Decade on, lessons still from 2007 bubble & 2008 crisis

The Bank for International Settlements was one of the few institutions to accurately predict the 2008 financial crisis and is very concerned policymakers are making the same mistakes today.

ON Thursday, August 9, it will be ten years since a panic freeze in banking liquidity paved the way to the 2008 financial crash.

The events before, during and after that period are a lesson to those who ignore signs of financial excess. The tenth anniversary of the liquidity crunch is also a warning that central bank intervention is a palliative but not a cure for the consequences of financial disorder. Today, the main concern is massive public and private debt that has been built up since the crash. History doesn’t repeat itself in the same way but those events of ten years ago are a cautionary reminder to those who claim “this time it is different”.

Today, central banks and governments are relying on tighter regulation to counter the excesses that brought about the crash. Compliance fines from 2007 to the end of 2016 amounted to a whopping US$321 billion, estimates The Boston Consultancy Group. But regulation can only partly work if the underlying cause is excessive monetary expansion.

“Each and every subsequent economic and financial hiatus has been a direct result of excessively loose monetary policy to clear up the previous mess,” says Albert Edwards, Societe Generale strategist. “The Bank For International Settlements (BIS) is one of the few institutions in the mid-2000s to accurately predict the impending financial crisis and is very concerned that policymakers are making exactly the same mistakes they did in the run-up to 2008.”

BIS chief economist Claudio Borio has cautioned that economies such as Canada and Sweden that largely avoided the last crash have since allowed huge borrowing and property booms that make their economies vulnerable. The largest emerging economies of China, India and Brazil are also vulnerable after a period of rapid growth, much of it based on cheap credit.

If there is another crash at some point in the future, the question is whether central banks would have the fire power to counter it. They have already slashed interest rates to zero or negative. The following history of the liquidity crunch that eventually led to the financial crisis of 2008 to 2009 shows that it doesn’t pay to be sanguine.

On 9 August, 2007, French bank BNP Paribas froze 1.6 billion euros (S$2.6 billion) because three of its hedge funds had massive losses from the collapsing sub-prime debt market in the US. BNP admitted that the hedge funds couldn’t value complex assets known as collateralised debt obligations (CDOs), notably derivative packages of sub-prime loans. Within days, banks in Germany and Holland acknowledged their risk of exposure to CDOs. Such was the panic that the European banking system was soon experiencing a systematic liquidity crisis. Banks were fearful of lending money to each other and in turn slashed credit to companies and individuals.

Mervyn King – governor of the Bank of England at the time – recalled in a recent BBC interview that it wasn’t so much the BNP announcement that rattled him but the sudden and dramatic response from the European Central Bank.

“What they did was to lend, for one day, 100 billion euros to the financial system. That’s rather a lot of money and what that did was to make people wonder what it was they knew that others didn’t – we wondered that too.”

“That was the first day of my holiday. It was also the last day of my holiday. In fact, the last holiday for four years.”

The seeds of the crisis came from the bursting of the US housing bubble in late 2006. Reckless banks and other financial institutions had lent multi-billions of dollars to people who couldn’t afford the mortgages, according to Markus K Brunnermeier, professor of Economics, Princeton. To offset risk, lenders “securitised” loans into CDOs. These instruments, that were bought by deluded hedge funds, banks and other investors, were not a hedge. Instead they were high risk leveraged instruments. When householders began defaulting on their loans and real estate prices began to slide, banks began to write down several hundred billion dollars, leaving hedge fund managers and other holders of CDOs with massive losses.

As early as February 2007, HSBC issued a profit warning following an emergency meeting of the board of directors, The Business Times reported at the time. They had found acute problems in their US division that had lent money to households that could neither pay interest nor repay capital. Expectations that sub prime borrowers with low credit ratings would default on their loans made the board decide that it should provide for an extra US$1.8 billion of bad debts, raising the total to US$10.6 billion. That announcement precipitated share slides of mortgage lenders and a knock-on effect on hedge funds. Growing numbers announced losses and several collapsed in May and June of 2007.

By August 2007, the liquidity crunch had spread to Europe and other parts of the world.

Typically, when the liquidity crisis enveloped US, European and other banks, institutions, financial experts and some financial journalists were sanguine.

The chief executive of French insurer AXA claimed that “there was no systemic crisis at the moment” while the finance chief of Germany’s Commerzbank said the problems in the US subprime market were not a “major issue”.

By mid-September, panic spread to retail banking. Britain experienced its first bank run, notably Northern Rock, since the nineteenth century.

The US Federal Reserve and other central banks joined the ECB and pumped money into the system and slashed interest rates. Several major US banks established a pool to buy dud derivative positions from hedge funds, similarly to what happened during the 1929 crash. Those moves gave people false hopes and Wall Street recovered and peaked in October 2007.

After that, the market topped out and bank and speculative money poured into precious metals and commodities in the first half of 2008. Fearing inflation, central banks raised interest rates in the summer of 2008, the stock market weakened, the dollar strengthened. The downward draft accelerated, culminating in the collapse of Lehman Brothers in September and a massive crash in October. A brief rally was scuppered when the Madoff Ponzi scheme was discovered in December 2008 and the bear market finally ended in March 2009. By then recession was deepening around the globe and unemployment soared.

© Copyright Neil Behrmann

This article was first published in The Business Times, Singapore

Jack of Diamonds, the sequel to Trader Jack- The Story of Jack Miner will be published in early this year. Neil is also author of anti-war children’s novel Butterfly Battle- The Story of the Great Insect War.  The updated 2015 Waterloo commemoration version of Butterfly Battle is on Kindle and e-books. Reviews are on neilbehrmann.net and Amazon and more reviews are welcome. If the books are purchased direct on this site, a proportion of the proceeds will go to low cost charities

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