Newsletter Thirteen

From Boom to Crash

“Why did nobody notice it?” Question posed by Queen Elizabeth 11 when attending a briefing about the global financial crisis at the London School of Economics in November 2008.

The Queen didn’t get much of an answer to her killer question at the time. I’ll see if I can do better in this newsletter. My answer includes some commentary on how, as well as why, the great crash happened. The ‘how’ answer involves some rather arcane stuff about the money market and repurchase agreements. You can check out the technical detail in the Appendix to the newsletter if you so wish.

There’s one other important point to make at the outset about the great crash. Yes, it was a global crisis but its impact was more profound in some countries than in others. Its epicentre was the US, and the interconnectedness of the global financial system allowed the crisis to spread from there to other developed economies like the UK and continental Europe. But the US’s northern neighbour Canada was much less impacted, mainly because Canadian banks were not permitted to securitise residential mortgages. But also because credit default swaps and collateralised debt obligations (see below) were and still are prohibited (personal communication from the Substack writer and retired Canadian lawyer Jan D. Weir). Australia, too, had tighter regulation of its banking sector and was impacted to a lesser extent than many other developed nations.

Tulip mania

The history of capitalism has been punctuated by a long line of booms, bubbles and busts stretching as far back as the 1637 tulip mania in Holland, when the price of rare tulip bulbs soared to absurd heights and then crashed abruptly. This newsletter describes another such boom, the period from the early 1980s to late 2006 known as the ‘Great Moderation’; and another such bust, the great financial crash of 2007- 08. Newsletter 14 puts the great crash in its place as a crisis of capitalism, not in capitalism. Newsletters 15 through to 18 extend the narrative beyond the great crash to the eurozone sovereign debt crisis of the mid-to-late 2010s and the policy responses (quantitative easing and fiscal austerity) to both crises.

Actually what I’ve just written about the tulip mania is a bit too simplistic. Firstly, because capitalism in its recognisably modern form of industrial capitalism dates only from the last third of the 18^th century. Secondly, because it’s not clear from my narrative whether tulip mania was a crisis in capitalism - part of a regular cycle of booms and busts - or a crisis of capitalism - a spectacular crash leading to far-reaching economic, social and political change (Gamble, 2009, p 7). There is no such ambiguity about the great financial crash, which is undoubtedly a crisis of capitalism. Or about the eurozone crisis, which is undoubtedly a crisis of democracy.

The Great Moderation

The vast expansion of securitisation triggered the massive and disproportionate growth of the financial sector in the 1980s. Finance became increasingly deregulated, increasingly global in nature, increasingly detached from the real economy (the part of the economy that is concerned with producing goods and non-financial services), and increasingly opaque. In this new era, banks could raise money from the money market, refreshing their capital as needed in a seemingly unending supply of credit. Problems arose when the securities pledged as collateral for short-term borrowing had their ratings questioned and/or downgraded.

The 1980s were the beginning, too, of the ‘Great Moderation’ or reduction in the volatility of business cycle fluctuations (expansions and contractions in economic activity across most developed economies, as measured by increases or decreases in GDP). This allowed bankers, regulators, politicians and the media to celebrate the economic benefits that were perceived to flow from an innovative financial sector and its capacity to disperse risk more broadly across deregulated financial markets, where national governments no longer imposed controls on the free movement of capital.

The intellectual roots of the Great Moderation lie within the mainstream economics profession’s theory of efficient and rational markets – a theory that ascribes to financial markets a superior capacity to regulators to monitor, measure and anticipate risk (Froud et al, 2012). This theory, also known as the ‘efficient markets hypothesis’, boils down to a belief that a self-regulating financial sector will necessarily converge on the correct pricing of risk (Innes, 2021).

Much of the new lending and borrowing in the years of the Great Moderation occurred in the so-called the ‘shadow banking system’, whose operations were not subject to regulatory oversight in the manner of deposit-taking banks. The system included those special purpose vehicles (SPVs) encountered in newsletter seven. These, you’ll remember, are separate legal entities involved in the process of converting a pool of ‘illiquid’ debt assets such as mortgage and credit card payments into a more complex income-generating security where investors could ‘pick and mix’ the risks on offer.

In due course, the SPVs’ reliance on short-term borrowing from the money market proved to be the global financial system’s Achilles heel. But in the boom years the process of recycling short-term borrowed money to fund the issue of trillions of dollars’ worth of tradeable securities fuelled a massive increase in lending in the mid-2000s1.

The perils of short-term funding

The rise in mortgage lending in the US was the proximate cause of the 2007 credit crunch2 and subsequent financial crash of 2008. In a nutshell, speculative lending by US financial institutions, especially of mortgage-backed securities, created a vast housing bubble lasting from 2001 through to 2006. When banks were deregulated in the 1980s, mortgage markets stopped being essentially national institutions and mortgage debt and other sorts of debt began to circulate around the globe. This allowed originating banks to bundle up mortgages into mortgage-backed securities and collateralised debt obligations (CDOs). CDOs pooled together mortgages, other cash-flow generating assets such as government and corporate bonds and consumer debt such as car loans and credit card repayments into separate tranches. Each tranche offered different combinations of risk and return that could be sold on to investors3. This global circuit of mortgage and other debt fuelled the massive indebtedness of owner-occupiers in many Western countries in the 1990s and 2000s.

Investment banks, which do not take deposits and need to borrow money to fund asset purchases, also used a different kind of security – short-term US government bonds (Treasuries) – for a different process, which would prove decisive in the events to come. They became collateral for obtaining short-term funding from the money market (see the Appendix).

Many of the banks and hedge funds that invested in MBS and CDOs during the US housing boom purchased credit default swap (CDS) contracts to protect or ‘hedge’ against default of their riskier assets. They made a series of payments, the CDS fee or ‘spread’, to the protection seller (other banks, hedge funds, insurance companies) over the life of the contract (typically five years) in exchange for a guarantee that they would be compensated for any losses on them, including the riskier tranches backed by sub-prime mortgages4. The percentage of sub-prime mortgages originated during a given year rose to approximately 20 per cent in the period from 2004 to 2006, with much higher percentages in some parts of the US.

When house prices across the US declined steeply after peaking in mid-2006, it became more difficult for borrowers to refinance their loans. As mortgages began to reset at higher interest rates, so millions of sub-prime borrowers defaulted on their loan payments. The SPVs and their sponsoring banks were squeezed in a vice: short-term funding disappeared and there was a collapse in the value of the assets they held. Securities backed with mortgages, including sub-prime mortgages – widely held by financial institutions globally – lost most of their value and became ‘toxic assets’.

Mortgage-backed securities also had the unfortunate effect of removing the lines of communication between the mortgage borrower, who was unaware that their mortgage had been sold by the original bank lender to investors. Negotiations over late mortgage payments were replaced in quick succession by rapid seizure of the property (a process known as foreclosure), often by an overseas bank looking to cut its losses, eviction of the homeowner and sale of the home at a knockdown price.

Over my dead body: the TARP bailout

The boom-turned-credit crunch culminated in the bankruptcy of one of the biggest, most leveraged players in the market, the Wall Street investment bank Lehman Brothers, in September 2008. The Bush administration’s decision to let Lehman fail forced central banks and governments across the world to intervene to bail out their own banks and ‘socialise’ their losses, at an enormous cost to national taxpayers.

The Troubled Assets Relief Programme (TARP) was a US federal government programme approved by Congress in October 2008 to purchase or insure up to $700 billion in assets and equity from eight US banks and other institutions. Although not described as such, this amounted to the de facto nationalisation of the troubled banks. TARP was hugely controversial, and when the House of Representatives voted down the original measure in what Timothy Garton Ash describes as a collision between the urgent demands of the contemporary American version of democracy and those of the contemporary American version of capitalism, it was House Republicans who defied President Bush’s appeal for support for the bailout. For some, the choice was ideological; they would rather die than vote for an expansion of government’s role in the US economy (Garton Ash, 2008).

The rapid effect of the collapse in the US mortgage market on the wider US economy was seen between mid-2007 and the end of 2008. Over three million jobs were lost, including over a million in manufacturing. Standard & Poor’s share index fell by 40 per cent. And with the market value of their homes and retirement assets declining fast, households lost $14 trillion (22 per cent) of their net worth (Panitch and Gindin, 2013, p 318).

The Fed to the rescue

Over and above the individual bailouts, there was one other, decisive ‘crisis management’ intervention that kept the global financial system afloat at this time. This was the reactivation of currency swap lines first used in the 1960s that enabled the Fed to pump massive amounts of US dollars into the world economy. The swap facility allowed the Federal Reserve to lend dollars to the Bank of England, the European Central Bank (ECB) and some other European central banks, which then channelled the dollars to the big European banks. The Fed also lent dollars, in smaller amounts, to some other favoured central banks such as those of Japan, South Korea and Mexico.

This ‘under the radar’ intervention re-affirmed the role of the US dollar as the world’s reserve currency and established the Fed as the indispensable global lender of last resort (Tooze, 2018, pp 210-216)5.

End Notes

1. I can’t resist drawing your attention to one particular detail of risk regulation, supposedly aligned with ‘best business practice’ as defined by the bankers themselves. This is because it is so revealing of the hubris of the banking and finance ‘policy community’ at the time. In 2004, when banks were shifting vast amounts of debt onto their SPVs, Basel 2 did require off-balance sheet risks to be brought onto the parent banks’ own accounts. But at the same time the proportion of mortgage assets that counted towards the necessary capital requirement was reduced from 50 to 35 per cent, making it more, not less, attractive for the big investment banks to hold mortgage-backed assets (Tooze, 2018, p. 86).

2. A credit crunch is a sudden sharp reduction in the availability of money or credit from banks or other lenders.

3. The marketability of these products relied on them being awarded a high grade by credit rating agencies such as Standard & Poor’s and Fitch.

4. Credit default swaps were not just used for hedging. CDS contracts could be struck even if the buyer did not own the debt they wanted to insure. And they could be used to speculate on the credit worthiness of an investment bank like Lehman Brothers which was thought to be over-leveraged.

5. By September 2011 total lending and repayment under the terms of the currency swap facility came to $10 trillion at varying lengths of maturity (Tooze, 2018, p 214).

References

Froud, J., Nilsson, A., Moran, M. and Williams, K. (2012) ‘Stories and interests in finance: agendas of governance before and after the financial crisis’, Governance, vol 25, no 1, pp 35-59.

Gamble, A. (2009) The spectre at the feast, Basingstoke: Palgrave Macmillan.

Garton Ash, T. (2008) ‘The US democratic-capitalist model is on trial. No schadenfreude, please’, The Guardian, 1 September.

Innes, A. 2021 ‘State capture’, London Review of Books, Vol. 43, No. 24.

Panitch, L. and Gindin, S. (2013) The making of global capitalism, London: Verso.

Pettifor, A (2021) ‘Money trouble’ Prospect, August/September pp 53-56.

Tooze, A (2018) Crashed: How a decade of financial crises changed the world, London: Allen Lane.

Appendix

This appendix explains how the big investment banks secured the cash to keep buying mortgages, which they then converted into securities and sold to investors. The answer is that they got the cash from the money market, which is best thought of as a great pool of cash held by institutional investors such as mutual funds, pension funds, insurance companies and asset management firms. It’s not a market with a fixed location but a global network for the purchase and sale of large volumes of debt products which can be exchanged for cash over alarmingly short periods of time (Pettifor, 2021). Inter-bank lending and borrowing is at its core.

One of the main ways the money market worked in the period leading up to the credit crunch was through a repurchase agreement, or repo. This is a contractual arrangement where one party (the borrower) agrees to sell government bonds (especially US Treasuries) to another party (the cash provider) jn exchange for cash and repurchase them later, often the next day, at a slightly higher price. Because US Treasuries were (and are) widely regarded as a ‘safe’ asset class, lots of banks were keen to engage in repo trades.

A normally functioning repo market allows financial institutions that own lots of securities but need money to finance day-to-day trades, such as investment banks and hedge funds, to borrow cheaply and allows parties with spare cash, such as mutual funds, to earn a return without taking too much risk. So an investment bank would ‘repo’ (sell in exchange for cash and then repurchase) Treasuries overnight with a money market cash provider. In doing so they’d take a small cut to the value. This was called the haircut. The big banks via their SPVs would then use this borrowed money to purchase longer-dated assets such as mortgages to securitise.

The repo arrangement would then ‘roll over’ regularly, with the repo rate being agreed, and the process would carry on. ‘Repo’ became the central funding source for investment banks. In the meantime, the haircut determined how much of its own money the investment bank would have to use to obtain the cash. Using this mechanism, a small amount of its own capital was able to support a far bigger number of assets on the bank’s balance sheet, always assuming the repo could be continually rolled over. By the 2000s, the New York repo market was going through trillions of dollars a day. In 2007, half of Lehman Brothers’ $691 billion balance sheet was funded by repo. For Goldman Sachs, Merrill Lynch and Morgan Stanley the share was 40 per cent (Tooze, 2018, p 62).

You may wish to note in passing that central banks apply haircuts to the collateral that commercial banks provide in order to secure loans from the central bank.

David Clark

04 November 2025