Goldilocks in Reverse: The Making of the Current Financial Crisis

Contributed by Martin Mitchell, director of eLearning for the Corporate Training Group

Background – Everything is “Just Right”

It all began when the economy was in what was said to be a ‘Goldilocks’ scenario – the world’s developed economies, particularly the US and Western Europe, were neither too hot nor too cold, but were just right.

The benign economic backdrop of low inflation and low interest rates meant investors were keen to find investments with competitive yields, and were even willing to borrow to invest in them and ‘leverage up.’ So, the bankers came up with variants of the old securitization model to provide instruments paying high yields. They repackaged pools of loans, especially mortgage loans and sold bonds linked to these loans to investors. These ‘asset backed securities’ were supplemented by credit enhancements, like insurance to enable the bonds to get high credit ratings from the ratings agencies. Special purpose vehicles (SPVs) were set up to facilitate the issuance and were variously known as collateralized debt obligations (CDOs) or collateralized loan obligations (CLOs). This was the golden age of what became known as ‘structured credit.’

The sub-prime crisis – too hot?

The mortgage market rapidly began to follow an ‘originate and distribute’ model. Providers and sellers of mortgages loaned the money and then replenished their cash balances by setting up special purpose vehicles, and selling the mortgage loans in securitization issues. The hunger for mortgage loans saw lending standards slip, particularly since the mortgage sellers and providers knew that shortly, the risk of non-payment would be somebody else’s problem – the holders of the mortgage backed securities or the insurers.

Mortgages were foisted upon many people who had never thought they would be able to buy their own home – the ‘sub-prime’ borrowers. Not unexpectedly, a large proportion of these subprime borrowers soon showed signs of defaulting on their loans – particularly as house prices in the US began to stabilize, and, in certain areas, actually fall.

The credit crunch – cooling down a bit too quickly?

When the effects of the above began to be felt, many of the banks still had significant quantities of mortgages and other loans sitting on their balance sheets due to the time taken to set up special purpose vehicles and distribute the asset-backed securities. Rumors began to circulate about which financial institutions might be sitting on significant problem assets. Banks began to get nervous about doing business with other banks – especially those banks that relied on wholesale finance. This ultimately lead to the US government facilitating the sale of Bear Stearns to JPMorgan and the run on Northern Rock in the UK before the UK government bailed it out.

Then, in September 2008, came what many see as the big mistake by the US government – it allowed Lehman Brothers to collapse. Although Lehman was certainly in a mess, it was so intertwined with other financial institutions that its collapse simply made the banks more paranoid about doing business with each other.

On the same weekend that the US government called the leaders of the major US banks together to try to facilitate another Bear Stearns-type rescue for Lehman, the chief executive of Merrill Lynch brokered a sale of Merrill to Bank of America. Without the sale, Merrill would likely have been the next bank in the firing line.

Like a house of cards, other banks were on the edge of collapse. Rumors were flying–even about the venerable Goldman Sachs–and governments internationally began a process of either providing banks with finance or nationalizing them. Massive amounts of public funds were provided to the likes of Citigroup in the US, Royal Bank of Scotland in the UK and Fortis Bank in Europe. And it wasn’t just banks. AIG, the world’s biggest insurance company at the time, required billions of dollars of US taxpayers’ money to stop it from collapsing and undermining the whole financial system.

Financial crisis and recession – too cold?

With a financial system that might be described as ‘not fit for purpose,’ the financial crisis began to spread to other areas of the economy. The big US car manufacturers had, for some time, used the financial markets and securitization of car loans to keep themselves financed, but this route was now closed. Given all the billions provided to the financial institutions, surely they could convince the US government to provide financial assistance to them? Well they could, but only after a rather embarrassing trip to Washington when the heads of the carmakers each flew in from Detroit in his own private corporate jet. The adverse publicity meant that by the time of the next trip, they were traveling by car and the jets were no longer company assets.

The lack of finance and constant bombardment about economic ills ended up bringing about recessions on both sides of the Atlantic. The words of Warren Buffett – ‘It is only when the tide is out that you see who is swimming naked!’ – rang true when a huge ‘Ponzi’ scheme ran by an investment manager in New York was revealed. Bernard Madoff had been falsely declaring profits on funds and relying on new investors to provide the money to pay out earlier investors. The slowdown meant new investment dried up. The scheme was exposed and Madoff arrested.

When will it be just right again?

How long and deep the recession will be remains to be seen, with many commentators estimating a minimum of a year before the financial markets will perk up. However, there was a significant green shoot announced on Monday, January 26th when Pfizer, one of the world’s biggest pharmaceutical companies, announced a $68bn takeover of another pharmaceutical company called Wyeth. Perhaps the tide is beginning to turn. Perhaps we have reached the end of the beginning and the ‘just right’ economic situation is somewhere in the distance.