1. Transition 3: Crisis
Mary Mellor

2. The Crisis Unfurls
• Speculative Boom
• Subprime Crisis
• Credit Crunch
• Banking/Financial Crisis
• Economic Crisis
• Sovereign Debt Crisis
• Austerity

3. Meltdown
• September 2007 Credit Crunch and run on
Northern Rock
• September 2008 Lehman fails - global banking
crisis
• May 2010 Greek bailout (Ireland, Portugal)
leading to euro crisis
• August 2011 US loses AAA rating
• Still no end in sight

4. The Boom
• House price boom
• ‘Equity release’ rapidly expanded money
supply
• Cheap consumer goods (China)
• Easy credit conditions – low interest rates
• Lax bank regulation - bonus culture
• Optimism and exuberance

5. Subprime Lending
• De-regulation of mortgage lending
• Liar loans – NINJA (no income, no job, no
assets)
• Teaser rates – people used to fixed rate
• Originate to Distribute (loans sold on, so less
attention to risk of default)
• All forms of debt expanded

6. Levels of Debt (% GDP)
• US Financial sector 1981 (22%) 2008 (117%)
• US Household 1997 (66%) 2007 (100%)
• US All sectors 1980 (160%) 2008 (350%)
• UK All sectors 1987 (200%) 2009 (540%)
• UK household debt peaked at 150% GDP

7. Where did the money go?
• UK money supply doubled 2003-2009
• 75% of loans linked to property
• 30% of loans issued to the financial sector
• 20% to manufacturing/nonfinancial sector

8. Trading in Debt
• Traditionally most house lending through
specialised sectors e.g. Building Societies
• Latter part of C20th banks more involved
• Debts (e.g. mortgages) seen as a financial
asset - investors could ‘buy’ a mortgage as an
investment (mortgage-backed security)

9. Securitisation
• Securitisation is a paper ownership of an asset
which can be bought and sold
• Share certificates are securities – the share
can be sold without selling the factory
• Various forms of debt (consumer, student,
mortgages etc.) were bundled up and sold as
Collatoralised Debt Obligations (CDOs)

10. Slicing and Dicing
• The CDOs were sold in ‘tranches’ with higher
interest for higher risk
• The first ‘tranches’ were rated AAA by the
rating agencies (employed by the issuing
bank) –this was essential to attract pension
funds
• The AAA tranche would pay out first in case of
default

11. Credit Derivatives
• Investors in credit insure against default
• These insurances became investments in
themselves and were traded over-the-counter
(i.e. not through regulated exchanges) as
Credit Default Swaps (CDSs) between banks
and other financial institutions
• Made insurances companies such as AIG very
vulnerable ($180 billion bailout)

12. Credit Derivatives
• Derivatives do not need any direct connection
with the product (debt) so large numbers of
‘naked’ CDSs were taken out e.g. on Greek
default while holding no Greek debt
• Default will mean multiple pay out with no
‘hair cut’ (unlike actual owners of the debt)
• Credit derivatives grew from $108bn in 1995
to $1.23 trillion in 2006 and $45.5 trillion in
2007 (nearly equivalent to world GDP)

13. Shadow Banking
• There was so much profit to be made in the
new securitisation that that banks started to
outstrip their capital adequacy ratios
• Banks are supposed to have sufficient bank
capital to allow for some losses on assets (e.g.
loan defaults)
• Bank capital is made up of retained profits and
any money raised by selling shares (equity)

14. Shadow Banking
• Banks solved their ‘balance sheet’ problem by
‘shadow banking’ holding the securitised
loans ‘off balance sheet’ in SIVs Special
Investment Vehicles which only needed 3%
external ownership
• Real capital ratios fell almost to nothing
• Total bank balance sheets grew bigger than
GDP (Iceland 10X, UK 5X, Ireland 8X)

15. Growth of Financial Sector
• US manufacturing % GDP
• 1950 29.3% 2005 12.0%
• US Financial services % GDP
• 1950 10.9% 2005 20.4%. (but only 8% if
exclude real estate/mortgages)
• 40% of GDP growth during boom

16. What went wrong?
• High levels of debt default (rare before)
• The bundles of debt-based securities not
carefully screened for risk - all securities
became suspect
• Financial institutions (insurance companies,
pension funds) could not buy them
• Banks left holding unsold bundles of debt

17. What went wrong?
• As defaults occurred the flow of debts and
investments stalled
• Credit crunch put most institutions on the
edge of bankruptcy as their assets could not
be valued i.e. they were ‘toxic’
• All types of bank affected
• States had to step in

18. State Responses
• Guaranteeing bank deposits (Ireland 2XGDP)
• Central banks issued cheap money
• Nationalisation or capital injection
• Toxic Asset purchase or insurance
• State expanded money: quantitative easing
• Supporting banks and the wider economy
transferred the debts to state budgets –
leading to sovereign debt crisis

19. Why did the Crisis happen?
• Financial innovations such as securitisation
• High levels of ‘leverage’ (borrowing)
• Bonus culture encouraged risk and rapid
turnover
• Lax regulation- regulators didn’t see the risk
• Could not isolate parts of the system (Lehman
collapse)
• Banks too big to fail (and too big to save?)

20. Forms of Leverage
• Reducing the ratio of capital available to meet
immediate liabilities relative to the size of the
firm’s assets
• Borrowing money to enhance the profit on
original money invested
• Buying ‘on the margin’ – making a large ‘bet’
with a small initial outlay e.g. putting a
‘deposit’ on share trade

21. Leverage Gamblers
• Hedge funds – use borrowing to enhance
clients’ money in short term trades – often
relying on computer-based trading (rocket
scientists)
• Already seen failure: Long Term Capital
Management 1998 and ENRON 2001
• Private Equity Companies : used borrowed
money to buy up companies: AA, Boots,
Debenhams, EMI - aim to sell at a profit

22. Disembedded Finance
• Financial investment became detached from
any interest in accumulating capital through
productive activities
• Confusion of money speculation with wealth-
creation – impact on productive investment
• Speculative investment in financial assets
themselves e.g. stock, shares, bonds,
derivatives, mergers and acquisitions – worth
10X world GDP

23. Credit and Investment Treadmill
• Speculative investment can only realise a
profit if the asset is sold on
• Needs new money coming into the market
from leverage (debt) or recycled wealth
• Boom cycles reinforce speculation
• Effectively a chain letter system or pyramid
scheme – no consumption as in production
• Vast room for fraud and deception (Madoff)

24. The Banks’ Problem
• Savings and mutual systems replaced by personal
investment and privatisation e.g. personal
pension plans - huge amounts of money looking
for profitable investment
• Obligation to shareholders (e.g. pension funds)
prioritised high share price
• High risk financial trading more profitable than
productive investments in short run. US Banks
bought CDOs because they paid 1% more than
Treasuries (government debt)

25. Credit crunch
• Most banks and financial institutions were
highly leveraged (30 – 100 %)
• Banks had built themselves into highly
interconnected global networks
• The ‘money market’ had become a key part of
the financial system (large scale borrowing)
• Susceptible to a credit crunch if any link in the
chain broke

26. The wider context
• Growing inequality
• Globalisation: low rates of profit in productive
sector of old economies, shift of production to
low wage economies led to global imbalance
• Stagnant wages and high levels of consumer
debt
• Privatisation of money issue as bank debt –
rapid increase in money supply

27. Inequality
• 19,000:1 US highest earners:average wage
• 2011 median salary of UK investment banker
£350,000 - total bonuses £7.5 billion
• In UK over last 30 years: Bottom 50% wage
earners share of GDP fell by 25%
• Top 1% of wage earners share rose 50%
• 2011 of each £100 of GDP bottom 50% of
wage earners get £12 the top 1% get £3(Report
of ‘Missing Out’ Resolution Foundation July 2011)

28. Globalisation of Production
• Exporting countries (China, Japan, Germany)
low consumption/high savings – leads to
balance of payments problems
• Importing countries high consumption/low
savings and high debt
• Export earnings are lent back to the importing
country (70% of dollars exported return to US
financial sector – mainly government debt)

29. Globalisation of Production
• Germany does the same in the eurozone –
earns money from the periphery and lends it
back to them thus increasing their
indebtedness
• Global money and trading needs a mechanism
to maintain balance – major concern of
Keynes

30. Why Public Rescue?
• Banks are a system of trust that have no
means of withstanding a ‘run’ - reserve notion
is meaningless in a crisis
• The financial sector has required periodic
rescue since stockmarkets/banking emerged.
• Banks underpinned by state authority
• People demand state recompense e.g.
Northern Rock, Icesave

31. Privatised Money - Public
Responsibility
• As the national money supply is now based on
bank issued debt it is subject to crisis
• State responsibility for the integrity of its
national money means it has to continually
bail out the privatised money system
• States now have to take on ‘sovereign debt’ to
rescue private debt - borrowed from the self-
same banks and ‘money markets’

32. Finance is not Private
• The financial system is not private
• It administers a public resource – money as
legal tender
• Late C20th 97% of all money has been issued
as bank debt
• The final resource of the money system is the
taxation/money issue capacity of states

33. State and the Banking System
• Viability of money system rests on the
capacity of the state to tax (viz Greece,
Argentina) or the consent of the taxed
(Iceland)
• Yet tax avoidance/off-shoring is rife even given
the excessive remuneration
• States can also create new money if hold own
currency (quantitative easing)

34. Sovereign Debt Crisis
• Most increased sovereign debt caused by the
crisis: banks (US, UK, Ireland), speculative
housing debts (Spain), GDP fall (Italy)
• A serious problem in the eurozone (Greece,
Portugal, Spain, Ireland, Italy)
• Problem of Maastricht rules and limited
powers of European Central Bank to issue new
money or lend to states

35. Sovereign Debt
• Less problematic if the country has its own
currency and borrows internally
• e.g. Japan national debt is 200% of GDP,
Greece 150% (95% of Japanese debt and stock
trading is domestic)
• Greek financial sector only 2 X GDP but 2/3 of
its debt is to foreign lenders
• Greek public and private debt 250% of GDP
(much less than US or UK)

36. Austerity
• Neo-liberal economics has constrained the
capacity of states, particularly on money
supply
• Assumes that money can only be issued as
bank debt
• Assumes that reducing state expenditure will
increase private expenditure
• Blames states for failures of the private sector

37. Austerity
• States are asked to cut expenditure and raise
more taxes to ‘pay’ for the deficit caused by
the crisis
• Already economic decline/stagnation – UK lost
6% of GDP in 2009 - less impact in BRIC
countries
• Unemployment rising rapidly – particularly
youth unemployment over 40% in Spain
• Public anger in many countries

38. Is this the 30’s?
• 1929-1930 US GDP fell 14%; 1931 25.3%
1932-3 25% (Greece – 4.5% 2010 15% overall)
• Unemployment 25% (Spain, Greece ?)
• US debt service 20% of GDP
• Nearly all banks collapsed
• FDR removed gold standard in 1933 – floating
exchange rates today except in eurozone
• Overall rate of debt higher than 1930s