Barcelona Field Studies Centre

2008 US Banking Crisis

A housing boom in the US was stimulated by cheap loans fuelled by billions of dollars of investment of the massive savings and surpluses of China and other Asian economies. This sucked in many people who borrowed money in order to purchase homes that were far more expensive than their ability to meet their mortgage obligations. This ultimately led to the collapse of the banking system under a mountain of debt.

Reckless borrowing was encouraged by the US government who pressured mortgage providers to lower their lending standards in order to make home ownership more affordable for low income groups. This led to 'NINJA' loans for borrowers with 'No Income, no Job or Assets' and self-certified loans, commonly called 'liars loans' for homebuyers to purchase homes of their dreams. Initially, homebuyers were able to meet their mortgage obligations due to their low "teaser" rates of as little as 1% in the first few years. However, many homeowners were stunned when their adjustable-rate mortgages began to reset to much higher rates in mid-2007 and their monthly payments jumped far above their ability to meet the monthly mortgage payments. Some borrowers began to default on their mortgages in mid-2007 and the cracks in the U.S. housing market and banking system began to appear.

The banks had lent far more than the value of their reserves, and were now unable to sell repossessed homes to recover their loans. Until the mid-'90s, banks had to keep huge amounts of money in reserve in case any of their loans went bad. Banking law was changed enabling banks to reduce their vulnerability by taking the loans they had made and selling them on to investors. The deals grew so complex that bank executives and regulators did not understand them, and banks discouraged government oversight of their activities, saying the interference would stifle financial innovation.

Bankers also hit on a sort of insurance policy: the world's largest insurance company, American International Group (AIG), would take on the risk of debts going bad, and in exchange would receive regular payments from the banks, similar to insurance premiums. Banks would then get to remove the risk from their books and free up their reserves in order to lend even more money.

These schemes to reduce risk were to completely fail, but in the meantime US investment banks were soon lending 40 times the value of their reserves. US Government sponsored mortgage giants Freddie Mac and Fannie Mae were using lending ratios (leverage) closer to 100 to 1.

Banks like high leverage because it allows them to make many loans, and therefore lots of money, with only a small amount of capital (cash) at stake. In good times, high leverage is a great way to make fantastic investment returns. In bad times, though, even small losses in a highly leveraged bank can completely wipe its reserves and make it insolvent.

Insolvency for many arrived by August 2008 when highly leveraged banks found themselves hopelessly over-extended as the U.S. property market hit an all-time low. Houses were selling for just 50 PENCE. The decline in housing values quickly emptied the banks' reserves, leading to the collapse or taxpayer bailout of Wall Street's biggest names: Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers, Bear Stearns, Citigroup, the world's largest insurers, AIG, and the US's largest bank, Bank of America.

While the public were gnashing its teeth at funding a $700 billion bank rescue, there were handsome winners. Wall Street's five biggest banks paid a record $39 billion in bonuses to their employees for 2007, larger than the gross domestic products of Sri Lanka, Lebanon or Bulgaria. The average bonus of $219,198 was more than four times higher than the median U.S. household income in 2006, according to data compiled by the U.S. Census Bureau.

Defenders of these giant bonuses claim they are justified by the fact that bankers are wealth-creators and risk-taking entrepreneurs whose achievements help the rest of the economy to thrive. But if wealth has been created, it does not appear to have been evenly spread. By 2008, the US had the most unequal distribution of income and wealth of any major country, with the top 1 percent owning more wealth than the bottom 90 percent. John A. Thain, chief executive of Merrill Lynch, headed the corporate bank bosses with $83 million in earnings for 2007, helping the top 1 percent of Americans to more income than the bottom 50 percent.

The risk-taking entrepreneurs failed, leading to the greatest destruction of world wealth since the devastation of World War 2. But the collapse of the banking system under a mountain of debt may be seen as a symptom and not the cause of the financial crisis. It is the imbalance in trade and financial flows between the US and China that lies at the root of the banking crisis, some bankers believe, with the US and the West maintaining an unsustainable standard of living by going ever deeper into debt. Cheng Siwei, head of China's green energy drive, agrees. "The US spends tomorrow's money today," he said. "We Chinese spend today's money tomorrow. That's why we have this financial crisis."

Any ultimate resolution of the financial crisis may require a rebalancing of trade and financial flows between the world's ageing and emerging superpowers, with the US taking the advice it normally gives poorer countries: export more and spend less.

How banks work


Sources:  China alarmed by US money printing, Daily Telegraph 07.09.2009