market was soon funded by this financial sleight of hand. Bananas. Except that it did actually turn out that way. Hardly any of the loans subsequently branded "toxic" lost money. Almost every toxic credit instrument turned out fine. 92% of over 81,000 AAA rated structured finance securities issued between 1993 and 2016 repaid investors in full, without missing a single interest payment, according to Moody's. In Europe only one-third of one percent of sub-prime bonds lost money. So what was it all about?

I've often said that the crisis was really mainly a good old-fashioned property bubble. Certainly this was the case in the Republic of Ireland and Spain, both of which had artificially low interest rates for their economies having joined the euro, a situation that friends may remember me calling a fascinating economic experiment. I predicted, at the time, that it would end in some kind of bust for those countries as their economies over-heated due to the step change down in interest rates which would normally produce an inflationary boom and a currency devaluation. In the euro this couldn't happen, so the rebalancing might come about through unemployment as those economies became uncompetitive on price, jobs were lost and debt issues emerged as loans at inflated prices turned into bad debts. The financial crisis short-circuited this process, but I would argue that is basically what happened in countries like Ireland and Spain.

Meanwhile the banks caught more than a cold because the loans couldn't be repaid. Except that ain't what happened either. I'm not sure why BNP Paribas, the French bank that was the harbinger of doom, got into trouble though I read that there had been a run on hedge funds it controlled. But often the trigger incident isn't necessarily the root cause. Sensing fear among global traders the US Fed and ECB started pumping money into the system at unprecedented levels, but the Bank of England ignored pleas to do the same, Mervyn King tutting about "moral hazard". At that stage he felt investors had to suffer if there were problems, to avoid the expectation that risky behaviour would be underwritten by bailouts leading to more risky behaviour. But a month later Northern Rock had to be supported as King didn't want moral hazard to extend to the queues of savers seeking to withdraw their cash. By February 2008 it was nationalised after two failed sale attempts. But the Rock didn't get into trouble because of sub-prime loans either. The bank, which had long been a traditional mutual, had grown rapidly by borrowing in the markets and offering racy mortgage deals - up to 125% mortgages, which I remember puzzling me at the time - how can that be a secured loan? But what sank it was the fact that it relied on international markets for 40% of its funding. My recollection is that many of the bonds that were the source of funding were on 3 year terms when their mortgages were of course on much longer terms. So every year they needed to raise money to cover their existing portfolio and more again to fuel their brisk expansion. When the markets "stopped working" the Rock was essentially insolvent overnight. So their business model proved to be flawed, but not because of the mortgage risk, as proved by the fact that the government made a £10m profit when its loan book was finally sold in 2015.

It can be argued that these loans and sub-prime loans in general turned out fine because governments printed vast amounts of money to prop up the global economy, underpinning asset values. But either way, many sub-prime court cases brought against banks have been settled by the lenders just buying back the bonds at face value, because they just aren't toxic.

Whatever the causes, real or imagined, markets got spooked and the system gummed up, with banks all eyeing each other and trying to second guess whose losses would be biggest. In a Mexican stand-off, they stopped buying, selling and lending to each other. Iain Dey suggests that this problem was exacerbated by the actions of a Scottish banker. No not ex-Sir Fred Goodwin of RBS, the still-Sir David Tweedie. "Who was he?" I hear many of you ask, apart maybe from the Chartered Accountants among you. Tweedie was the head of the International Accounting Standards Board and he oversaw the implementation of "mark-to-market" accounting, where everything on a company's asset book should be valued at the current clearing price. To be fair, Tweedie was reacting to the Enron and WorldCom scandals. But the effect, when no-one will buy or sell, is that assets which clearly have some value have a current market price of zero. Mark-to-market pricing helped turn transitory, paper losses into crystallised pounds and pence. The law of unintended consequences was never writ larger.

This all lead to the scariest moment of the financial crisis, when Lord Darling (then plain Alistair and Chancellor of the Exchequer) was called out of a meeting of European finance ministers in 2008 to take a call from Tom McKillop, the then chairman of RBS, to be told that the bank was haemorrhaging money. RBS was then the world's largest bank and about the size of the whole UK economy. Darling asked how long they could last, expecting an answer in terms of a number of days, but was told "We're going to run out of money in the early afternoon". So an immediate bail out was essential: there really was no alternative. People sometimes complain that "the bankers got bailed out". No, the banks got bailed out, else ordinary people wouldn't have been able to get at their cash. Unthinkable.

When I heard that ATMs might have run dry, remembering the old adage that anarchy is only three missed meals away, I freely admit to spooking my wife by insisting that we stocked up on tinned food, never got short of cash, or let the cars get low on petrol. A couple of years later we had delights such as spam and chips for dinner as my emergency supplies were going out of date. Meanwhile she got heartily fed up of me saying "there'll be a lost decade, kind of like Japan's had". The phrase "lost decade" has been used quite a bit lately, in terms of productivity and real levels of pay in our economy, but I didn't think it needed much of a crystal ball: you can get into debt quite quickly, but it's always drawn out and painful paying it off.

Where does this leave us? With some arguing that the new regulations brought in since the crisis are helping to create another bubble. Banks are much safer, with higher capital reserves, though of course the fact that they have had to build up those reserves rather than lending the money has held back the economy. Complaints from politicians that the banks won't lend have always puzzled me, since they ordained it. But while the system should be more resilient, the performance of the banks has been hit. The average return on equity for bank shareholders has dropped from 25% to 10%, pushing the banks to make riskier loans. "Banks are struggling to make returns, so they are creeping out along the risk curve" Dey quotes a senior financier. This is not dissimilar to before the crisis. There is a quest for yield, hence pushing credit cards, car finance deals etc. Concentrations of risk are also a by-product of the new rules. With banks encouraged to make "safer" types of loan, they are behaving like a herd, with risk accumulating in more specific places.

Indeed, the main reason the taxpayer will lose money on its stake in RBS, unlike Lloyds, is that RBS, being majority owned by the government, has had to get rid of all its most profitable bits and concentrate on less profitable retail banking, condemning it to low returns and a total inability to cover its debt write offs. While Barclays stayed out of the clutches of the state (and don't the Treasury still hate them for it) their business has also been harmed, partly by having to also tone down its investment banking activities and partly because of the damage from the LIBOR rate fixing scandal, when arguably its chief executive Bob Diamond was wrongfully squeezed out after Barclays did what it thought the Bank of England wanted, i.e. report falsely low numbers for the rate it had to pay other banks to borrow money. I still think the underlying cause for the actual Barclays rate being higher was that the other British banks were underwritten by the government, so of course they could borrow money more cheaply. Barclays reported false numbers, the Bank of England was happy and the markets breathed a sigh of relief. It was one of the moments in the crisis when it felt we were moving into safer waters. I'm not necessarily suggesting this was a victimless crime, but the Bank and the Treasury didn't ask any of the obvious questions at the time. I would argue they were complicit and even that it might have worked out for the best, apart from the obvious risk of encouraging false reporting in the future.

You'll have noted that none of the above root causes or triggers had anything whatsoever to do with investment banking. Vince Cable isn't the only one not to have realised this, though perhaps he's the best known. His repetition of the phrase "casino banking" like a vinyl record stuck for years reveals either a deep or wilful misunderstanding of what actually happened in the financial crisis. He's not the only economically illiterate politician by any means but until and unless he changes this tune I won't pay any attention to anything he suggests about what economic policy should be in the future.

Meanwhile some other "experts" are arguing that Northern Rock style 100% mortgages weren't a bad thing and should be reintroduced to avoid a housing market disaster (see the Telegraph article referenced below: Ten years after Northern Rock: bring back 100pc mortgages to fix the housing crisis), while others argue that Britain's consumer debt is out of control. Those who play down the risks offer exactly the same rationale as before the crisis: everything is backed by bricks and mortar. As it was last time. "Maybe they are right, maybe they are not" says Dey.

As I have remarked before, we are kidding ourselves a decade on if we think that things are back to normal. Siren voices say we should spend and borrow more, even though our government debt ratios are still very much worse than before the crisis. Interest rates remain at long term historical lows and have been there for an unprecedented length of time. Quantitative easing has not been wound back and the government is sitting on its purchases expecting it will get its money back (OK, apart from RBS). The next crisis may not be just round the corner, but if it is we will be in much worse shape to react to it.

And while markets here, in the EU and the USA seem to be going well, asset values are still underpinned by government money, with any hint that monetary policy might tighten or quantitative easing be withdrawn causing jitters, though the US has at least started to try to move towards normality. Growth in the EU has finally improved, but only because the ECB got round to quantitative easing quite some time after the UK and USA. Victory can only be declared when life support has been fully withdrawn. "With the best will in the world, winding this down is a phenomenally difficult task. It could take another 5 or 10 years to return to normal" James Nixon, the chief European economist at Oxford Economics was quoted as saying.

And those markets are showing some signs of stress. The dividend cover ratio (company profits divided by payouts to shareholders) is at its lowest for 7 years, points out Ian Cowie. Share Centre, an online stock broker, says that dividends paid out by Britain's biggest 350 companies have exceeded their after-tax profits for 5 consecutive quarters. Not only is that clearly unsustainable, the last time it happened was in 2008.

But I'm not stocking up on Spam. Yet.

PS sorry if you thought this was going to be a music post, Alvin Lee, Love Like A Man and all that! Though the phrase "and more again" recalls the Love song from the famous 1967 album Forever Changes, a year on from their single 7 and 7 is after which this blog is titled.

Sources:
Ten years on from the crisis, Iain Dey, Sunday Times 6 August 2017
Wikipedia: Nationalisation of Northern Rock
The Telegraph. Ten years after Northern Rock... 6 Aug 2017
The Telegraph. Lord Darling reveals scariest moment of the financial crisis. 9 August 2017
James Nixon was quoted in the Sunday Times on 6 August 2017 by Tommy Stubbington in a piece sub-titled "Europe's economy is flying, prompting plaudits for the president of the ECB. But will it all hold together when he sucks money out of the system"
Ian Cowie's piece "Hold on tight: the road may be getting a little Northern Rocky" was in the Sunday Times on 30 July 2017
and a rehashing of my own amateur analysis from time to time since the introduction of the euro in 1999.