Where the Credit Crash came from

Awash with cash in a low-interest rate climate, the financial institutions started lending with an astonishing disregard for risk. The crisis came when they realised that payback time would never come. Alex Brummer looks across the abyss.

by
Last Updated: 09 Oct 2013

August 9, 2007 dawned like any other quiet summer's day in the world's financial centres. London and Frankfurt were dry and cloudy. Even New York was not as hot and humid as normal in August. The dealing rooms in the big investment banks flickered to life in the usual way - although, because it was August, trading seemed less frenetic and there were more empty desks.

The Masters of the Universe, the supermen and superwomen who run the world's largest banks, were on yachts in the Mediterranean or entertaining at beach homes in the Hamptons. Jean-Claude Trichet, president of the European Central Bank, was taking it easy in Saint-Malo, the rocky port on the Brittany coast, where he relaxes among the motor and sailing boats. His counterparts Ben Bernanke of the Federal Reserve and Mervyn King, Governor of the Bank of England, were both, however, at their desks. King presents his Inflation Report in August and the Federal Reserve had an interest rate decision to deliver.

Early that morning, Trichet's BlackBerry pinged quietly. But the courtly ECB chief with the matinee idol looks had yet to come to terms with this particular technology; colleagues eventually reached him by mobile phone. The message from his Frankfurt office was not comforting. France's largest bank, BNP Paribas, was teetering. It had revealed that two off-balance-sheet funds had loaded up on securities based around American trailer park mortgages. And at least one German bank - IKB - was in similar difficulties. Others, including two of the big regional Landesbanken, possibly had similar problems. The inter-bank markets (through which banks lend to each other) had become so nervous about sub-prime lending that the credit markets had frozen over. A day later, Northern Rock chief executive Adam Applegarth admitted to its regulator, the Financial Services Authority, that it had only enough cash in its coffers to hold out until the end of the month.

Banks simply would not lend to fellow banks - they had lost trust in each other's balance sheet. The Credit Crunch had begun. The world was facing what the normally undramatic International Monetary Fund described as 'the largest financial shock since the Great Depression'. Equity markets around the globe were in freefall. The debt-fuelled binge that had propelled the world economy forward over the early years of this decade was coming to an abrupt end.

The origins of this freeze in financial markets date back to 9/11 and the collapse of the dot.com bubble shortly after. The chairman of the Federal Reserve at the time, Alan Greenspan, was desperate to avoid recession on his watch. He also feared deflation, as cheap goods flowed out of Asia Pacific and China, pushing down prices everywhere, from Fifth Avenue to Oxford Street. Greenspan's answer was to cut interest rates, and keep cutting them. Other central banks, including the Bank of England, followed suit. The global plumbing that had clogged up on 9/11 was cleaned through, the system flooded with cash and US interest rates were eventually cut to just 1%.

Money on both sides of the Atlantic was cheaper than it had been for decades. The banks, desperate to increase both their profits and the bonuses paid to their star performers, began an extraordinary lending bonanza. Initially, there was a search for 'yield' - higher returns at a time when interest rates were low. Lenders like New Century and Countrywide Financial in the US - both of which were later to come unstuck - came up with a great yield-enhancing ruse. By lending to the poorest sections of society, from the streets of downtown Cleveland, Ohio to the trailer parks of California, they found they could charge higher interest rates.

The investment banks would do the rest. They'd turn these high-risk, poor-quality loans into marketable securities. These would be sliced and diced, packaged up, stamped with the double-A and triple-A credit rating seal of approval and sold on. On this flimsy foundation would be built a mountain of new financial instruments and off-balance sheet vehicles. Eventually, the scale of the toxic debt on the balance sheets of banks and other financial institutions would grow to an astounding $945bn (£500bn). On this pile of sand the investment banks created a huge new credit derivatives market, which would be measured not in billion but in trillions. When Bear Stearns collapsed earlier this year, it was revealed that the bank was at the vortex of $10trn of such transactions. If it had been allowed to go down, it might have taken great chunks of Wall Street with it.

The economist JK Galbraith (1908-2006) observed that all financial crises are caused by excessive borrowing or 'leverage'. In each boom, the rapacious bankers find new names to disguise their foolishness. In the bubble of 2002-07, the new instruments were called 'collateralised debt obligations' and no-one questioned their underlying value. They were held on bank balance sheets because of their high returns; in some cases, they even replaced traditional securities like government stock. Changes in banking regulation, the so called Basel 2 rules, made it easier for banks to go on lending, irrespective of the quality of the underlying capital, because most now did their own risk-assessment.

In Britain, the lending spree led to a credit explosion. By 2006, total credit in the UK economy, including both mortgages and credit cards, reached £1,300bn, a sum equal to the nation's total output. There were literally hundreds of mortgages on offer, many at huge discounts, and consumers would receive offers of new credit cards in the post each day, irrespective of their ability to pay them off. The banks were on a roll, profits were climbing exponentially and they were continuing to find new people to lend to. In the late stages of the credit build-up of 2005-06, billions of pounds were lent to hedge funds and private equity firms to buy out household names such as Debenhams, Alliance Boots and BAA. Bankers thought they could do no wrong and their regulators seemed to nod in agreement.

The regulators gave the banks effective carte blanche to lend without constraint. Advice by former Bank of England deputy governor Sir Andrew Large that banks should hold more liquidity in cash and Treasury securities in their balance sheets, in case the global economy slowed down, went unheeded.

Indeed, the regulators themselves were divided. In its two 2006 risk reports, Britain's super-regulator the FSA drew attention to the huge profitability of the banks as a reason why investors need not worry about a credit implosion. The banks had never been so profitable, so now the world was safe. This proved to be a myth. When the realisation dawned that those American sub-prime loans were worth just pennies in the pound, the brakes were slammed on. Mortgage lenders cut back their exposure, credit card limits were slashed and the US economy fell into recession in 2008, with growth in Britain strangled. With its huge exposure to the financial sector, the UK would prove more vulnerable than almost any other Western economy bar the US.

Trichet, the most seasoned of the world's central bankers, knew exactly what to do when the Crunch began in August last year. In a series of faxes and mobile phone calls, he ordered his colleagues to pump massive assistance into the inter-bank market. In by far the biggest intervention in the ECB's history, it offered banks that were short of cash up to EUR95bn (£69bn) in short-term and overnight loans. The ECB was also less restricted than other central banks in the collateral it could take against these loans - mortgage loans were acceptable security.

In the City of London, Europe's main financial centre, Mervyn King was keeping a close watch on events but decided to do nothing. The Bank of England, he believed, had a perfectly acceptable system for making sure that UK banks remained liquid. They could bid for reserves at the Bank's regular auction. If they needed extra funds overnight, they would pay the 'penalty' rate of one full point over Libor (then 5.75%). The commercial banks had to understand there could be no free ride. They should not feel able to behave imprudently in the upswing of the economic cycle, in the expectation that central bankers would come running to their rescue at the first sign of trouble. Such behaviour would constitute what the Governor believed was 'moral hazard'. Bankers would go on taking ever bigger risks, secure in the knowledge that the central bank would always bail them out if things went wrong.

In New York, the bearded and fiercely intellectual chairman of the Federal Reserve Board, Ben Bernanke, was feeling his way in his new job. But he had close Wall Street connections through the operational arm of the central banking system, the Federal Reserve Bank of New York. Its activist board is peopled by the heads of some of Manhattan's biggest financial outfits and acts like the Fed's internal lobby group. Urged to follow Trichet's lead, Bernanke spent $28bn on day one of the Crunch making sure the US banking system remained liquid, a sum increased the next day.

In the UK - Newcastle, to be precise - Adam Applegarth, the normally confident CEO of Northern Rock, recognised that he might have a serious problem. The former building society had adopted what it - and much of the City - saw as a brilliant strategy. Instead of lending against the funds it took in as deposits through its branches, it had a bolder approach. It packaged up its mortgages into parcels, turned them into tradeable securities and sold them on, thus raising cash for new lending. As a result, just 30% of its mortgage loans were funded from retail deposits, and 70% in the wholesale markets. By contrast, Lloyds TSB funding ratio was the exact reverse. Northern Rock's unconventional funding model enabled it to grow quickly; it had become an aggressive lender.

Early in 2007, Applegarth went on a lending spree. At the same time, other major mortgage providers - including Halifax Bank of Scotland - were reining in their activities, fearing that the UK housing market had become overheated. By June, the relatively modest Newcastle lender had grabbed 20% of the new-mortgage market: an astonishing achievement. And Applegarth had done it all without a murmur from his board - which included at least one heavyweight banker, Sir Derek Wanless - or the FSA.

When the credit markets froze on August 9, Applegarth found himself in the same pickle as the French and German banks that had been temporarily assisted by the ECB. But he could not expect the same easy treatment. First, his model of securitisation was suddenly being viewed with great suspicion: he was doing exactly what the US banks had been doing with the sub-prime mortgages that caused the mess in the first place. Panicky markets were not prepared distinguish Northern Rock's reasonably solid mortgages on British homes from the rotten loans made in the US. Second, whereas the ECB and the Fed were taking a benign view of banking behaviour and opting to bail the system out, Britain's central banker, King, was not, at first, inclined to do the same.

On August 10, the day after the markets froze, Applegarth told the FSA that his company had only enough liquidity - ready cash - to see it through to early September. If the big freeze in credit markets were to continue beyond then, the bank would need help. On August 14, the FSA's chief executive scheduled a call with the Bank of England and the Treasury to inform them of the Rock's problems. The Tripartite - T3 to insiders - had effectively been convened for the first time. Yet there was no immediate evidence that either the Bank or the chancellor (then relaxing poolside at a Mallorcan villa) had any idea of the looming crisis.

The task of finding either a buyer for the Rock or long-term funding was given to its broker Merrill Lynch, in the form of pugnacious investment banker Matt Greenberg. He approached Lloyds TSB, which expressed an interest. By the start of September, the bank and its advisers had a proposal. It would be willing to buy Northern Rock for £2 a share - a fraction of the company's peak share price - if the Government promised to guarantee the £30bn or so of deposits that would fall due in the period to 2009. Lloyds might never need to use the guarantee, but if the crunch were to persist (as it did) then funding would need to be secured.

By Monday, 10 September, the Rock was told that the Government wouldn't guarantee the Lloyds TSB proposal. To have done so, they argued, would have been unfair on the rest of the banking system - and would breach European state-aid laws. The squeeze went on tightening, and confidence in banks generally was low. All that was left for the Rock, if it was to survive, was a 'lender of the last resort' loan from the Bank of England.

On Thursday, 13 September, the Bank's court met at 9.30pm. The non-executives gathered in a small modern conference room to be told of the problems of the Rock and the proposed rescue. But even as they were meeting, the BBC was reporting both the Rock's difficulties and its decision to seek a loan from the Bank. The intention was to announce the rescue to the stock market the next day - with the appropriate reassurances - but the cat was out of the bag. A silent run on the Rock began that very evening as online customers sought to remove their cash, only to find their efforts foiled: the Rock's IT systems collapsed under the strain and the website went down. By Friday, September 14, the first mass run on a British bank since the 1860s was under way.

Worse for the Government, fear was spreading and the shares of all banks - led by Alliance & Leicester and Bradford & Bingley - were in freefall. Selling approached panic proportions and 17/9 looked like becoming as fixed in the public memory as Black Wednesday, 16 September 1992, the day Britain was ejected from the European exchange rate mechanism. Nerves were jangling in Whitehall. Shortly after 5pm, Alistair Darling called reporters to the Treasury and announced that the Government would insure deposits at the Rock and, if necessary, at other banks, too.

Last autumn was a horror show for Darling. Attempts to conjure up a rescue for the Rock foundered one by one. Would-be saviours from the world of private equity, JC Flowers and Cerberus Capital, fell away. Darling had refused to give Flowers the right to sell the Rock on while the taxpayer was still funding it. The cost of the government subvention had shot up to £55bn - a sum higher than Britain's defence budget. By year-end, the only buyers left in the field were Sir Richard Branson's Virgin Money and an internal bid led by Northern Rock's new board, bolstered by the addition of insurance boss Paul Thompson of Resolution.

Privately, the Government saw nationalisation as the way forward, and recruited Ron Sandler, the Zimbabwean-born former Lloyd's of London boss, as leader. On February 17, at a lunchtime summit between Gordon Brown and Darling, the decision was made to take the Rock into public ownership, under Sandler.

The drama at the Rock had taken place against the most turbulent conditions imaginable. The £55bn of taxpayer funds tied up for at least three years was minor-league compared to the £500bn of sub-prime debts that crippled global banking. One after another, major investment banks - Merrill Lynch, Citigroup, Morgan Stanley and Lehman Brothers - revealed their massive sub-prime losses. Chief execs, some of the most famous names in finance, including Stan O'Neal of Merrills, fell like ninepins.

But the biggest shock to the system was yet to come. In March, the Federal Reserve, with the aid of JP Morgan Chase, bailed out and took control of Bear Stearns. The investment house, which had survived the Great Crash of 1929, didn't make it through the Credit Crunch. The Fed had no choice - Bear Stearns had more than $10trn of open trading positions. To have closed them all out at once would have sent the world economy over a precipice.

The Credit Crunch, which began last August as a financial-sector problem, is now being felt decisively in the real world of jobs and growth. Many banks and mortgage providers on both sides of the Atlantic have withdrawn from the market. In the US, house prices slumped 10% in 2007 and are expected to fall another 10% this year, as millions of unsold and repossessed homes hit the market. In Britain, the house-price explosion that made us all feel wealthier has come to an abrupt halt, growth forecasts have been slashed and dark talk of recession is in the air. The party is over - not just for the banks and financial institutions but for all of us. The only question now remaining is how long - and how bad - the hangover is going to be.

- Alex Brummer is City Editor of the Daily Mail. His new book, The Crunch: The scandal of Northern Rock and the escalating credit crisis, will be published in July by Random House Business Books at £11.99. Readers can buy copies for the special price of £9.99 - including UK p&p. To order, call 01206 255 800, quoting ref 'Management Today'.

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