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Big Freeze part 1: How it began

By Gillian Tett

Published: August 3 2008 19:46 | Last updated: August 3 2008 19:46

Just over a year ago, Hiroshi Nakaso, a
senior official at the Bank of Japan, started to fear that the global financial
system was heading for a jolt. Back then, most American policymakers assumed
that the western banking system was extraordinarily strong. Thus while US
mortgage defaults were rising, western officials were convinced that such losses
would be easily “contained”.

But as Mr Nakaso watched western markets in July 2007, he had a sense of déjà
vu. “I see striking similarities in what I see today with the early stages of
our own financial crisis [in Japan] more than a decade ago,” he privately warned
international contacts shortly after IKB, a German lender, imploded as a result
of subprime losses. “Probably we will have to be prepared for more events to
come ... the crisis management skills of central banks and financial authorities
will be truly tested.”

His fears proved well-founded. On August 9 2007, the European Central Bank
sent shock waves around world financial capitals when it injected €95bn ($150bn,
£75bn) worth of funds into the money markets to prevent borrowing costs from
spiralling sharply. The US Federal Reserve soon followed suit. But while the
central banks had billed these moves as “pre-emptive” actions to quell incipient
market tensions, they did not bring the panic to an end.

On the contrary, as markets that were crucial for raising funds started to
dry up last August, a network of financial vehicles slid into crisis, causing
the price of many debt securities to collapse. That started a chain reaction
that created liquidity and solvency crises at US and European banks – on a scale
last seen in Japan almost exactly a decade ago.

A year later, there is still no sign of an end to these problems. Instead,
the sense of pressure on western banks has risen so high that by some measures
this is now the worst financial crisis seen in the west for 70 years.

What has made this upheaval so shocking is not simply its scale and duration
but the fact that almost all western policymakers and bankers were caught
unawares. “If you had said a year ago that America could suffer a banking crisis
on the scale of Japan, people would have laughed,” one former senior US
regulator admits.

Or as the Bank for International Settlements, which groups central banks,
observes in its latest annual
report: “The duration of the turmoil, its scope and the growing evidence of
effects on the real economy have come as a great surprise to most commentators,
private as well as public.”

Adding that it “is essential we understand what is going on”, the BIS points
out that the crucial question is: “How could problems with subprime mortgages,
being such a small sector of global financial markets, provoke such
dislocation?”

The answer to this seeming mystery lies in the slippery concept of financial
“faith”. Over the past decade, western banking has experienced an extraordinary
burst of innovation, as financiers have discovered ways to slice and dice their
loans – such as the now controversial subprime mortgages – and then turn these
into securities that can be sold to investors all over the world.

Tracking the scale of this activity with any precision has always been hard,
since much of it occurs in private deals. However, industry data suggest that
between 2000 and 2006, nominal global issuance of credit instruments rose
twelvefold, to $3,000bn (£1,519bn, €1,929bn) a year from $250bn. This activity
appears to have become particularly intense from 2004, partly because investors
were searching for ways to boost returns after a long period in which central
banks had kept interest rates low.

To be sure, ahead of last summer’s crisis some policymakers and investors
were uneasy about the scale of this explosion. In particular, there was growing
concern that “slicing and dicing” was fuelling a credit bubble, leading to
artificially low borrowing costs, spiralling leverage and a collapse in lending
standards. When world leaders gathered in Davos for the annual economic forum in
January 2007, Jean-Claude Trichet, governor of the ECB, complained about the
opacity of some financial innovation and warned that there could soon be some
“repricing of credit risk”.

From 2005 onwards, Timothy Geithner, president of the New York Federal
Reserve, called on banks to prepare for so-called “fat tails” – a statistical
term for extremely negative events which occur more commonly than usual banking
models suggest. Behind the scenes, a few bankers and investors also prepared for
a crash. Deutsche Bank, for example, started betting on subprime defaults as
early as 2006, while JPMorgan Chase placed trades to protect itself from a crash
in spring 2007 and asset managers such as Pimco and BlackRock stopped purchasing
many debt instruments in early 2007. Yet most investors, bankers and even
regulators did not change their behaviour to any significant degree, owing to a
widespread adherence to three big assumptions – or articles of faith – that have
steathily underpinned 21st century finance in recent years.

The first of these was a belief that modern capital markets had become so
much more advanced than their predecessors that banks would always be able to
trade debt securities. This encouraged banks to keep lowering lending standards,
since they assumed they could sell the risk on. “Abundant market liquidity led
some firms to overestimate the market’s capacity to absorb risk,” says the
Institute of International Finance, a Washington-based lobby group, in a recent report.
“The same buoyant environment resulted in market pressure for high returns ...
and high levels of competition among financial firms.”

Second, many investors assumed that the credit rating agencies offered an
easy and cost-effective compass with which to navigate this ever more complex
world. Thus many continued to purchase complex securities throughout the first
half of 2007 – even though most investors barely understood these products.

But third, and perhaps most crucially, there was a widespread assumption that
the process of “slicing and dicing” debt had made the financial system more
stable. Policymakers thought that because the pain of any potential credit
defaults was spread among millions of investors, rather than concentrated in
particular banks, it would be much easier for the system to absorb shocks than
in the past. “People had looked at what had happened to the Japanese banks and
said, ‘this simply cannot happen here’, because the banks were no longer holding
all the credit risk,” one senior European policymaker recalls.

In private, some central bank officials
harboured doubts about this new creed. From 2003, senior officials at the BIS in
Basel, for example, repeatedly warned that risk dispersion might not always be
benign. However, such warnings were largely kept out of public view, partly
because the US Federal Reserve was convinced that financial innovation had
changed the system in a fundamentally beneficial way.

Consequently, no attempt was made to force banks to boost their capital
reserves to offset exploding debt issuance; instead, regulatory rules permitted
banks to cut their capital levels sharply, which they duly did. “People really
believed that the world was different,” recalls Larry Fink, head of BlackRock
investment group. “There was this huge trust in the intellectual capital of Wall
Street – and that appeared to be supported by the fact that banks were making so
much money.”

As a result, when high rates of subprime default emerged in late 2006, there
was initially a widespread assumption that the system would absorb the pain
relatively smoothly. After all, the system had easily weathered shocks earlier
in the decade, such as the attacks of September 11 2001 or the collapse of the
Amaranth hedge fund in 2006. Moreover, the US government initially estimated
that subprime losses would be just $50bn-$100bn – a tiny fraction of the total
capital of western banks or assets held by global investment funds.

In fact, the subprime losses started to hit the financial system in the early
summer of 2007 in unexpected ways, triggering unforeseen events such as the
implosion of IKB. And as the surprise spread, the three pillars of faith that
had supported the credit boom started to crumble.

First, it became clear to investors that it was dangerous to use the ratings
agencies as a guide for complex debt securities. In the summer of 2007, the
agencies started downgrading billions of dollars of supposedly “ultra-safe” debt
– causing prices to crumble. Last week, for example, Merrill Lynch sold a
portfolio of complex debt at 22 per cent of its face value, even though this had
carried the top-notch triple-A rating.

Then, as bewildered investors lost faith in ratings, many stopped buying
complex instruments altogether. That created an immediate funding crisis at many
investment vehicles, since most had funded themselves by issuing notes in the
asset-backed commercial paper market. It also meant that banks were no longer
able to turn assets such as mortgages into subprime bonds and sell these on.
That in turn meant the second key assumption that had underpinned 21st-century
finance – that the capital markets would always stay liquid – was overturned.
Worse still, the third pillar of faith – that banks would be better protected
from a crisis because of risk dispersion – also cracked. As investment vehicles
lost their ability to raise finance, they turned to their banks for help. That
squeezed the banks’ balance sheets at the very moment that they were facing
their own losses on debt securities and finding it impossible to sell on
loans.

As a result, western banks found themselves running out of capital in a way
that no regulator or banker had ever foreseen. Peter Fisher, a managing director
of BlackRock and former US Treasury undersecretary, wrote in a recent paper: “It
seems clear that risk dispersion did not work as expected. Major financial
institutions did not succeed in shedding risks so much as transferring them
among their own business lines.”

Banks started hoarding cash and stopped lending to each other as financiers
lost faith in their ability to judge the health of other institutions – or even
their own. “Firms became reluctant to participate in money markets ... as a
result subprime credit problems turned into a systemic liquidity crunch,” says
the IIF.

Then a vicious deleveraging spiral got under way. As banks scurried to
improve their balance sheets, they began selling assets and cutting loans to
hedge funds. But that hit asset prices, hurting those balance sheets once again.
What made this “feedback loop” doubly intense was that the introduction of
mark-to-market accounting earlier this decade forced banks to readjust their
books after every panicky price drop – in contrast to the pattern seen in the
1990s Japanese banking crisis, or the Latin American debt debacle of the 1980s.

At several points over the past year,
policymakers have hoped that this vicious cycle might be coming to an end. Last
autumn, for example, conditions briefly improved; early this year brought
another respite when central banks pumped more liquidity into the system.
Similarly, when the Fed stepped in to prevent the implosion of Bear Stearns in
March, sentiment stabilised for a period.

However, in practical terms, the real challenge for financiers and
policymakers now – as in Japan a decade ago – is how to build a new sense of
trust in finance. In the medium term, regulators are preparing reforms that aim
to make the system look credible, even in a world where the benefits of risk
dispersion are no longer taken as a creed. These would force banks to hold more
capital and ensure that the securitisation process is more transparent.
Separately, groups such as the IIF are trying to introduce measures that could
rebuild confidence in complex financial instruments.

More immediately, the banks are trying to rekindle investor trust by
replenishing their capital bases. The IIF calculates that in the year to June,
banks made $476bn in credit writedowns, as debt prices plunged in the panic
(although tangible credit losses are hitherto just $50bn). However, they have
also raised $354bn in capital. Financiers are also trying to restart trading in
frozen debt markets. Experience from earlier financial crises suggests that this
will only occur when investors are convinced that they have seen true “clearing
prices”. Events such as Merrill Lynch’s recent fire sale of its CDO portfolio
may be a step in this direction.

But while confidence is returning in some areas, it continues to be
undermined in others. A decade ago in Japan, the banking woes started with a
property slump but later spread when banks were forced to cut their lending –
which unexpectedly created more bad loans. Thus far, banks have not yet
encountered this “second round” effect on a significant scale.

Though defaults are rising on consumer loans, for example, losses on
corporate debt remain modest. However, most bankers and policymakers fear that a
second wave is simply a matter of time. That makes it hard to predict when the
credit crunch will end, how big the total losses may eventually be or even
whether the banks are adequately capitalised yet.

“What we learnt in Japan is that banks have a tendency to underestimate how
their assets could deteriorate due to the feedback problems,” Mr Nakaso
recalls.

A year into the credit crisis, in other words, trust remains a rare commodity
in the banking world. It will take years, not months, to restore that crucial
ingredient – particularly given that so many of the assumptions underlying
21st-century finance have turned out to be so dangerously wrong.

The writer, the FT’s capital markets editor, is on sabbatical writing a
book about the credit crisis. Her first book, on Japan’s banking crisis, was
published in 2003 as ‘Saving the Sun’

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