The first is from Harvard professor Niall Ferguson, whose new report “Too Big to Live” was released today and is summarized in the Telegraph. Ferguson puts the academic gloss on what many main-street bankers know in their bones:
“This crisis was not the result of deregulation and market failure. In reality, it was born of a highly distorted financial market, in which excessive concentration, excessive leverage, spurious theories of risk management and, above all, moral hazard in the form of implicit state guarantees, combined to create huge ticking time-bombs on both sides of the Atlantic. The greatest danger we currently face is that the emergency measures adopted to remedy the crisis have made matters even worse.”
Ferguson’s summary of concentration is useful:
“Between 1990 and 2008, the share of financial assets held by the 10 largest US financial institutions rose from 10 per cent to 50 per cent, even as the number of banks fell from over 15,000 to about 8,000.
By the end of 2007, 15 megabanks, with combined shareholder equity of $857 billion, had total assets of $13.6 trillion and off-balance-sheet commitments of $5.8 trillion – an aggregate leverage ratio of 23 to 1. They also had underwritten derivatives with a gross notional value of $216 trillion – more than a third of the total.
This was far from being a purely American phenomenon. By 2003 the five largest banking groups in the UK accounted for 71 per cent of deposits and 75 per cent of loans.”
Then, drawing on a recent statement from Treasury Secretary Tim Geithner, Ferguson concludes:
“As [Geithner] clearly understands, the real aim of government should be to give the TBTFs ‘positive incentives … to shrink and to reduce their leverage, complexity, and interconnectedness’.
The best way of creating such incentives is to reiterate, preferably once a week, one key point: in case of failure, ‘the largest, most interconnected firms’ should in future be wound up ‘in a way that protects taxpayers and the broader economy while ensuring that losses are borne by creditors and other stakeholders’.
That was the principle that was thrown overboard in the crisis, when it was decided to prevent the holders of bank bonds (apart from those of Lehman Brothers) from losing their money. Removing that protection will necessarily raise the cost of credit for the TBTFs, reduce their profitability and encourage them to split themselves up.”
It’s the sub-prime, stupid
The second article, called “The Man Who Crashed the World,” was published earlier this year by Vanity Fair. It summarizes the sub-prime bets that hobbled AIG. It’s remarkable how just one institution–or, as author Michael Lewis indicates, a small group within a single business unit (AIG Financial Products)–spurred so much dangerous activity. Earlier this decade, AIG took the technology it had developed to distribute corporate credit risk and started applying it to consumer credit. In a period of a couple of years AIG was insuring bonds comprised almost exclusively of sub-prime mortgages. Lewis describes the frenetic pace:
“In June 2004 the Fed began to contract the money supply, and interest rates rose. In a normal economy, when interest rates rise, consumer borrowing falls—and in the normal end of the U.S. economy that happened: from June 2004 to June 2005 prime-mortgage lending fell by half. But in that same period subprime lending doubled—and then doubled again. In 2003 there had been a few tens of billions of dollars of subprime-mortgage loans. From June 2004 until June 2007, Wall Street underwrote $1.6 trillion of new subprime-mortgage loans and another $1.2 trillion of so-called Alt-A loans.”
AIG assumed “the vast majority of the risk of all the subprime mortgage bonds created in 2004 and 2005,” before perceiving the danger and curbing its program. At that point:
“The big Wall Street firms [started] taking the risk themselves. The hundreds of billions of dollars in subprime losses suffered by Merrill Lynch, Morgan Stanley, Lehman Brothers, Bear Stearns, and the others were hundreds of billions in losses that might otherwise have been suffered by A.I.G. F.P. Unwilling to take the risk of subprime-mortgage bonds in 2004 and 2005, the Wall Street firms swallowed the risk in 2006 and 2007. Lending standards had fallen, property values had risen, and the more recent loans were thus far riskier than the earlier ones, but still they gobbled them up…”
