The former chair of the US Federal Reserve, Alan Greenspan, has been widely reported as describing the global financial crisis as a “once in a century credit tsunami” (reports here and here). It’s an interesting statement, mostly because it is so utterly disingenuous.
We can see just how misleading it is with the help of the insightful analysis recently provided by Nicholas Hildyard. In his paper, Hildyard has examined the “(crumbling) wall of money” built by financial geniuses using the tools of securitisation, private equity and hedge funds.
Banks started the securitisation ball rolling through their desire to shift their loans ‘off balance sheet’. They want to do this because banking rules require them to set aside reserves to cover any loan they hold in case it turns sour. Banks think they can do far better than just raking in the interest on the loan – they want to send capital reserves out to work. They do this by getting around the banking rules on reserves using securitisation.
It works like this. The bank sets up a company called a ‘special purpose vehicle’ (SPV) in an offshore tax haven such as the Cayman Islands. The SPV – which is legally a separate entity – buys the loan from the bank and so begins to receive the income from the loan. And the bank no longer owns the loan, so its reserves are freed up for investment.
Now the SPV raises the money to buy assets such as loans and mortgages by issuing bonds. These bonds give investors the right to the income from the loan or other asset owned by the SPV (ie, the investor does not acquire the asset itself, just the right to the income stream). They are called derivatives because their value is derived from the underlying asset. These derivatives are more specifically known as ‘collaterised debt obligations’ (CDOs) or ‘asset backed securities’ or ABSs.
Of course, these bonds themselves are assets so the owner of the CDO can take them back to the bank to use as collateral on a new loan which is invested then in the purchase of more CDOs; meanwhile the bank busily securitises the new loan into an SPV which creates a new CDO.
Securitised assets don’t have to be loans or mortgages; they can actually be anything from retail gas or water supply to private aged care homes, from road or rail infrastructure to the songs of David Bowie. One suggestion floated by the New Zealand Treasury a few years back was to securitise the student loans scheme. It doesn’t really matter what the assets are just so long as they generate regular “receivables.”
It is important to remember these origins. This tale is not just about abstract numbers whirling around the ether – these numbers are grounded in real assets that are part of the fabric of the lives of us down here in the real world. While they have become financial playthings generating enormous bonuses for some, when the game is over, the fallout lands on our heads.
Private equity and infrastructure finance
For a while this securitisation pyramid scheme really did create a wall of money, and a considerable amount of it was aggregated through private equity firms and directed into infrastructure companies – gas and water supply, roading, railways, etc. Hildyard explains that the opportunity arose from the neoliberal assault on government in the 80s, which both massively reduced state spending on infrastructure projects and also privatised much of the state owned infrastructure.
More recently, investors have obtained opportunities to finance new infrastructure projects through ‘public-private partnerships’ (PPPs). It is estimated that, globally, private sector investors now provide more than one-fifth of infrastructure finance. These and other financial opportunities have allowed allow private equity firms and others to act as what Hildyard describes as an unregulated shadow banking system.
Not surprisingly, the finance put into infrastructure projects has itself been securitised into investment funds, and these funds have proved to be very attractive to institutional investors such as pension funds. US$34 billion was raised globally by infrastructure funds in 2007 – more than seven times the 2005 figure. One reason for this growth may be that infrastructure is seen as a lower risk investment in difficult times. And if governments are short of cash for necessary projects in future – because they have been pouring tax dollars into propping up ailing banks – then there well be even more demand for private infrastructure finance.
Hedge funds and the carbon market
Hedge funds have been another unregulated aspect of financial markets that have boomed in recent years. Hedge funds first arose as a way to combine bets on stock prices rising with bets on stock prices falling (ie, ‘hedging one’s bets’, as the expression goes). But they have long ago moved on from such simple concepts, and now they continuously morph into whatever unregulated form best meets the demand for ‘alpha’ returns. Hildyard notes that hedge funds now account for between 30% and 60% of daily global turnover in financial markets – and, as he says, these are “deals that are not subject even to the minimum oversight that institutional investors provide for public companies.”
The carbon market has attracted hedge funds right from the start, with Hildyard suggesting that US$12.5 billion is invested globally in carbon funds. Hedge funds have also been the big winners from trading in the European Emissions Trading Scheme (ETS) market; unsurprisingly, consumers are considered the big losers on the deal. Hedging in the carbon market comes in the form of weather derivatives. While it may sound faintly ridiculous, this isn’t a new concept – previously, fizzy drink manufacturers have hedged their profits against bad weather through such instruments. For heavy carbon emitters, such as thermal power generators, unusually hot or cold weather may increase emissions so, if they are hedged against such an eventuality, the hedge pays out to satisfy the increased need for carbon credits.
A survey of energy traders reported by Hildyard suggests that few believe the carbon market will do anything to tackle global warming. But from the hedge funds’ perspective, that is hardly the point. As I’ve written before, what is important to hedge fund managers is that it is a great way to make truck loads of money.
Bank executives and bond traders have not been shy about extracting their personal piece of the action either. Hildyard relates how in 2006 the highest earning hedge fund manager was paid US$1.7 billion; in 2007 the five leading investment banks on Wall Street paid out US$40 billion in bonuses. The nature of the self interest at play here is captured by Hildyard in an apt quote from a bond fund manager who describes hedge funds as “a remuneration strategy, not an investment strategy.”
And on and on everyone thought it would go, ad infinitum. It only got as far as ad nauseam.
Bring on the credit crisis
Right from the start, one of the problems with the way this wall of money was being generated was that, in terms of risk, not all loans are created equal. Some are far more risky propositions than others, notably the so-called ‘sub-prime’ mortgages that have been mentioned so frequently in the last few months; these are the 100% mortgages arranged with poor, often black, Americans to allow them to purchase a home.
(Hildyard comments caustically on the not-so-subtle undertone of the phrase ‘sub-prime’ being used with reference to the poor and to African-Americans.)
Investors in the bonds issued by SPVs were not always interested in these riskier investments but, in finance, a problem is always just another opportunity for creative thinking. So the high risk mortgages were bundled up with lower risk assets to make the bond more attractive overall. Other investors didn’t give a toss, they just loved the look of those double-digit returns on the bonds and jumped right in without asking any further questions.
The theory behind this process of securitisation is that it spreads the risk of issuing loans away from the banks. Unfortunately, the reality is different, because the banks retained shares in the SPVs that they set up, and when the loans in the SPVs’ portfolios defaulted, the shareholders – ie, the banks – took the hit first.
Amidst the uncertainty, the banks decided not to lend against CDOs and the value of these bonds dropped, leaving many investors critically damaged. Most people will be familiar with the collapse of Lehmann Bros, the takeover of Merrill Lynch, and the nationalisation of Fanny Mae and Freddy Mac. Others to suffer included Swiss bank UBS, which lost US$50 billion when the value of the CDOs it held fell by 30%. Closer to home, National Australia Bank (owner of the Bank of New Zealand) lost A$830 million on CDO deals. Credit dried up altogether as banks refused to lend to each other. The so-called credit crunch had arrived.
Not a tsunami …
The above outline of the world of derivatives, securitisation, private equity and hedge funds shows the credit crunch is most definitely not, as Greenspan would have us believe, a tsunami.
Firstly, by using the idea of a tsunami, Greenspan tries to suggest that this is some sort of random ‘natural disaster’ that arrived out of the blue, rather than an entirely human-made series of events that the financial ‘masters of the universe’ have constructed and brought down on themselves (and us).
Secondly Greenspan implies that this random natural disaster might have taken place at any time in the past 100 years. The fact is that the formal market in financial derivative instruments such as futures, options and swaps only opened in the US in 1973, nearly collapsed in 1987, and has grown to its current proportions only in the last decade with the mania for the (hitherto) enormously lucrative securitisation transactions.
This crisis is no random natural disaster; it is entirely self-inflicted, a monument to human frailty.
… but an opportunity
While humans are indeed prone to frailty on a daily basis, we are also very good at learning from our mistakes. The short term responses we have seen so far from governments and central banks have been aimed merely at keeping the system running on the same old terms. What we really need, in the long term, is to learn from the crisis so that we avoid it happening again.
On the back of this crisis, while questions about the validity of the existing system linger in the minds of the wider public, there is a chance to put forward grassroots alternatives that move us in a new direction. What we need is a financial system that does not run on fear and greed. This alternative system, Hildyard suggests, must be rooted in a moral economy of the public good, and must function through a market that operates in terms of solidarity and economic security.