Section 1
Q1. Point out some of the similarities and differences between the balance sheets of
European banks and those of the so-called Structured Investment Vehicles (SIVs) that were
sponsored by American banks.
When securitisation started in the united states of america, European Banks too, felt the
need to cash in on them. The banks, being European, held capital in euros. This meant that in
order to deal in securities which had dollar denominations, they needed a source for american
dollars. This limited dollar capital resembled the way SIVs operated. They had to support these
huge securitised assets on their balance sheets with limited capital. Hence, even they, just like
SIVs, started funding themselves through the wholesale funding market. They lent dollars in
america by borrowing dollars from america itself.
“For nonconforming high-risk MBS, those not backed by Fannie Mae or Freddie Mac,
the share held by European investors was in the order of 29 percent.” - Tooze/
SIVs had a backing from their parent banks. This made sure they had good ratings, thus
ensuring credibility in the market. The European banks too had credibility in terms of their
ratings. The American SIVs were majorly involved in the ABCP market. Both these entities,
namely European banks and SIVs, were in the business of issuing commercial paper backed by
their ratings and the mortgage backed assets for raising funds to deal in more securities.This
paper was bought by money market funds in the US which was the same place the American
Investment bank SIVs sold their ABCPs to. 57% of the dollar denominated commercial paper
was issued by European banks in 2007. The both entities had huge similarities in the assets the
held and the mismatch that existed in the maturity period of ABCPs. However, European banks
went much beyond the limited functions of the SIV balance sheets. They parked mortgage
backed securities off the main balance sheets of the parent bank. Their functions were expanded
to integrate the entire securities supply chain so as to control the mortgage origination. They
furnished a chain of assets and liabilities on their balance sheets by packaging CDOs and
servicing mortgages. Their balance sheets also had different currency denominations. This
feature wasn’t seen in the american investment bank balance sheets.
/“Britain’s HSBC aggressively bought into the American mortgage market. By 2005
HSBC could boast of having serviced 450,000 mortgages to a total value of $70 billion.10 Credit
Suisse built an American mortgage-servicing department that fed one of the largest ABS CDO
operations of the early 2000s.” - Tooze/
Basel II had led to very few and limited regulations on the European banks. This was an
advantage they enjoyed over the SIVs. They could have much largwer leverages as they had the
freedom to assess their own risks. Their leverage ratios went as much as double as compared to
their american counterparts. While american SIVs had leverage ratios of 20:1, European banks
had leverage ratios of about 40:1
Q2. What is market-based banking otherwise known as the shadow banking system?
Outline how it is different from regular banking. If both systems are fragile, which is more
fragile and why? Use at least three quotes from Tooze.
Shadow banks are a chain of institutions that work in an unregulated manner. These are
mostly private institutions that work like banks. They are a feature of modern neoliberalism in
the light of deregulation. These institutions work separately from the public sector and have no
oversight whatsoever. The government, having no oversight on these institutions, does not even
back these banks or provide guarantees for them. These institutions include securitization
vehicles, asset-backed commercial paper conduits, money market funds, markets for repurchase
agreements, investment banks, and mortgage companies. These institutions are linked by a chain
of assets and liabilities. From and outside view, this system of shadow banks appears like a bank.
A bank that provides loans based on deposits. Although seemingly similar from the outside, they
work very differently. If one looks at shadow banking as a whole system barring the MMMFs,
the Assets of the system can be securitised loans and their liabilities are REPOs and commercial
papers. The Securitised loans come from the GSEs and small banks that give mortgages to
homeowners. These loans are bundled and bought by SPVs and then packed and repacked in
different ways until these reach the other end of the chain in the form of Asset-Backed
Commercial Papers. These ABCPs are REPOed by investors on this end and are rolled until
these investors have confidence in these investment banks. Compared to this a regular bank has
deposits whcih are deposited by account holders of the back. On the other hand a retail bank
gives loans to common people. These are your everyday banks. Hence theri Assets are the loans
that thge give and their liabilities are people’s deposits. Among these to systems, The shadow
banking system is definitely more fragile. On the outset, the shadow banking system has to
government guarantee. It being completely in the private domain, The government doesn’t back
this system. These individual entities work on the principle of leverage. They, hence get
wholesale investments. Apart from that, they work on extremely thin margins. These entities
have very little cash reserves. Stalled cash reserves acts like stagnated money and don't make
these banks any money, hence, it is in their interest to keep the money in the system and not have
huge, but have marginal reserves. But for keeping the system running, and to avoid a cash
crunch, they need a continuous inflow of money from the investors. Which in regular scenarios,
they do have. Here's where investor confidence plays an important role. The investors invest
money in an investment bank through a repo deal. That means, they can essentially withdraw
their money whenever they want. This keeps the whole shadow banking system on the mercy of
the confidence that the investors have in the market. This is what makes them definitely more
fragile that retail banks.
Q3. What are eurodollars? What is the central role of the eurodollar market to the
emergence of the market-based banking system otherwise known as the shadow banking
system? Use at least three quotes from Tooze.
Dollars held offshore in Europe, specifically in London, for unregulated deposit taking
and lending in dollars are called EuroDollars. They came into existence in the mid-20th century
when the Bretton Woods system of fixed exchange rates was still in effect and the US had a tight
hold on capital inflows. Eurodollars sidestepped these constraints imposed on the dollars
imposed by the Fed in American dollar markets. This made a number of countries, like the
OPEC and Soviet Union, hold their dollar reserves in Europe, away from regulation.
/“British, American, European and then Asian banks too began to use London as a center
for unregulated deposit taking and lending in dollars.” - Tooze/
European banks had liabilities in Euros, To avail themselves of dollars to trade in
securities, they turned to the American money markets. They borrowed dollars to lend dollars.
By way of debt-financing at the bottom of the securitisation chain and buying risky private-label
Asset-Backed Securities (ABS), they were able to raise a lot of dollars.
“From the point of view of generating high-yielding CDOs, it was precisely the bottom of
the mortgage barrel that was the most attractive,” - Tooze.
The Eurodollar market was huge.
/“In 2008, $1 trillion, or half of the prime-government money market funds in the US, were
invested in the debt and commercial paper of European banks and their vehicles.” - Tooze/
Part of the reason, Bretton Woods failed because of the pressures of global dollar trading
and the pressures it put on the gold peg. The US had thus abolished controls on capital
movements and Margaret Thatcher’s “Big Bang” deregulation would cause the City of London
to become a major hub for dollar rerouting into the US. Under Tony Blair, the government
pushed for a further round of deregulation, that allowed financial engineering such as collateral
rehypothecation to take place without limit, in which the banks could take the securities offered
as collateral in repo deals and use them in further repo loans known as reverse repo. This allowed
for much higher leverage ratios. This led to a sort of deregulation race between the US and
Europe. Each wanted dominance in terms of being the financial capitals of the world. The Basel
1 regulation enabled European banks to hold billions of dollars on the balance sheets of Special
Purpose Vehicles for a fraction of the capital required by a sponsoring bank and Basel 2 allowed
banks to apply their own proprietary risk-weighting measures to expand their balance sheets
even further. The chasm between the leverage of the Europeans and the American was met with
the hue and cry of Wall Street that insisted that US financial markets be deregulated, that was
made possible unchecked financial engineering and the shadow-banking system to flourish not
only in London, but also in New York.
Q5. What is repo? In what way was the financial crisis a “run on repo”? Outline the
mechanics of a run on repo. Explain using at least three quotes from Tooze.
A form of short term borrowing where the borrower sells a security as a collateral to the
lender with an agreement to purchase it back at the end of a specified period, often even
overnight is called REPO. This is a way of raising short term capital in the money market. With
the MBS boom, to fund larger balance sheets holding mortgage backed securities (MBS),
Investment banks turned to wholesale funding from the repo markets. They bought MBS and
sold it as collateral to pay for it in a repo agreement with a mutual fund or another investment
bank. The party repoing would pay an interest and also accept a haircut. This haircut would
determine how much of its own capital would be required by the investment bank to support the
balance sheet. This way banks needed little of their own capital to fund their MBS. This model
would work as long as the haircuts did not suddenly increase and the repo could be repeatedly
rolled over. Repo markets transactions were on the order of trillions of dollars a day. There were
two kinds of repo markets - Bilateral and Tri Party repo. The tri party repo market used treasurys
or agency MBS as collateral and was more secure. Financing for private label MBS and CDOs
came from the bilateral repo market. Here the collaterals and terms of repo (like haircuts) were
more wide-ranging. Repo was susceptible to risk. If by any reason there was a lack of confidence
in the repoing party, it would lose its access to repo markets as no one would lend to them. This
is what happened during the run on repo during 2008. Repo being a secured form of borrowing,
with the holder having rights to the collateral in a situation of bankruptcy, was not expected to
fail in the case of Bear Stearns. However, the losses Bear faced in the commercial paper market
reflected in the loss of confidence in the investors as they backed out from lending. They did not
want to bear the risk of lending to a failing bank and hold its securities.
/“Unfortunately for Bear, given that there were plenty of other counterparties to engage in
repo trades with, no one wanted to take the risk of having to seize collateral from a failing bank”
- Tooze/
As its credibility disappeared and the investors lost faith in mortgage securities as a
whole, haircuts rose for Bear in the bilateral repo market because investors were uncertain about
the spreads of the ABS collateral.
/“When news of a new round of mortgage failures hit the markets in March 2008 and
hedge funds began emptying their prime brokerage accounts, quite suddenly the haircuts Bear
Stearns faced in the bilateral repo market steepened” - Tooze/
It was also shut out of the triparty repo market as its ratings fell. Hence Bear Stearns lost
its access to wholesale funding completely. Lehman followed on the same path with collateral
calls being the final nail on the coffin.
Q6. What is the difference between too big to fail, too interconnected to fail, and too
Chinese to fail? Explain using at least three quotes from Tooze.
The 2008 Financial crisis let to the coining of the term Too big to fail (TBTF). This phrase refers
to entities in a financial system, who, if they fail, threaten the whole financial or economic
system’s integrity. Their failures risks the systems failure. These entities are so deep rooted and
their influence is so pervasive in the system, that their failure can have respective impacts.
Hence, these entities, if they can't handle the size of their balance sheets, have to be kept afloat to
stability by the balance sheets of the government. These entities are called too big referring to the
sheer size of their balance sheets. Commercial banks and Investment banks such as Citigroup,
Goldman Sacs etc. can be considered as banks that are too big to fail. These backs serve
important functions in the market such as giving credit to companies, maintaining checking
entities for depositors, and essentially acting market makers for the economy. Failure of suge
huge entities can lead to huge ripples in the economy under whose influence, the systems
foundations can shake. Their failure may lead to credit crunches in the markets putting the whole
enemy at the risk of choking.
/“It was the implosion of the financial system, imagined as something akin to a massive
electrical power failure that threatened the entire economy.” - Tooze/
Although, even if an entity might be too big to fail, it is not necessary that it'll be too
interconnected to fail. Too interconnected to fail (TICF), on the other hand, is an index that
shows how many connections does that entity have if one considers that entity a bode in a
complex system. It shows how deeply interconnected its balance sheet is with the remaining
system. The phenomenon of TICF can best be seen in instances like the failure of Lehman
brothers. The failure of Lehman sent a shockwave through the global financial system due to
how inteconnected the global finance is. Especially how interconnected it had become in the
wake of the massive securitization wave and the wholesale money market. AIG, being how
interconnected it is though its derivatives, repo and securities lending, that it had to be bailed out.
/“The financial markets would not withstand a second shock, and AIG’s level of
interconnectedness through derivatives, repo and securities lending was even greater than that of
Lehman.” - Tooze/
On the other hand, the concept of ‘Too Chinese to Fail’ refers to a situation where there
are overly high claims on the american institutions through Government securities and Agency
bonds. Their insanely high leverage ratio suggested that, if allowed, they would have precipitated
in mass dumping of American Goov securities and would have tanked their and the dollars value.
/“If they folded, they would take down the last remaining lenders in the mortgage market
and put in doubt the credit of the United States…In the summer of 2008, foreign investors held
$800 billion in debt issued by GSEs.” - Tooze/
Section 2
Q1. Outline the debate over the nationalisation of banks in US at the time of the crisis. How
was this different from the debate in the UK and Europe? What reasons were given by
both sides? What crisis and post-crisis measures in the US amounted to nationalisation in
all but name? In what way does this debate indicate that (mal)functioning of the credit
system involves both a technical level and an ideological level (a battle of ideas)? Use at
least five quotes from Tooze.
The debate about the nationalization of American banks at the peak of the financial crisis
of 2008 was one that was born out of America's insistence on sticking to its hard-earned
Neoliberal credentials after the financial crisis of the 1980s on the one hand and on the other
hand a very real need to nationalize its banks to prevent the financial crisis from worsening.
Laissez-faire regulations and the neoliberal economic doctrine were central to American market.
This made them believe in the ability and freedom of private markets to organize themselves
with minimal public intervention and regulation. However, as the crisis would soon prove, the
reality was that after the crisis, the American market and banks that ran up trillion-dollar debts
needed the support the public balance sheet in order to sustain itself. The bush administration
supported the restructuring and recapitalisation and in effect nationalize banks as suggested by
Greenspan. But this wasn’t acceptable to the Republican oligarchs, which created a rift between
them and conservatives such as Bernanke and Paulson. This rift is also evident how badly the
vote on the first TARP bill split the US Congress and especially the Republican party. On the
other hand, nationalisation was considered almost common logic in Europe and the UK.
/“What would once have been dismissed as Luddite was now merely common sense.” Tooze/
The UK had nationalized HBOS and RBS through recapitalization and restructuring
efforts, Germany committed $400 billion to recapitalize and put Commerz and Hypo Banks
under state control, and Sweden had nationalized its banks in the 1990s. One way of looking at
borrowing liquidity is to see it as borrowing time and in crises, time comes at a premium. Swift
action taken by state goes a longer way in stabilizing economies, as is evidenced Japan’s
inability to do so due to their reluctance towards restructuring and recapitalization. This view
taken by the European lay in stark contrast to the prevailing common logic in the States which
was championed for by newly-christened President Barack Obama who, while invoking and
praising Sweden’s example, dismissed the size of their financial complex which dwarfed in
comparison to America’s. Obama insisted that tradition in the US was to allow private capital
markets to get credit flowing and ultimately drive the economy. Tim Geithner, Obama’s
Treasury Secretary, denounced nationalization as a huge policy mistake. On the subject of
Geithner’s definition of public interest, he writes “First and foremost, his commitment was to
upholding the stability of ‘the financial system,’ because without that, the entire economy was
bound to fail.” Obama’s Chief of Staff Rahm Emmanuel too ruled out the possibility of a
Sweden-styled $700 billion restructuring and recapitalisation. But despite the Obama and Bush
administration’s insistence on private solution through acquisitions and private capital injections,
it was the public interventions that finally averted doom. At the height of the crisis the GSEs
Fannie Mae and Freddie Mac were far too overleveraged.
/“If they folded, they would take down the last remaining lenders in the mortgage market
and put doubt the credit of the United States.” - Tooze/
Foreign claims on only the
GSE-issued debt touched $800 billion and in the face of political lethargy in the American
Congress, threatened major dumping of US Government Securities by the Chinese.
Hank Paulson, who recognized the need to expand government powers, was finally
granted authority to mobilize funds limited only by the borrowing ceiling of the US and put
Freddie Mac and Fannie Mae under conservatorship owing to their insolvency. This further
inflamed Republican sentiments.
/“On the right of the Republican Party, fully mobilized for the hotly contested
presidential election, the nationalization of Fannie Mae and Freddie Mac unleashed a firestorm.”
- Tooze/
In similar fashion, insurance giant AIG, would also come to be practically under state
control after the New York Fed backstopped its outstanding CDS commitments and bought
79.9% equity stake in its insurance business. Another major initiative, the second TARP bill,
which passed with an updated phased roll-out and tax breaks for the middle class, concentrated
on injecting capital into the system under which nine major banks were required to accept
Government capital in return for preferred shares. They would receive FDIC guarantees on all
checking accounts upto 125% of debt maturing by the end of the year, but only on the condition
that they accept the Government capital. The TARP act put limits on executive compensation
that could be removed only once they paid their dues back. While it might have cheap capital for
the likes of the Citigroup who could finally find the capitalized enough to gain access to capital
markets at a cheap rate, but this was in effect a partial nationalization, held short only by a lack
of voting rights for the Government. After the crisis, in a bid to prevent future recessions, the
Government introduced stress-testing measures – a program to scrutinize private balance sheets
and assess their capital requirements in simulations – that essentially acted as a Government
rating and the convoluted Dodd-Frank act that listed crisis diagnoses which failed critical
standards of stringency married American finance with Big Government that is reminiscent of
nationalization.
/“Obama and Geithner might have blocked the push toward nationalization, but in a truly
ironic historical twist, less than twenty years after the defeat of communism, in the deepest crisis
global capitalism had experienced since the 1930s, the bastions of American finance would be
required to negotiate government-approved ‘capital plans’ before paying dividend to
shareholders” - Tooze/
One can argue that the technical reason for the way credit in the US financial system
functions is based on profit-making and market-making by American banks. The size and
complexity of these banks too, is something that cannot possibly be overlooked. It was assumed
that growth and stability would be driven by the profits of private banks. But there was a
problem in that. The technicalities of the American financial system, almost invariably create
moral hazard. Ideologically, neoliberalism always held a high position in the American market.
But after the crisis, neoliberalism, didn’t remain to look promising. In the aftermath of a crisis,
there was nothing new that rushed into the vacuum left by the disaster caused by Neoliberalism.
The paranoia of the American government regarding socialist ideas and their rigidity about
private credit over public credit is an invitation to disaster.