More Banks Will Need Capital

Stress Tests Identify About Ten; Wells, BofA, Citigroup Face Order to Refill Coffers

DAMIAN PALETTA DEBORAH SOLOMON

WASHINGTON -- The U.S. is expected to direct about 10 of the 19 banks undergoing government stress tests to boost their capital, according to several people familiar with the matter, a move that officials hope will quell fears about the solvency of the financial sector.

The exact number of banks affected remains under discussion. It could include Wells Fargo & Co., Bank of America, Citigroup Inc. and several regional banks. At one point, officials believed as many as 14 banks would need to raise more funds to create a stronger buffer against future losses, these people said, but that number has fallen in recent days.

Representatives from Wells, Bank of America and Citi declined to comment.

MORE

• Real Time Econ: Bankers Worry Worse to Come
• Small Banks Hit by Commercial Real Estate
• Investors Seem Resigned to Bank USA
• Opinion: We Can't Subsidize the Banks Forever

The Obama administration announced the stress tests -- a process of examining banks' ability to withstand future losses -- back in February. At the time, the news sparked concern among investors and depositors that the results would be used to shut down or nationalize some of the country's weaker institutions. But Federal Reserve Chairman Ben Bernanke and Treasury Secretary Timothy Geithner assured investors that none of the banks undergoing stress tests would be allowed to fail and that all would have access to government funds if needed.

In fact, the stress-test regimen appears so far to have eased some of the fears that swept through financial markets in February, just as President Franklin D. Roosevelt's bank holiday did in 1933. He shut down the nation's banks for several days during a banking panic and only reopened those the government deemed safe. One possible explanation for the recent, calmer state of affairs: The problems the tests appear to be uncovering aren't as bad as some analysts' worst expectations.

Also, if multiple banks are being directed to boost their capital, that could make the process seem less daunting than if it were singling out a few companies as weak.

In a sign of how much the doomsday scenario has faded, bank stocks surged Monday despite reports that Wells Fargo was identified in an initial review as one of the financial institutions needing a stronger buffer.

The San Francisco bank's stock jumped 24%, or $4.64, to $24.25 in New York Stock Exchange composite trading at 4 p.m. Bank of America shares rose 19% on Monday, while Citigroup was up 7.7%.

The stock prices of all three banks, which may need to raise tens of billions in new capital as a result of the stress tests, have tripled since early March.

Getty Images

A Wells Fargo customer enters a bank branch May 4, 2009 in San Francisco, Calif.

It's possible Wall Street is being overly optimistic about the impact of the results and the resulting dash by banks to bolster capital. One big risk worrying industry officials is that the market will view banks on the list as insolvent when the official results are announced Thursday, even though Fed officials have repeatedly said that's not the case.

Several banks are expected to already have enough capital to weather a worsening economy, including Goldman Sachs Group Inc. and J.P. Morgan Chase & Co. J.P. Morgan Chase Chairman and Chief Executive James Dimon expressed confidence Monday that the banking system can withstand losses from the recession, even though it will take years for the industry to recover.

"The banking system can handle an awful lot of stress and be OK," he said in a Monday conference call sponsored by Calyon Securities Inc., a unit of Credit Agricole Group.

Mr. Dimon also reiterated J.P. Morgan's goal to repay the $25 billion the New York bank received from the government last year "as soon as possible," saying company officials plan to discuss details of the potential repayment after the stress-test results are announced.

An initial stress test identified Wells Fargo as among the banks needing a bigger buffer, said a person close to the company. It is unclear whether Wells would be forced to raise fresh capital or if regulators would accept the bank's argument that it can earn its way through the losses in future years. Wells expects more clarity Tuesday.

Any bank holding company with more than $100 billion in assets was required to undergo the tests, which were largely conducted by the Fed. Their purpose was to ensure that major financial institutions had enough capital to continue lending if the economy worsened through 2010. Government officials are expected to meet with banks beginning Tuesday to go over final results. Banks directed to raise more capital aren't necessarily in trouble today, but regulators think they don't have enough of a buffer against potential future losses.

Administration officials believe many banks will be able to raise capital without tapping the Troubled Asset Relief Program's remaining $109.6 billion. They're optimistic the bulk of the money will come from private investors made more confident by the glut of information provided by the tests. Banks could sell assets and stakes in their companies, a move that could accomplish another government goal of shrinking some of the country's largest banks.

Officials say banks that can't tap private markets will be able to raise capital by agreeing to convert some of the government's existing preferred shares into common equity, a move that would leave the government owning chunks of the nation's largest banks.

"There undoubtedly will be banks that need more capital," White House spokesman Robert Gibbs said Monday in a news briefing. He said he didn't believe the Obama administration would need to ask Congress for more money. "I think everyone involved will be looking for banks to raise this through either private means or the selling of some assets that they have or that they control."

The tests have set off some tense exchanges in private between Treasury officials and bank regulators at the Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency, who worried that disclosing too much information publicly could threaten the health of banks that are trying to repair themselves.

The Fed plans to release the results of the stress tests on Thursday after U.S. stock markets close. Anticipating the test results, McGraw-Hill Cos.' Standard & Poor's Ratings Service unit put on watch for downgrade the credit ratings of 22 banks and one thrift.

The affected companies face at least a 50% chance of being downgraded by at least one notch in the next 90 days.

Fed Is Said to Seek Capital for at Least Six Banks (Update1)

Fed Is Said to Seek Capital for at Least Six Banks (Update1)

April 29 (Bloomberg) -- At least six of the 19 largest U.S. banks require additional capital, according to preliminary results of government stress tests, people briefed on the matter said.

While some of the lenders may need extra cash injections from the government, most of the capital is likely to come from converting preferred shares to common equity, the people said. The Federal Reserve is now hearing appeals from banks, including Citigroup Inc. and Bank of America Corp., that regulators have determined need more of a cushion against losses, they added.

By pushing conversions, rather than federal assistance, the government would allow banks to shore themselves up without the political taint that has soured both Wall Street and Congress on the bailouts. The risk is that, along with diluting existing shareholders, the government action won’t seem strong enough.

“The challenge that policy makers will confront is that more will be needed and it’s not clear they have the resources currently in place or the political capability to deliver more,” said David Greenlaw, the chief financial economist at Morgan Stanley, one of the 19 banks that are being tested, in New York.

Final results of the tests are due to be released next week. The banking agencies overseeing the reviews and the Treasury are still debating how much of the information to disclose. Fed Chairman Ben S. Bernanke, Treasury Secretary Timothy Geithner and other regulators are scheduled to meet this week to discuss the tests.

Options for Capital

Geithner has said that banks can add capital by a variety of ways, including converting government-held preferred shares dating from capital injections made last year, raising private funds or getting more taxpayer cash. With regulators putting an emphasis on common equity in their stress tests, converting privately held preferred shares is another option.

Firms that receive exceptional assistance could face stiffer government controls, including the firing of executives or board members, the Treasury chief has warned.

Today, Kenneth Lewis, chief executive officer of Bank of America, faces a shareholder vote on whether he should be re- elected as the company’s chairman of the board. While Lewis has been at the helm, the bank has received $45 billion in government aid.

‘Out of Our Hands’

Scott Silvestri, a spokesman for Charlotte, North Carolina- based Bank of America, declined to comment on Lewis yesterday. Lewis said earlier this month that the firm “absolutely” doesn’t need more capital, while adding that the decision on whether to convert the U.S.’s previous investments into common equity is “now out of our hands.”

Citigroup, in a statement, said the bank’s “regulatory capital base is strong, and we have previously announced our intention to conduct an exchange offer that will significantly improve our tangible common ratios.”

Along with Bank of America and New York-based Citigroup, some regional banks are likely to need additional capital, analysts have said.

SunTrust Banks Inc., KeyCorp, and Regions Financial Corp. are the banks that are most likely to require additional capital, according to an April 24 analysis by Morgan Stanley.

Bank of America advanced 2.6 percent to $8.36 in German trading and Citigroup climbed 3.5 percent to $2.99. SunTrust slipped 0.2 percent to $13.69 in Germany.

By taking the less onerous path of converting preferred shares, the Treasury is husbanding the diminishing resources from the $700 billion bailout passed by Congress last October.

‘Politically Constrained’

“Does that indicate that’s what the regulators actually believe, or is it that they felt politically constrained from doing much more than that?” said Douglas Elliott, a former investment banker who is now a fellow at the Brookings Institution in Washington.

Geithner said April 21 that $109.6 billion of TARP funds remain, or $134.6 billion including expected repayments in the coming year. Lawmakers have warned repeatedly not to expect approval of any request for additional money.

Some forecasts predict much greater losses are still on the horizon for the financial system. The International Monetary Fund calculates global losses tied to bad loans and securitized assets may reach $4.1 trillion next year.

Geithner has said repeatedly that the “vast majority” of U.S. banks have more capital than regulatory guidelines indicate. The stress tests are designed to ensure that firms have enough reserves to weather a deeper economic downturn and sustain lending to consumers and businesses.

‘Thawing’ Markets

He also said there are signs of “thawing” in credit markets and some indication that confidence is beginning to return. His remarks reflected an improvement in earnings in several lenders’ results for the first quarter, and a reduction in benchmark lending rates this month.

Financial shares are poised for their first back-to-back monthly gain since September 2007. The Standard & Poor’s 500 Financials Index has climbed 18 percent this month, while still 73 percent below the high reached in May 2007.

Finance ministers and central bankers who met in Washington last weekend singled out banks’ impaired balance sheets as the biggest threat to a sustainable recovery. Geithner has crafted a plan to finance purchases of as much as $1 trillion in distressed loans and securities. Germany has proposed removing $1.1 trillion in toxic assets.

The Tax Capital of the World

States are raising taxes despite the 'stimulus'; New York is No. 1.

Like the old competition to have the world's tallest building, New York can't resist having the nation's highest taxes. So after California raised its top income tax rate to 10.55% last month, Albany's politicians leapt into action to reclaim high-tax honors. Maybe C-Span can make this tax competition a new reality TV series; Carla Bruni, the first lady of France, could host.

Getty Images

They can invite politicians from the at least 10 other states that are also considering major tax hikes, including Oregon, Illinois, Wisconsin, Washington, Arizona and New Jersey. One explicit argument for the $787 billion "stimulus" bill was to help states avoid these tax increases that even Keynesians understand are contractionary. Instead, the state politicians are pocketing the federal cash to maintain spending, and raising taxes anyway. Just another spend-and-tax bait and switch.

In New York, Assembly Speaker (and de facto Governor) Sheldon Silver and other Democrats will impose a two percentage point "millionaire tax" on New Yorkers who earn more than $200,000 a year ($300,000 for couples). This will lift the top state tax rate to 8.97% and the New York City rate to 12.62%. Since capital gains and dividends are taxed as ordinary income, New York will impose the nation's highest taxes on investment income -- at a time when Wall Street is in jeopardy of losing its status as the world's financial capital.

But who and where are all these millionaires to pluck? More than any other state, New York has been hurt by the financial meltdown, and its $132 billion budget is now $17.7 billion in deficit. The days of high-roller Wall Street bonuses that finance 20% of the New York budget are long gone. The richest 1% of New Yorkers already pay almost 40% of the income tax, and the top 0.5% pay 30%.

Mr. Silver thinks he can squeeze more from these folks without any economic harm, arguing that recent income tax hikes didn't hurt New Jersey. (Yes, the pols in New York actually hold up New Jersey, whose economy and budget are also in shambles, as their role model.) The tax hike lobby in Albany points to a paper by Princeton researchers reporting that the number of "half-millionaires," those with incomes above $500,000, increased by 60% from 2003-2006 after New Jersey taxes rose (the top rate is now 8.98%). But this was a boom time for the national economy, especially in the financial industry where many New Jerseyites work, or at least used to work.

The better comparison is how New Jersey compared to the rest of the nation. According to the study's own data, over the same period the U.S. saw an increase of 76% in half-millionaire households. E.J. McMahon, a budget expert at the Manhattan Institute, calculates that New Jersey lost more than 4,000 high-income taxpayers after the tax increase.

Mr. Silver says of the coming tax hikes: "We've done it before. There hasn't been a catastrophe." Oh, really? According to Census Bureau data, over the past decade 1.97 million New Yorkers left the state for greener pastures -- the biggest exodus of any state. New York City has lost more than 75,000 jobs since last August, and many industrial areas upstate are as rundown as Detroit. The American Legislative Exchange Council recently said New York had the worst economic outlook of all 50 states, including Michigan. And that analysis was done before these $4 billion in new taxes. How does Mr. Silver define "catastrophe"?

Oh, and it isn't just high earners who get smacked. The new budget raises another $2 billion or so on top of the $4 billion in income taxes with some 100 new taxes, fees, fines, surcharges and penalties to be paid by all New York residents. There are new charges for cell phone usage, fishing permits, health insurance (the "sick tax"), electric bills, and on bottled water, cigars, beer and wine. A New York Post analysis found that a typical family of four with an income below $100,000 would pay more than $800 a year in higher taxes and fees.

This is advertised as a plan of "shared sacrifice," but the group that is most responsible for New York's budget woes, the all-powerful public employee unions, somehow walk out of this with a 3% pay increase. The state is receiving an estimated $10 billion in federal stimulus money, and Democrats are spending every cent while raising the state budget by 9%. Then they insist with a straight face that taxes are the only way to close the budget deficit.

And so Albany is about to make a gigantic gamble on New York's economic future. The gamble is that the state with the highest cost of doing business can raise taxes on everyone who lives, works, breathes, eats or drinks in the state and not pay a heavy price for it. If they're wrong, New York will enhance its reputation as the Empire in Decline State.

WHAT ELSE F.D. OBAMA?

Obama's 'Change' Is Capital On Strike

By Investor's Business Daily

Economy: Barack Obama won the presidency by vowing to bring "hope and change" to America. We've seen the change as the economy's deterioration accelerated. Now where's the hope?

In the three months since the election, the broadest measure of the stock market's value, the Wilshire 5000 Index, has plunged more than 30%, slicing over $3 trillion from Americans' wealth. Investors have walked away from investing, while businesses shut down factories and offices and slash jobs.

This is both highly significant and dangerous. Capital, bluntly put, has gone on strike. Those who own wealth are pushing it to the sidelines, as a young and inexperienced president tries to jam through the most sweeping economic changes in over 70 years.

The prospect of these changes becoming law has already radically altered our nation's economy. Entrepreneurs and CEOs who once created new products, new services, jobs and trillions in wealth for America's workers and retirees now find themselves vilified and punished for their success.

ABC News reported this week that many upper-income taxpayers already are planning to cut back on work and investments to stay under $250,000 in income — the point where Obama's punitive taxes kick in. No one wins from this, yet Obama seems oblivious.

This isn't the only warning sign. A new study asserts that some 100,000 highly educated, well-trained Indians now living in the U.S. will return home in the next few years. Ditto China.

Immigrant entrepreneurs are highly sensitive bellwethers of economic and social conditions. They know where the opportunities are — and where they aren't. They're voting with their feet.

The economy shrank 6.2% in the fourth quarter, worse than first expected. Home sales continue to fall, unemployment is rising sharply, and business investment is prostrate. Such an economy cries out for tax cuts, but we get none. Just punishment of those with wealth who might be able to pull us out of the slump.

An estimated $1.4 trillion in new taxes planned by the new administration over the next decade explicitly target the people President Teddy Roosevelt once derided as the "malefactors of great wealth" — those in the top 5% of the income spectrum. Yet, they're the ones who've made our economy the envy of the world.

By the way, under Obama's plan the rich won't pick up the whole tab. New energy taxes of $646 billion will hit the middle-class hard. Meanwhile, in just eight years, our national debt will double to $20 trillion, as nondefense federal spending jumps from the long-term average of 16.5% of GDP to above 23%.

You — or your children — face higher taxes for decades to come.

As our stock markets melt under a barrage of new taxes on incomes, estates, capital gains, dividends and energy, it's good to recall that more than 100 million people own stocks or mutual funds. And that the stock market is the main wealth- and growth-creating mechanism in our capitalist society.

But when taxes go up, regulations proliferate and the rule of law and private property protections are weakened, the economy will invariably suffer. This is a universal lesson of economic history, one we ignore at our peril. And yes, this is what's happening now.

No, we don't blame all our current ills on President Obama. He came in at a tough time, when many bad decisions had already been made. But he is responsible for what he's done since.

His stimulus package is little more than a down payment on a socialist economy. It raises taxes on the successful, brings back the welfare state, hands out favors and cash to friends of one political party, while imposing government control over the entire free market in ways that just a year ago would have seemed unimaginable.

Economics focus

Banks need more capital

In a guest article, Alan Greenspan says banks will need much thicker capital cushions than they had before the bust

Alan Greenspan was the chairman of the Federal Reserve Board from 1987 to 2006. He is now president of Greenspan Associates

GLOBAL financial intermediation is broken. That intricate and interdependent system directing the world’s saving into productive capital investment was severely weakened in August 2007. The disclosure that highly leveraged financial institutions were holding toxic securitised American subprime mortgages shocked market participants. For a year, banks struggled to respond to investor demands for larger capital cushions. But the effort fell short and in the wake of the Lehman Brothers default on September 15th 2008, the system cracked. Banks, fearful of their own solvency, all but stopped lending. Issuance of corporate bonds, commercial paper and a wide variety of other financial products largely ceased. Credit-financed economic activity was brought to a virtual standstill. The world faced a major financial crisis.

For decades, holders of the liabilities of banks in the United States had felt secure with the protection of a modest equity-capital cushion, allowing banks to lend freely. As recently as the summer of 2006, with average book capital at 10%, a federal agency noted that “more than 99% of all insured institutions met or exceeded the requirements of the highest regulatory capital standards.”

Today, fearful investors clearly require a far larger capital cushion to lend, unsecured, to any financial intermediary. When bank book capital finally adjusts to current market imperatives, it may well reach its highest levels in 75 years, at least temporarily (see chart). It is not a stretch to infer that these heightened levels will be the basis of a new regulatory system.

The three-month LIBOR/Overnight Index Swap (OIS) spread, a measure of market perceptions of potential bank insolvency and thus of extra capital needs, rose from a long-standing ten basis points in the summer of 2007 to 90 points by that autumn. Though elevated, the LIBOR/OIS spread appeared range-bound for about a year up to mid-September 2008. The Lehman default, however, drove LIBOR/OIS up markedly. It reached a riveting 364 basis points on October 10th.

The passage by Congress of the $700 billion Troubled Assets Relief Programme (TARP) on October 3rd eased, but did not erase, the post-Lehman surge in LIBOR/OIS. The spread apparently stalled in mid-November and remains worryingly high.

How much extra capital, both private and sovereign, will investors require of banks and other intermediaries to conclude that they are not at significant risk in holding financial institutions’ deposits or debt, a precondition to solving the crisis?

The insertion, last month, of $250 billion of equity into American banks through TARP (a two-percentage-point addition to capital-asset ratios) halved the post-Lehman surge of the LIBOR/OIS spread. Assuming modest further write-offs, simple linear extrapolation would suggest that another $250 billion would bring the spread back to near its pre-crisis norm. This arithmetic would imply that investors now require 14% capital rather than the 10% of mid-2006. Such linear calculations, of course, can only be very rough approximations. But recent data do suggest that, while helpful, the Treasury’s $250 billion goes only partway towards the levels required to support renewed lending.

Government credit has in effect acted as counterparty to a large segment of the financial intermediary system. But for reasons that go beyond the scope of this note, I strongly believe that the use of government credit must be temporary. What, then, will be the source of the new private capital that allows sovereign lending to be withdrawn? Eventually, the most credible source is a partial restoration of the $30 trillion of global stockmarket value wiped out this year, which would enable banks to raise the needed equity. Markets are being suppressed by a degree of fear not experienced since the early 20th century (1907 and 1932 come to mind). Human nature being what it is, we can count on a market reversal, hopefully, within six months to a year.

Though capital gains cannot finance physical investment, they can replenish balance-sheets. This can best be seen in the context of the consolidated balance-sheet of the world economy. All debt and derivative claims are offset in global accounting consolidation, but capital is not. This leaves the market value of the world’s real physical and intellectual assets reflected as capital. Obviously, higher global stock prices will enlarge the pool of equity that can facilitate the recapitalisation of financial institutions. Lower stock prices can impede the process. A higher level of equity, of course, makes it easier to issue debt.

Another critical price for the return of global financial stability is that of American homes. Those prices are likely to stabilise next year and with them the levels of home equity—the ultimate collateral for global holdings of American mortgage-backed securities, some toxic. Home-price stabilisation will help clarify the market value of financial institutions’ assets and therefore more closely equate the size of their book capital with the realities of market pricing. That should help stabilise their stock prices. The eventual partial recovery of global equities, as fear inevitably dissipates, should do the rest. Temporary public capital injections into banks would facilitate this process and arguably provide far more benefit per dollar than conventional fiscal stimulus.

Even before the market linkages among banks, other financial institutions and non-financial businesses are fully re-established, we will need to start unwinding the massive sovereign credit and guarantees put in place during the crisis, now estimated at $7 trillion. The economics of such a course are fairly clear. The politics of draining off that much credit support in a timely way is quite another matter.

Wall Street Lays Another Egg

Wall Street Lays Another Egg

NEIL FERGUSON

This year we have lived through something more than a financial crisis. We have witnessed the death of a planet. Call it Planet Finance. Two years ago, in 2006, the measured economic output of the entire world was worth around $48.6 trillion. The total market capitalization of the world’s stock markets was $50.6 trillion, 4 percent larger. The total value of domestic and international bonds was $67.9 trillion, 40 percent larger. Planet Finance was beginning to dwarf Planet Earth.

Planet Finance seemed to spin faster, too. Every day $3.1 trillion changed hands on foreign-exchange markets. Every month $5.8 trillion changed hands on global stock markets. And all the time new financial life-forms were evolving. The total annual issuance of mortgage-backed securities, including fancy new “collateralized debt obligations” (C.D.O.’s), rose to more than $1 trillion. The volume of “derivatives”—contracts such as options and swaps—grew even faster, so that by the end of 2006 their notional value was just over $400 trillion. Before the 1980s, such things were virtually unknown. In the space of a few years their populations exploded. On Planet Finance, the securities outnumbered the people; the transactions outnumbered the relationships.

Read Niall Ferguson’s prescient article on today’s financial woes, Empire Falls (November 2006).
New institutions also proliferated. In 1990 there were just 610 hedge funds, with $38.9 billion under management. At the end of 2006 there were 9,462, with $1.5 trillion under management. Private-equity partnerships also went forth and multiplied. Banks, meanwhile, set up a host of “conduits” and “structured investment vehicles” (sivs—surely the most apt acronym in financial history) to keep potentially risky assets off their balance sheets. It was as if an entire shadow banking system had come into being.

Then, beginning in the summer of 2007, Planet Finance began to self-destruct in what the International Monetary Fund soon acknowledged to be “the largest financial shock since the Great Depression.” Did the crisis of 2007–8 happen because American companies had gotten worse at designing new products? Had the pace of technological innovation or productivity growth suddenly slackened? No. The proximate cause of the economic uncertainty of 2008 was financial: to be precise, a crunch in the credit markets triggered by mounting defaults on a hitherto obscure species of housing loan known euphemistically as “subprime mortgages.”

Central banks in the United States and Europe sought to alleviate the pressure on the banks with interest-rate cuts and offers of funds through special “term auction facilities.” Yet the market rates at which banks could borrow money, whether by issuing commercial paper, selling bonds, or borrowing from one another, failed to follow the lead of the official federal-funds rate. The banks had to turn not only to Western central banks for short-term assistance to rebuild their reserves but also to Asian and Middle Eastern sovereign-wealth funds for equity injections. When these sources proved insufficient, investors—and speculative short-sellers—began to lose faith.

Beginning with Bear Stearns, Wall Street’s investment banks entered a death spiral that ended with their being either taken over by a commercial bank (as Bear was, followed by Merrill Lynch) or driven into bankruptcy (as Lehman Brothers was). In September the two survivors—Goldman Sachs and Morgan Stanley—formally ceased to be investment banks, signaling the death of a business model that dated back to the Depression. Other institutions deemed “too big to fail” by the U.S. Treasury were effectively taken over by the government, including the mortgage lenders and guarantors Fannie Mae and Freddie Mac and the insurance giant American International Group (A.I.G.).

By September 18 the U.S. financial system was gripped by such panic that the Treasury had to abandon this ad hoc policy. Treasury Secretary Henry Paulson hastily devised a plan whereby the government would be authorized to buy “troubled” securities with up to $700 billion of taxpayers’ money—a figure apparently plucked from the air. When a modified version of the measure was rejected by Congress 11 days later, there was panic. When it was passed four days after that, there was more panic. Now it wasn’t just bank stocks that were tanking. The entire stock market seemed to be in free fall as fears mounted that the credit crunch was going to trigger a recession. Moreover, the crisis was now clearly global in scale. European banks were in much the same trouble as their American counterparts, while emerging-market stock markets were crashing. A week of frenetic improvisation by national governments culminated on the weekend of October 11–12, when the United States reluctantly followed the British government’s lead, buying equity stakes in banks rather than just their dodgy assets and offering unprecedented guarantees of banks’ debt and deposits.

Since these events coincided with the final phase of a U.S. presidential-election campaign, it was not surprising that some rather simplistic lessons were soon being touted by candidates and commentators. The crisis, some said, was the result of excessive deregulation of financial markets. Others sought to lay the blame on unscrupulous speculators: short-sellers, who borrowed the stocks of vulnerable banks and sold them in the expectation of further price declines. Still other suspects in the frame were negligent regulators and corrupt congressmen.

This hunt for scapegoats is futile. To understand the downfall of Planet Finance, you need to take several steps back and locate this crisis in the long run of financial history. Only then will you see that we have all played a part in this latest sorry example of what the Victorian journalist Charles Mackay described in his 1841 book, Extraordinary Popular Delusions and the Madness of Crowds.

Nothing New

As long as there have been banks, bond markets, and stock markets, there have been financial crises. Banks went bust in the days of the Medici. There were bond-market panics in the Venice of Shylock’s day. And the world’s first stock-market crash happened in 1720, when the Mississippi Company—the Enron of its day—blew up. According to economists Carmen Reinhart and Kenneth Rogoff, the financial history of the past 800 years is a litany of debt defaults, banking crises, currency crises, and inflationary spikes. Moreover, financial crises seldom happen without inflicting pain on the wider economy. Another recent paper, co-authored by Rogoff’s Harvard colleague Robert Barro, has identified 148 crises since 1870 in which a country experienced a cumulative decline in gross domestic product (G.D.P.) of at least 10 percent, implying a probability of financial disaster of around 3.6 percent per year.
If stock-market movements followed the normal-distribution, or bell, curve, like human heights, an annual drop of 10 percent or more would happen only once every 500 years, whereas in the case of the Dow Jones Industrial Average it has happened in 20 of the last 100 years. And stock-market plunges of 20 percent or more would be unheard of—rather like people a foot and a half tall—whereas in fact there have been eight such crashes in the past century.

The most famous financial crisis—the Wall Street Crash—is conventionally said to have begun on “Black Thursday,” October 24, 1929, when the Dow declined by 2 percent, though in fact the market had been slipping since early September and had suffered a sharp, 6 percent drop on October 23. On “Black Monday,” October 28, it plunged by 13 percent, and the next day by a further 12 percent. In the course of the next three years the U.S. stock market declined by a staggering 89 percent, reaching its nadir in July 1932. The index did not regain its 1929 peak until November 1954.

That helps put our current troubles into perspective. From its peak of 14,164, on October 9, 2007, to a dismal level of 8,579, exactly a year later, the Dow declined by 39 percent. By contrast, on a single day just over two decades ago—October 19, 1987—the index fell by 23 percent, one of only four days in history when the index has fallen by more than 10 percent in a single trading session.
This crisis, however, is about much more than just the stock market. It needs to be understood as a fundamental breakdown of the entire financial system, extending from the monetary-and-banking system through the bond market, the stock market, the insurance market, and the real-estate market. It affects not only established financial institutions such as investment banks but also relatively novel ones such as hedge funds. It is global in scope and unfathomable in scale.

Had it not been for the frantic efforts of the Federal Reserve and the Treasury, to say nothing of their counterparts in almost equally afflicted Europe, there would by now have been a repeat of that “great contraction” of credit and economic activity that was the prime mover of the Depression. Back then, the Fed and the Treasury did next to nothing to prevent bank failures from translating into a drastic contraction of credit and hence of business activity and employment. If the more openhanded monetary and fiscal authorities of today are ultimately successful in preventing a comparable slump of output, future historians may end up calling this “the Great Repression.” This is the Depression they are hoping to bottle up—a Depression in denial.

To understand why we have come so close to a rerun of the 1930s, we need to begin at the beginning, with banks and the money they make. From the Middle Ages until the mid-20th century, most banks made their money by maximizing the difference between the costs of their liabilities (payments to depositors) and the earnings on their assets (interest and commissions on loans). Some banks also made money by financing trade, discounting the commercial bills issued by merchants. Others issued and traded bonds and stocks, or dealt in commodities (especially precious metals). But the core business of banking was simple. It consisted, as the third Lord Rothschild pithily put it, “essentially of facilitating the movement of money from Point A, where it is, to Point B, where it is needed.”

The system evolved gradually. First came the invention of cashless intra-bank and inter-bank transactions, which allowed debts to be settled between account holders without having money physically change hands. Then came the idea of fractional-reserve banking, whereby banks kept only a small proportion of their existing deposits on hand to satisfy the needs of depositors (who seldom wanted all their money simultaneously), allowing the rest to be lent out profitably. That was followed by the rise of special public banks with monopolies on the issuing of banknotes and other powers and privileges: the first central banks.
With these innovations, money ceased to be understood as precious metal minted into coins. Now it was the sum total of specific liabilities (deposits and reserves) incurred by banks. Credit was the other side of banks’ balance sheets: the total of their assets; in other words, the loans they made. Some of this money might still consist of precious metal, though a rising proportion of that would be held in the central bank’s vault. Most would be made up of banknotes and coins recognized as “legal tender,” along with money that was visible only in current- and deposit-account statements.

Until the late 20th century, the system of bank money retained an anchor in the pre-modern conception of money in the form of the gold standard: fixed ratios between units of account and quantities of precious metal. As early as 1924, the English economist John Maynard Keynes dismissed the gold standard as a “barbarous relic,” but the last vestige of the system did not disappear until August 15, 1971—the day President Richard Nixon closed the so-called gold window, through which foreign central banks could still exchange dollars for gold. With that, the centuries-old link between money and precious metal was broken.
Though we tend to think of money today as being made of paper, in reality most of it now consists of bank deposits. If we measure the ratio of actual money to output in developed economies, it becomes clear that the trend since the 1970s has been for that ratio to rise from around 70 percent, before the closing of the gold window, to more than 100 percent by 2005. The corollary has been a parallel growth of credit on the other side of bank balance sheets. A significant component of that credit growth has been a surge of lending to consumers. Back in 1952, the ratio of household debt to disposable income was less than 40 percent in the United States. At its peak in 2007, it reached 133 percent, up from 90 percent a decade before. Today Americans carry a total of $2.56 trillion in consumer debt, up by more than a fifth since 2000.
Even more spectacular, however, has been the rising indebtedness of banks themselves. In 1980, bank indebtedness was equivalent to 21 percent of U.S. gross domestic product. In 2007 the figure was 116 percent. Another measure of this was the declining capital adequacy of banks. On the eve of “the Great Repression,” average bank capital in Europe was equivalent to less than 10 percent of assets; at the beginning of the 20th century, it was around 25 percent. It was not unusual for investment banks’ balance sheets to be as much as 20 or 30 times larger than their capital, thanks in large part to a 2004 rule change by the Securities and Exchange Commission that exempted the five largest of those banks from the regulation that had capped their debt-to-capital ratio at 12 to 1. The Age of Leverage had truly arrived for Planet Finance.

Credit and money, in other words, have for decades been growing more rapidly than underlying economic activity. Is it any wonder, then, that money has ceased to hold its value the way it did in the era of the gold standard? The motto “In God we trust” was added to the dollar bill in 1957. Since then its purchasing power, relative to the consumer price index, has declined by a staggering 87 percent. Average annual inflation during that period has been more than 4 percent. A man who decided to put his savings into gold in 1970 could have bought just over 27.8 ounces of the precious metal for $1,000. At the time of writing, with gold trading at $900 an ounce, he could have sold it for around $25,000.
Those few goldbugs who always doubted the soundness of fiat money—paper currency without a metal anchor—have in large measure been vindicated. But why were the rest of us so blinded by money illusion?

Blowing Bubbles

In the immediate aftermath of the death of gold as the anchor of the monetary system, the problem of inflation affected mainly retail prices and wages. Today, only around one out of seven countries has an inflation rate above 10 percent, and only one, Zimbabwe, is afflicted with hyperinflation. But back in 1979 at least 7 countries had an annual inflation rate above 50 percent, and more than 60 countries—including Britain and the United States—had inflation in double digits.

Inflation has come down since then, partly because many of the items we buy—from clothes to computers—have gotten cheaper as a result of technological innovation and the relocation of production to low-wage economies in Asia. It has also been reduced because of a worldwide transformation in monetary policy, which began with the monetarist-inspired increases in short-term rates implemented by the Federal Reserve in 1979. Just as important, some of the structural drivers of inflation, such as powerful trade unions, have also been weakened.

By the 1980s, in any case, more and more people had grasped how to protect their wealth from inflation: by investing it in assets they expected to appreciate in line with, or ahead of, the cost of living. These assets could take multiple forms, from modern art to vintage wine, but the most popular proved to be stocks and real estate. Once it became clear that this formula worked, the Age of Leverage could begin. For it clearly made sense to borrow to the hilt to maximize your holdings of stocks and real estate if these promised to generate higher rates of return than the interest payments on your borrowings. Between 1990 and 2004, most American households did not see an appreciable improvement in their incomes. Adjusted for inflation, the median household income rose by about 6 percent. But people could raise their living standards by borrowing and investing in stocks and housing.

Nearly all of us did it. And the bankers were there to help. Not only could they borrow more cheaply from one another than we could borrow from them; increasingly they devised all kinds of new mortgages that looked more attractive to us (and promised to be more lucrative to them) than boring old 30-year fixed-rate deals. Moreover, the banks were just as ready to play the asset markets as we were. Proprietary trading soon became the most profitable arm of investment banking: buying and selling assets on the bank’s own account.


There was, however, a catch. The Age of Leverage was also an age of bubbles, beginning with the dot-com bubble of the irrationally exuberant 1990s and ending with the real-estate mania of the exuberantly irrational 2000s. Why was this?

The future is in large measure uncertain, so our assessments of future asset prices are bound to vary. If we were all calculating machines, we would simultaneously process all the available information and come to the same conclusion. But we are human beings, and as such are prone to myopia and mood swings. When asset prices surge upward in sync, it is as if investors are gripped by a kind of collective euphoria. Conversely, when their “animal spirits” flip from greed to fear, the bubble that their earlier euphoria inflated can burst with amazing suddenness. Zoological imagery is an integral part of the culture of Planet Finance. Optimistic buyers are “bulls,” pessimistic sellers are “bears.” The real point, however, is that stock markets are mirrors of the human psyche. Like Homo sapiens, they can become depressed. They can even suffer complete breakdowns.

This is no new insight. In the 400 years since the first shares were bought and sold on the Amsterdam Beurs, there has been a long succession of financial bubbles. Time and again, asset prices have soared to unsustainable heights only to crash downward again. So familiar is this pattern—described by the economic historian Charles Kindleberger—that it is possible to distill it into five stages:
(1) Displacement: Some change in economic circumstances creates new and profitable opportunities. (2) Euphoria, or overtrading: A feedback process sets in whereby expectation of rising profits leads to rapid growth in asset prices. (3) Mania, or bubble: The prospect of easy capital gains attracts first-time investors and swindlers eager to mulct them of their money. (4) Distress: The insiders discern that profits cannot possibly justify the now exorbitant price of the assets and begin to take profits by selling. (5) Revulsion, or discredit: As asset prices fall, the outsiders stampede for the exits, causing the bubble to burst.
The key point is that without easy credit creation a true bubble cannot occur. That is why so many bubbles have their origins in the sins of omission and commission of central banks.

The bubbles of our time had their origins in the aftermath of the 1987 stock-market crash, when then novice Federal Reserve chairman Alan Greenspan boldly affirmed the Fed’s “readiness to serve as a source of liquidity to support the economic and financial system.” This sent a signal to the markets, particularly the New York banks: if things got really bad, he stood ready to bail them out. Thus was born the “Greenspan put”—the implicit option the Fed gave traders to be able to sell their stocks at today’s prices even in the event of a meltdown tomorrow.

Having contained a panic once, Greenspan thereafter had a dilemma lurking in the back of his mind: whether or not to act pre-emptively the next time—to prevent a panic altogether. This dilemma came to the fore as a classic stock-market bubble took shape in the mid-90s. The displacement in this case was the explosion of innovation by the technology and software industry as personal computers met the Internet. But, as in all of history’s bubbles, an accommodative monetary policy also played a role. From a peak of 6 percent in February 1995, the federal-funds target rate had been reduced to 5.25 percent by January 1996. It was then cut in steps, in the fall of 1998, down to 4.75 percent, and it remained at that level until June 1999, by which time the Dow had passed the 10,000 mark.

Why did the Fed allow euphoria to run loose in the 1990s? Partly because Greenspan and his colleagues underestimated the momentum of the technology bubble; as early as December 1995, with the Dow just past the 5,000 mark, members of the Fed’s Open Market Committee speculated that the market might be approaching its peak. Partly, also, because Greenspan came to the conclusion that it was not the Fed’s responsibility to worry about asset-price inflation, only consumer-price inflation, and this, he believed, was being reduced by a major improvement in productivity due precisely to the tech boom.

Greenspan could not postpone a stock-exchange crash indefinitely. After Silicon Valley’s dot-com bubble peaked, in March 2000, the U.S. stock market fell by almost half over the next two and a half years. It was not until May 2007 that investors in the Standard & Poor’s 500 had recouped their losses. But the Fed’s response to the sell-off—and the massive shot of liquidity it injected into the financial markets after the 9/11 terrorist attacks—prevented the “correction” from precipitating a depression. Not only were the 1930s averted; so too, it seemed, was a repeat of the Japanese experience after 1989, when a conscious effort by the central bank to prick an asset bubble had ended up triggering an 80 percent stock-market sell-off, a real-estate collapse, and a decade of economic stagnation.

What was not immediately obvious was that Greenspan’s easy-money policy was already generating another bubble—this time in the financial market that a majority of Americans have been encouraged for generations to play: the real-estate market.

The American Dream

Real estate is the English-speaking world’s favorite economic game. No other facet of financial life has such a hold on the popular imagination. The real-estate market is unique. Every adult, no matter how economically illiterate, has a view on its future prospects. Through the evergreen board game Monopoly, even children are taught how to climb the property ladder.

Once upon a time, people saved a portion of their earnings for the proverbial rainy day, stowing the cash in a mattress or a bank safe. The Age of Leverage, as we have seen, brought a growing reliance on borrowing to buy assets in the expectation of their future appreciation in value. For a majority of families, this meant a leveraged investment in a house. That strategy had one very obvious flaw. It represented a one-way, totally unhedged bet on a single asset.

To be sure, investing in housing paid off handsomely for more than half a century, up until 2006. Suppose you had put $100,000 into the U.S. property market back in the first quarter of 1987. According to the Case-Shiller national home-price index, you would have nearly tripled your money by the first quarter of 2007, to $299,000. On the other hand, if you had put the same money into the S&P 500, and had continued to re-invest the dividend income in that index, you would have ended up with $772,000 to play with—more than double what you would have made on bricks and mortar.

There is, obviously, an important difference between a house and a stock-market index. You cannot live in a stock-market index. For the sake of a fair comparison, allowance must therefore be made for the rent you save by owning your house (or the rent you can collect if you own a second property). A simple way to proceed is just to leave out both dividends and rents. In that case the difference is somewhat reduced. In the two decades after 1987, the S&P 500, excluding dividends, rose by a factor of just over six, meaning that an investment of $100,000 would be worth some $600,000. But that still comfortably beat housing.
There are three other considerations to bear in mind when trying to compare housing with other forms of assets. The first is depreciation. Stocks do not wear out and require new roofs; houses do. The second is liquidity. As assets, houses are a great deal more expensive to convert into cash than stocks. The third is volatility. Housing markets since World War II have been far less volatile than stock markets. Yet that is not to say that house prices have never deviated from a steady upward path. In Britain between 1989 and 1995, for example, the average house price fell by 18 percent, or, in inflation-adjusted terms, by more than a third—37 percent. In London, the real decline was closer to 47 percent. In Japan between 1990 and 2000, property prices fell by more than 60 percent.

The recent decline of property prices in the United States should therefore have come as less of a shock than it did. Between July 2006 and June 2008, the Case-Shiller index of home prices in 20 big American cities declined on average by 19 percent. In some of these cities—Phoenix, San Diego, Los Angeles, and Miami—the total decline was as much as a third. Seen in international perspective, those are not unprecedented figures. Seen in the context of the post-2000 bubble, prices have yet to return to their starting point. On average, house prices are still 50 percent higher than they were at the beginning of this process.

So why were we oblivious to the likely bursting of the real-estate bubble? The answer is that for generations we have been brainwashed into thinking that borrowing to buy a house is the only rational financial strategy to pursue. Think of Frank Capra’s classic 1946 movie, It’s a Wonderful Life, which tells the story of the family-owned Bailey Building & Loan, a small-town mortgage firm that George Bailey (played by James Stewart) struggles to keep afloat in the teeth of the Depression. “You know, George,” his father tells him, “I feel that in a small way we are doing something important. It’s satisfying a fundamental urge. It’s deep in the race for a man to want his own roof and walls and fireplace, and we’re helping him get those things in our shabby little office.” George gets the message, as he passionately explains to the villainous slumlord Potter after Bailey Sr.’s death: “[My father] never once thought of himself.… But he did help a few people get out of your slums, Mr. Potter. And what’s wrong with that? … Doesn’t it make them better citizens? Doesn’t it make them better customers?”

There, in a nutshell, is one of the key concepts of the 20th century: the notion that property ownership enhances citizenship, and that therefore a property-owning democracy is more socially and politically stable than a democracy divided into an elite of landlords and a majority of property-less tenants. So deeply rooted is this idea in our political culture that it comes as a surprise to learn that it was invented just 70 years ago.

Fannie, Ginnie, and Freddie

Prior to the 1930s, only a minority of Americans owned their homes. During the Depression, however, the Roosevelt administration created a whole complex of institutions to change that. A Federal Home Loan Bank Board was set up in 1932 to encourage and oversee local mortgage lenders known as savings-and-loans (S&Ls)—mutual associations that took in deposits and lent to homebuyers. Under the New Deal, the Home Owners’ Loan Corporation stepped in to refinance mortgages on longer terms, up to 15 years. To reassure depositors, who had been traumatized by the thousands of bank failures of the previous three years, Roosevelt introduced federal deposit insurance. And by providing federally backed insurance for mortgage lenders, the Federal Housing Administration (F.H.A.) sought to encourage large (up to 80 percent of the purchase price), long (20- to 25-year), fully amortized, low-interest loans.

By standardizing the long-term mortgage and creating a national system of official inspection and valuation, the F.H.A. laid the foundation for a secondary market in mortgages. This market came to life in 1938, when a new Federal National Mortgage Association—nicknamed Fannie Mae—was authorized to issue bonds and use the proceeds to buy mortgages from the local S&Ls, which were restricted by regulation both in terms of geography (they could not lend to borrowers more than 50 miles from their offices) and in terms of the rates they could offer (the so-called Regulation Q, which imposed a low ceiling on interest paid on deposits). Because these changes tended to reduce the average monthly payment on a mortgage, the F.H.A. made home ownership viable for many more Americans than ever before. Indeed, it is not too much to say that the modern United States, with its seductively samey suburbs, was born with Fannie Mae. Between 1940 and 1960, the home-ownership rate soared from 43 to 62 percent.
These were not the only ways in which the federal government sought to encourage Americans to own their own homes. Mortgage-interest payments were always tax-deductible, from the inception of the federal income tax in 1913. As Ronald Reagan said when the rationality of this tax break was challenged, mortgage-interest relief was “part of the American dream.”

In 1968, to broaden the secondary-mortgage market still further, Fannie Mae was split in two—the Government National Mortgage Association (Ginnie Mae), which was to cater to poor borrowers, and a rechartered Fannie Mae, now a privately owned government-sponsored enterprise (G.S.E.). Two years later, to provide competition for Fannie Mae, the Federal Home Loan Mortgage Corporation (Freddie Mac) was set up. In addition, Fannie Mae was permitted to buy conventional as well as government-guaranteed mortgages. Later, with the Community Reinvestment Act of 1977, American banks found themselves under pressure for the first time to lend to poor, minority communities.

These changes presaged a more radical modification to the New Deal system. In the late 1970s, the savings-and-loan industry was hit first by double-digit inflation and then by sharply rising interest rates. This double punch was potentially lethal. The S&Ls were simultaneously losing money on long-term, fixed-rate mortgages, due to inflation, and hemorrhaging deposits to higher-interest money-market funds. The response in Washington from both the Carter and Reagan administrations was to try to salvage the S&Ls with tax breaks and deregulation. When the new legislation was passed, President Reagan declared, “All in all, I think we hit the jackpot.” Some people certainly did.

On the one hand, S&Ls could now invest in whatever they liked, not just local long-term mortgages. Commercial property, stocks, junk bonds—anything was allowed. They could even issue credit cards. On the other, they could now pay whatever interest rate they liked to depositors. Yet all their deposits were still effectively insured, with the maximum covered amount raised from $40,000 to $100,000, thanks to a government regulation two years earlier. And if ordinary deposits did not suffice, the S&Ls could raise money in the form of brokered deposits from middlemen. What happened next perfectly illustrated the great financial precept first enunciated by William Crawford, the commissioner of the California Department of Savings and Loan: “The best way to rob a bank is to own one.” Some S&Ls bet their depositors’ money on highly dubious real-estate developments. Many simply stole the money, as if deregulation meant that the law no longer applied to them at all.

When the ensuing bubble burst, nearly 300 S&Ls collapsed, while another 747 were closed or reorganized under the auspices of the Resolution Trust Corporation, established by Congress in 1989 to clear up the mess. The final cost of the crisis was $153 billion (around 3 percent of the 1989 G.D.P.), of which taxpayers had to pay $124 billion.

But even as the S&Ls were going belly-up, they offered another, very different group of American financial institutions a fast track to megabucks. To the bond traders at Salomon Brothers, the New York investment bank, the breakdown of the New Deal mortgage system was not a crisis but a wonderful opportunity. As profit-hungry as their language was profane, the self-styled “Big Swinging Dicks” at Salomon saw a way of exploiting the gyrating interest rates of the early 1980s.

The idea was to re-invent mortgages by bundling thousands of them together as the backing for new and alluring securities that could be sold as alternatives to traditional government and corporate bonds—in short, to convert mortgages into bonds. Once lumped together, the interest payments due on the mortgages could be subdivided into strips with different maturities and credit risks. The first issue of this new kind of mortgage-backed security (known as a “collateralized mortgage obligation”) occurred in June 1983. The dawn of securitization was a necessary prelude to the Age of Leverage.

Once again, however, it was the federal government that stood ready to pick up the tab in a crisis. For the majority of mortgages continued to enjoy an implicit guarantee from the government-sponsored trio of Fannie, Freddie, and Ginnie, meaning that bonds which used those mortgages as collateral could be represented as virtual government bonds and considered “investment grade.” Between 1980 and 2007, the volume of such G.S.E.-backed mortgage-backed securities grew from less than $200 billion to more than $4 trillion. In 1980 only 10 percent of the home-mortgage market was securitized; by 2007, 56 percent of it was.

These changes swept away the last vestiges of the business model depicted in It’s a Wonderful Life. Once there had been meaningful social ties between mortgage lenders and borrowers. James Stewart’s character knew both the depositors and the debtors. By contrast, in a securitized market the interest you paid on your mortgage ultimately went to someone who had no idea you existed. The full implications of this transition for ordinary homeowners would become apparent only 25 years later.

The Lessons of Detroit

In July 2007, I paid a visit to Detroit, because I had the feeling that what was happening there was the shape of things to come in the United States as a whole. In the space of 10 years, house prices in Detroit, which probably possesses the worst housing stock of any American city other than New Orleans, had risen by more than a third—not much compared with the nationwide bubble, but still hard to explain, given the city’s chronically depressed economic state. As I discovered, the explanation lay in fundamental changes in the rules of the housing game.

I arrived at the end of a borrowing spree. For several years agents and brokers selling subprime mortgages had been flooding Detroit with radio, television, and direct-mail advertisements, offering what sounded like attractive deals. In 2006, for example, subprime lenders pumped more than a billion dollars into 22 Detroit Zip Codes.

These were not the old 30-year fixed-rate mortgages invented in the New Deal. On the contrary, a high proportion were adjustable-rate mortgages—in other words, the interest rate could vary according to changes in short-term lending rates. Many were also interest-only mortgages, without amortization (repayment of principal), even when the principal represented 100 percent of the assessed value of the mortgaged property. And most had introductory “teaser” periods, whereby the initial interest payments—usually for the first two years—were kept artificially low, with the cost of the loan backloaded. All of these devices were intended to allow an immediate reduction in the debt-servicing costs of the borrower.

In Detroit only a minority of these loans were going to first-time buyers. They were nearly all refinancing deals, which allowed borrowers to treat their homes as cash machines, converting their existing equity into cash and using the proceeds to pay off credit-card debts, carry out renovations, or buy new consumer durables. However, the combination of declining long-term interest rates and ever more alluring mortgage deals did attract new buyers into the housing market. By 2005, 69 percent of all U.S. householders were homeowners; 10 years earlier it had been 64 percent. About half of that increase could be attributed to the subprime-lending boom.

Significantly, a disproportionate number of subprime borrowers belonged to ethnic minorities. Indeed, I found myself wondering, as I drove around Detroit, if “subprime” was in fact a new financial euphemism for “black.” This was no idle supposition. According to a joint study by, among others, the Massachusetts Affordable Housing Alliance, 55 percent of black and Latino borrowers in Boston who had obtained loans for single-family homes in 2005 had been given subprime mortgages; the figure for white borrowers was just 13 percent. More than three-quarters of black and Latino borrowers from Washington Mutual were classed as subprime, whereas only 17 percent of white borrowers were. According to a report in The Wall Street Journal, minority ownership increased by 3.1 million between 2002 and 2007.

Here, surely, was the zenith of the property-owning democracy. It was an achievement that the Bush administration was proud of. “We want everybody in America to own their own home,” President George W. Bush had said in October 2002. Having challenged lenders to create 5.5 million new minority homeowners by the end of the decade, Bush signed the American Dream Downpayment Act in 2003, a measure designed to subsidize first-time house purchases in low-income groups. Between 2000 and 2006, the share of undocumented subprime contracts rose from 17 to 44 percent. Fannie Mae and Freddie Mac also came under pressure from the Department of Housing and Urban Development to support the subprime market. As Bush put it in December 2003, “It is in our national interest that more people own their own home.” Few people dissented.

As a business model, subprime lending worked beautifully—as long, that is, as interest rates stayed low, people kept their jobs, and real-estate prices continued to rise. Such conditions could not be relied upon to last, however, least of all in a city like Detroit. But that did not worry the subprime lenders. They simply followed the trail blazed by mainstream mortgage lenders in the 1980s. Having pocketed fat commissions on the signing of the original loan contracts, they hastily resold their loans in bulk to Wall Street banks. The banks, in turn, bundled the loans into high-yielding mortgage-backed securities and sold them to investors around the world, all eager for a few hundredths of a percentage point more of return on their capital. Repackaged as C.D.O.’s, these subprime securities could be transformed from risky loans to flaky borrowers into triple-A-rated investment-grade securities. All that was required was certification from one of the rating agencies that at least the top tier of these securities was unlikely to go into default.
The risk was spread across the globe, from American state pension funds to public-hospital networks in Australia, to town councils near the Arctic Circle. In Norway, for example, eight municipalities, including Rana and Hemnes, invested some $120 million of their taxpayers’ money in C.D.O.’s secured on American subprime mortgages.

In Detroit the rise of subprime mortgages had in fact coincided with a new slump in the inexorably declining automobile industry. That anticipated a wider American slowdown, an almost inevitable consequence of a tightening of monetary policy as the Federal Reserve belatedly raised short-term interest rates from 1 percent to 5.25 percent. As soon as the teaser rates expired and mortgages were reset at new and much higher interest rates, hundreds of Detroit households swiftly fell behind in their mortgage payments. The effect was to burst the real-estate bubble, causing house prices to start falling significantly for the first time since the early 1990s. And the further house prices fell, the more homeowners found themselves with “negative equity”—in other words, owing more money than their homes were worth.

The rest—the chain reaction as defaults in Detroit and elsewhere unleashed huge losses on C.D.O.’s in financial institutions all around the world—you know.

Drunk on Derivatives

Do you, however, know about the second-order effects of this crisis in the markets for derivatives? Do you in fact know what a derivative is? Once excoriated by Warren Buffett as “financial weapons of mass destruction,” derivatives are what make this crisis both unique and unfathomable in its ramifications. To understand what they are, you need, literally, to go back to the future.

For a farmer planting a crop, nothing is more crucial than the future price it will fetch after it has been harvested and taken to market. A futures contract allows him to protect himself by committing a merchant to buy his crop when it comes to market at a price agreed upon when the seeds are being planted. If the market price on the day of delivery is lower than expected, the farmer is protected.

The earliest forms of protection for farmers were known as forward contracts, which were simply bilateral agreements between seller and buyer. A true futures contract, however, is a standardized instrument issued by a futures exchange and hence tradable. With the development of a standard “to arrive” futures contract, along with a set of rules to enforce settlement and, finally, an effective clearinghouse, the first true futures market was born.

Because they are derived from the value of underlying assets, all futures contracts are forms of derivatives. Closely related, though distinct from futures, are the contracts known as options. In essence, the buyer of a “call” option has the right, but not the obligation, to buy an agreed-upon quantity of a particular commodity or financial asset from the seller (“writer”) of the option at a certain time (the expiration date) for a certain price (known as the “strike price”). Clearly, the buyer of a call option expects the price of the underlying instrument to rise in the future. When the price passes the agreed-upon strike price, the option is “in the money”—and so is the smart guy who bought it. A “put” option is just the opposite: the buyer has the right but not the obligation to sell an agreed-upon quantity of something to the seller of the option at an agreed-upon price.

A third kind of derivative is the interest-rate “swap,” which is effectively a bet between two parties on the future path of interest rates. A pure interest-rate swap allows two parties already receiving interest payments literally to swap them, allowing someone receiving a variable rate of interest to exchange it for a fixed rate, in case interest rates decline. A credit-default swap (C.D.S.), meanwhile, offers protection against a company’s defaulting on its bonds.

There was a time when derivatives were standardized instruments traded on exchanges such as the Chicago Board of Trade. Now, however, the vast proportion are custom-made and sold “over the counter” (O.T.C.), often by banks, which charge attractive commissions for their services, but also by insurance companies (notably A.I.G.). According to the Bank for International Settlements, the total notional amounts outstanding of O.T.C. derivative contracts—arranged on an ad hoc basis between two parties—reached a staggering $596 trillion in December 2007, with a gross market value of just over $14.5 trillion.

But how exactly do you price a derivative? What precisely is an option worth? The answers to those questions required a revolution in financial theory. From an academic point of view, what this revolution achieved was highly impressive. But the events of the 1990s, as the rise of quantitative finance replaced preppies with quants (quantitative analysts) all along Wall Street, revealed a new truth: those whom the gods want to destroy they first teach math.

Working closely with Fischer Black, of the consulting firm Arthur D. Little, M.I.T.’s Myron Scholes invented a groundbreaking new theory of pricing options, to which his colleague Robert Merton also contributed. (Scholes and Merton would share the 1997 Nobel Prize in economics.) They reasoned that a call option’s value depended on six variables: the current market price of the stock (S), the agreed future price at which the stock could be bought (L), the time until the expiration date of the option (t), the risk-free rate of return in the economy as a whole (r), the probability that the option will be exercised (N), and—the crucial variable—the expected volatility of the stock, i.e., the likely fluctuations of its price between the time of purchase and the expiration date (s). With wonderful mathematical wizardry, the quants reduced the price of a call option to this formula (the Black-Scholes formula).

Feeling a bit baffled? Can’t follow the algebra? That was just fine by the quants. To make money from this magic formula, they needed markets to be full of people who didn’t have a clue about how to price options but relied instead on their (seldom accurate) gut instincts. They also needed a great deal of computing power, a force which had been transforming the financial markets since the early 1980s. Their final requirement was a partner with some market savvy in order to make the leap from the faculty club to the trading floor. Black, who would soon be struck down by cancer, could not be that partner. But John Meriwether could. The former head of the bond-arbitrage group at Salomon Brothers, Meriwether had made his first fortune in the wake of the S&L meltdown of the late 1980s. The hedge fund he created with Scholes and Merton in 1994 was called Long-Term Capital Management.

In its brief, four-year life, Long-Term was the brightest star in the hedge-fund firmament, generating mind-blowing returns for its elite club of investors and even more money for its founders. Needless to say, the firm did more than just trade options, though selling puts on the stock market became such a big part of its business that it was nicknamed “the central bank of volatility” by banks buying insurance against a big stock-market sell-off. In fact, the partners were simultaneously pursuing multiple trading strategies, about 100 of them, with a total of 7,600 positions. This conformed to a second key rule of the new mathematical finance: the virtue of diversification, a principle that had been formalized by Harry M. Markowitz, of the Rand Corporation. Diversification was all about having a multitude of uncorrelated positions. One might go wrong, or even two. But thousands just could not go wrong simultaneously.
The mathematics were reassuring. According to the firm’s “Value at Risk” models, it would take a 10-s (in other words, 10-standard-deviation) event to cause the firm to lose all its capital in a single year. But the probability of such an event, according to the quants, was 1 in 10,24—or effectively zero. Indeed, the models said the most Long-Term was likely to lose in a single day was $45 million. For that reason, the partners felt no compunction about leveraging their trades. At the end of August 1997, the fund’s capital was $6.7 billion, but the debt-financed assets on its balance sheet amounted to $126 billion, a ratio of assets to capital of 19 to 1.

There is no need to rehearse here the story of Long-Term’s downfall, which was precipitated by a Russian debt default. Suffice it to say that on Friday, August 21, 1998, the firm lost $550 million—15 percent of its entire capital, and vastly more than its mathematical models had said was possible. The key point is to appreciate why the quants were so wrong.

The problem lay with the assumptions that underlie so much of mathematical finance. In order to construct their models, the quants had to postulate a planet where the inhabitants were omniscient and perfectly rational; where they instantly absorbed all new information and used it to maximize profits; where they never stopped trading; where markets were continuous, frictionless, and completely liquid. Financial markets on this planet followed a “random walk,” meaning that each day’s prices were quite unrelated to the previous day’s, but reflected no more and no less than all the relevant information currently available. The returns on this planet’s stock market were normally distributed along the bell curve, with most years clustered closely around the mean, and two-thirds of them within one standard deviation of the mean. On such a planet, a “six standard deviation” sell-off would be about as common as a person shorter than one foot in our world. It would happen only once in four million years of trading.

But Long-Term was not located on Planet Finance. It was based in Greenwich, Connecticut, on Planet Earth, a place inhabited by emotional human beings, always capable of flipping suddenly and en masse from greed to fear. In the case of Long-Term, the herding problem was acute, because many other firms had begun trying to copy Long-Term’s strategies in the hope of replicating its stellar performance. When things began to go wrong, there was a truly bovine stampede for the exits. The result was a massive, synchronized downturn in virtually all asset markets. Diversification was no defense in such a crisis. As one leading London hedge-fund manager later put it to Meriwether, “John, you were the correlation.”
There was, however, another reason why Long-Term failed. The quants’ Value at Risk models had implied that the loss the firm suffered in August 1998 was so unlikely that it ought never to have happened in the entire life of the universe. But that was because the models were working with just five years of data. If they had gone back even 11 years, they would have captured the 1987 stock-market crash. If they had gone back 80 years they would have captured the last great Russian default, after the 1917 revolution. Meriwether himself, born in 1947, ruefully observed, “If I had lived through the Depression, I would have been in a better position to understand events.” To put it bluntly, the Nobel Prize winners knew plenty of mathematics but not enough history.

One might assume that, after the catastrophic failure of L.T.C.M., quantitative hedge funds would have vanished from the financial scene, and derivatives such as options would be sold a good deal more circumspectly. Yet the very reverse happened. Far from declining, in the past 10 years hedge funds of every type have exploded in number and in the volume of assets they manage, with quantitative hedge funds such as Renaissance, Citadel, and D. E. Shaw emerging as leading players. The growth of derivatives has also been spectacular—and it has continued despite the onset of the credit crunch. Between December 2005 and December 2007, the notional amounts outstanding for all derivatives increased from $298 trillion to $596 trillion. Credit-default swaps quadrupled, from $14 trillion to $58 trillion.
An intimation of the problems likely to arise came in September, when the government takeover of Fannie and Freddie cast doubt on the status of derivative contracts protecting the holders of more than $1.4 trillion of their bonds against default. The consequences of the failure of Lehman Brothers were substantially greater, because the firm was the counter-party in so many derivative contracts.
The big question is whether those active in the market waited too long to set up some kind of clearing mechanism. If, as seems inevitable, there is an upsurge in corporate defaults as the U.S. slides into recession, the whole system could completely seize up.

The China Syndrome

Just 10 years ago, during the Asian crisis of 1997–98, it was conventional wisdom that financial crises were more likely to happen on the periphery of the world economy—in the so-called emerging markets of East Asia and Latin America. Yet the biggest threats to the global financial system in this new century have come not from the periphery but from the core. The explanation for this strange role reversal may in fact lie in the way emerging markets changed their behavior after 1998.
For many decades it was assumed that poor countries could become rich only by borrowing capital from wealthy countries. Recurrent debt crises and currency crises associated with sudden withdrawals of Western money led to a rethinking, inspired largely by the Chinese example.
When the Chinese wanted to attract foreign capital, they insisted that it take the form of direct investment. That meant that instead of borrowing from Western banks to finance its industrial development, as many emerging markets did, China got foreigners to build factories in Chinese enterprise zones—large, lumpy assets that could not easily be withdrawn in a crisis.

The crucial point, though, is that the bulk of Chinese investment has been financed from China’s own savings. Cautious after years of instability and unused to the panoply of credit facilities we have in the West, Chinese households save a high proportion of their rising incomes, in marked contrast to Americans, who in recent years have saved almost none at all. Chinese corporations save an even larger
proportion of their soaring profits. The remarkable thing is that a growing share of that savings surplus has ended up being lent to the United States. In effect, the People’s Republic of China has become banker to the United States of America.

The Chinese have not been acting out of altruism. Until very recently, the best way for China to employ its vast population was by exporting manufactured goods to the spendthrift U.S. consumer. To ensure that those exports were irresistibly cheap, China had to fight the tendency for its currency to strengthen against the dollar by buying literally billions of dollars on world markets. In 2006, Chinese holdings of dollars reached 700 billion. Other Asian and Middle Eastern economies adopted much the same strategy.
The benefits for the United States were manifold. Asian imports kept down U.S. inflation. Asian labor kept down U.S. wage costs. Above all, Asian savings kept down U.S. interest rates. But there was a catch. The more Asia was willing to lend to the United States, the more Americans were willing to borrow. The Asian savings glut was thus the underlying cause of the surge in bank lending, bond issuance, and new derivative contracts that Planet Finance witnessed after 2000. It was the underlying cause of the hedge-fund population explosion. It was the underlying reason why private-equity partnerships were able to borrow money left, right, and center to finance leveraged buyouts. And it was the underlying reason why the U.S. mortgage market was so awash with cash by 2006 that you could get a 100 percent mortgage with no income, no job, and no assets.

Whether or not China is now sufficiently “decoupled” from the United States that it can insulate itself from our credit crunch remains to be seen. At the time of writing, however, it looks very doubtful.

Back to Reality

The modern financial system is the product of centuries of economic evolution. Banks transformed money from metal coins into accounts, allowing ever larger aggregations of borrowing and lending. From the Renaissance on, government bonds introduced the securitization of streams of interest payments. From the 17th century on, equity in corporations could be bought and sold in public stock markets. From the 18th century on, central banks slowly learned how to moderate or exacerbate the business cycle. From the 19th century on, insurance was supplemented by futures, the first derivatives. And from the 20th century on, households were encouraged by government to skew their portfolios in favor of real estate.
Read Niall Ferguson’s prescient article on today’s financial woes, Empire Falls (November 2006).

Economies that combined all these institutional innovations performed better over the long run than those that did not, because financial intermediation generally permits a more efficient allocation of resources than, say, feudalism or central planning. For this reason, it is not wholly surprising that the Western financial model tended to spread around the world, first in the guise of imperialism, then in the guise of globalization. Yet money’s ascent has not been, and can never be, a smooth one. On the contrary, financial history is a roller-coaster ride of ups and downs, bubbles and busts, manias and panics, shocks and crashes. The excesses of the Age of Leverage—the deluge of paper money, the asset-price inflation, the explosion of consumer and bank debt, and the hypertrophic growth of derivatives—were bound sooner or later to produce a really big crisis. It remains unclear whether this crisis will have economic and social effects as disastrous as those of the Great Depression, or whether the monetary and fiscal authorities will succeed in achieving a Great Repression, averting a 1930s-style “great contraction” of credit and output by transferring the as yet unquantifiable losses from banks to taxpayers. Either way, Planet Finance has now returned to Planet Earth with a bang. The key figures of the Age of Leverage—the lax central bankers, the reckless investment bankers, the hubristic quants—are now feeling the full force of this planet’s gravity.

But what about the rest of us, the rank-and-file members of the deluded crowd? Well, we shall now have to question some of our most deeply rooted assumptions—not only about the benefits of paper money but also about the rationale of the property-owning democracy itself. On Planet Finance it may have made sense to borrow billions of dollars to finance a massive speculation on the future prices of American houses, and then to erect on the back of this trade a vast inverted pyramid of incomprehensible securities and derivatives.

But back here on Planet Earth it suddenly seems like an extraordinary popular delusion.

Niall Ferguson is Laurence A. Tisch Professor of History at Harvard University and a Senior Fellow of the Hoover Institution at Stanford, and the author of The War of the World: Twentieth-Century Conflict and the Descent of the West

---