The Great Financial Crisis of 2007
The storm that nearly destroyed the global banking system appeared in the eyes of many observers as something terrible and sudden, striking without warning. Of course the experts were aware of the credit boom, the unprecedented rise in US property prices and the proliferation of esoteric credit products from CLOs to “CDOs-squared”. PhD-wielding quantitative analysts, or “quants”, occupied prime positions in every major investment bank.
The champagne was flowing at securitization forums in Las Vegas and Barcelona and the City of London was touted as the miracle engine that powered the Blair economy. Wall Street basked in a golden age unseen since the days of Michael Douglas and Charlie Sheen in the eponymous motion picture. Banks were not mere issuers and arrangers but often aggressive investors in mortgage-backed securitizations. They kept the junior retained tranches in transactions and their “prop”, or proprietary trading, desks actively speculated in asset-backed products.
By the summer of 2007, the first increases in defaults and delinquencies in U.S. sub-prime mortgage rates were visible as interest rates crept upwards. Yet a pervasive belief that residential property had never suffered a national decline in value still held sway, a belief as erroneous as the “Dow 40,000” rhetoric that had powered the Nineties equity and tech bubbles. Yet no-one, from policymakers to economists, anticipated the ferocity of the new storm front when it actually struck.
The first straws in the wind were felt in July and August 2007, as asset backed commercial paper conduits (ABCP) began to seize up. Suddenly investor demand fell away and liquidity issues started affecting this corner of the wholesale banking markets. Various attempts were made to re-ignite the ABCP markets, including a Canadian conference, but nothing seemed to work. Even then, this was viewed as a local problem with limited impact on the real economy, where business continued to boom. Few however had anticipated the reliance of the banking system on wholesale money markets for their daily liquidity needs.
So the next sudden and unprecedented shock that hit the U.K. in 2007 was the collapse of Northern Rock. An assertive regional lender, this institution had transformed itself from a sleepy Newcastle-based mutual society to an expansionist and dynamic organisation. Its speciality was financing marginal borrowers with poor credit histories and offering loan-to-value ratios in the frothy British property markets. Northern Rock’s “Together” products famously combined a mortgage and a secured loan up to a value of 125% of the property, and were relentlessly promoted on television. Then suddenly the share price fell, and chief executive Adam Applegarth was forced to admit that funding had, quite literally, dried up. The first British banking bail-out since the nineteenth century had taken place. The reputation of the regulator, the Financial Services Authority, never quite recovered. The Labour government, which had blessed the boom years and indeed contributed to them with its own unfunded increases in public spending, was suddenly politically exposed.
As 2007 ended the British and American economies continued to power ahead. Ominously, the share prices of major high street banks continued to fall but talk of falling house prices was dismissed as scaremongering. Few could have imagined that within a year the entire global banking system would have come close to a fatal cardiac arrest. The venerable House of Lehman would be dust and great names from the Royal Bank of Scotland to Fannie Mae and Freddie Mae would be wards of the state. The great sovereign debt crisis of the European periphery, that began in the fjords of Reykjavik and flowed via the River Liffey onto the streets of Athens, was about to begin.