The common man’s wealth lay in the value of his home and with the rise in the value of property the perception of his personal value had multiplied beyond all he could have previously imagined, mechanically lifting his expectations. When home prices started to fall those expectations faded and a great many ordinary families awoke to discover their new found prosperity had been nothing but a chimera.
In the euphoria of their make-believe wealth people had gotten carried away; everyone wanted a bigger and better house, a better car, exotic holidays and why not a second home. Suddenly, in a brutal awakening, people were forced to abandon the affluent lifestyles they had just had time to get used to. Slowly they realized the objects of their imagined affluence had been financed by credit and, like it or not, that credit had to be paid back interest included.
The City of London with its newly invented financial products given birth to a new breed of manager, fortune-hunters who invented a new way of exploiting the system: gambling on the rise and fall of complex financial products and commodity markets. Few understood the risk of their actions, even fewer imagined the devastating effect the bubble they created would have when it burst, as it inevitably did. The widespread belief that modern City bankers were a new species of wunderkind crumbled with the collapse of the sub-prime mortgage industry as the chain reaction it provoked wreaked its damage across the entire planet.
Investment bankers grew rich by trading a vast new spectrum of financial products. Their goal was nothing less than short term personal gains, huge salaries and outrageously large bonuses. However, it would have been a mistake to imagine that only the bankers were guilty. There were also the rating agencies. Their task was to determine the quality of the financial products placed on financial markets by the banks. This was however problematic since the rating agencies depended almost entirely on the banks for their business. This inevitably led to a certain degree partiality when it came to rating investment bank’s mortgage linked products.
As for regulators they had little real understanding of what the mathematical geniuses of the investment banks had created. They were totally out of touch and thoroughly failed to understand the mentality of the managers who ran the bank’s sales obsessed culture with its system of excessive rewards; a bonus system based on short-term objectives, driven by unrestrained risk.
Tom Barton had observed the extraordinarily rapid transformation of long established building societies, whose business was based on the staid traditional values of creditworthiness, into irresponsible mortgage banks offering doubtful customers, and even those with clearly fraudulent evaluations, almost unlimited credit and based entirely on self-certification.
As a long time City mortgage broker Barton knew why mortgages were essential to the economy, how they formed the financial foundations of the country’s housing market, without which the great majority of honest home buyers would never be able to buy their own homes.
Traditionally, UK building societies made home loans with the money deposited by their savers, first locally and then nationally. Then after demutualization the newly established mortgage banks such as Northern Rock and West Mercian Finance, lacking access to the kinds of funds traditional commercial banks, had progressively turned to financial markets to raise money to finance loans.
During the boom years, when interest rates were at historic lows, investors both in the UK and the US poured vast sums of money into mortgage backed securities that bore attractive yields. Those low interest rates coupled with lax mortgage requirements created a whole multitude of new home buyers whilst offering existing homeowners the possibility of drawing down on the equity in their properties, inflated by the spectacular rise in home prices.
When the reckoning came the halcyon days of New Labour’s Cool Britannia would be gone, leaving bitter memories, and nothing but a sea of debt and misery. The reckless risks taken by investment bankers, with their complex mortgage related products had provoked a crisis that was even threatening the American mortgage giants, Fannie Mae and Freddie Mac and many smaller mortgage lenders. Hedge funds, pension funds and investment institutions looked on fearing their turn would come next sucking into the yawning black hole.
The City trembled. The crisis that threatened the future of its venerable banking system that went back to the middle of the 17th century. At that time goldsmith bankers offered the gentry and aristocracy a secure place to deposit their gold and valuables. At the end of that century forty four such bankers were established in London, mostly small independent firms. In the course of the following century more than one hundred banks were set up in England.
Banking underwent a transformation in 1826, when the government introduced new laws for the creation of joint stock banking. These laws permitted owners to spread the risk among their shareholders, providing the conditions necessary for the development of national banks. Three major banking sectors came into being: clearing banks, merchant banks and building societies.
During the course of the following century British banking to provided loans, current account services, and safe-custody facilities for valuables. Then in the 1950s the British government eased controls relative to the financial services that banks offered and a decade later approved bank mergers, giving birth to the so called big five high streets banks that offered savings facilities, personal loans, home loans, credit cards and ATMs.
Demutualization allowed the transformation of building societies into banks enabling them to not only offer mortgages, but also a complete range of banking services. Banks and building societies merged: Lloyds Bank merged with the Trustee Savings Bank to become Lloyds TSB and the Bank of Scotland with the Halifax Building Society to become HBOS.
After the 1929 crash, the US government introduced the Banking Act of 1933, separating commercial and investment banking activities. This act was designed to prevent commercial banks from engaging in securities activities thereby avoiding the possibility of trading losses, and the risks losses entailed for customers deposits. As a consequence American banking progressively lost business to foreign competition. To reverse this situation the Banking Act was repealed by the Clinton government in 1999, allowing American banks, as elsewhere in the world, to offer both commercial banking and investment banking services to their customers.
This had already taken place in the UK. The Thatcher government deregulated financial markets with what was called the Big Bang in 1986, designed to reinforce the financial institutions of the City of London, which had been overtaken as the leading financial centre by New York. Deregulation changed this and London became the world’s leading financial capital. The economic boom that followed lasted two decades, giving birth to a new class of nouveau riche and the expansion of the City eastwards to the Isle of Dogs and in particularly Canary Wharf.
By 2006, the City had become the home of unrestrained capitalism, with the presence of over five hundred banks, the London Stock Exchange, Lloyd’s of London and the Bank of England. In addition it was also an important centre for the trading of Eurobonds, foreign exchange, energy futures and global insurance.
Finance became to the UK what industry was to Germany, agriculture to France, and tourism to Spain. It became the most dynamic sector of Britain’s economy, the heart of modern capitalism. Since the Big Bang the City prospered beyond all expectations with the value of shares traded increased fifteen fold and banking assets seven.
The trouble came when Banks forgot their real vocation, that is to say lending and started to act like hedge funds. Historically lending had always been a staid business entailing low risks and unexciting profits. That was all thrown out the window when bonus related compensation was imported from the US.
To achieve management’s goal, banks became risk driven with highly leveraged transactions generating huge profits, and with correspondingly high risks. Progressively the banks and hedge funds came to resemble casinos and if Wall Street resembled Las Vegas, the City resembled Wall Street.
Few bankers stopped to consider
what would happen when the music stopped, as it inevitably would. Wall Street had invented sub-prime mortgages, a casino with its one arm bandits, with jackpots for the poor and vast profits for the casinos. Jackpots came in the form of mortgages for borrowers with poor credit histories, who under normal circumstances would not have qualified for a mortgage.
These high risk borrowers were sold mortgages designed to rake in high profits. The most pernicious were adjustable rate mortgages, ARMs, luring the naïve with low introductory interest rates that after a predefined period of time became variable, indexed to the LIBOR rate. Borrowers unable to keep up with the interest inflated repayments defaulted and were foreclosed. However, unlike casinos, the banks found themselves in the same dire predicament as the hapless borrowers.
In terms of volume, more derivatives were traded on international financial markets than any other financial instrument, though most people outside of banking had never heard of the term ‘derivatives’ before the onset of the financial crisis.
The term derivative described financial instruments that had no intrinsic value and derived their worth from some other action. In reality these were nothing more than bets, which could be hedged by placing a side bet to offset the possibility of a loss. Thus hedge funds took their name from the business of hedging bets in the derivatives market. Surprisingly bets could be placed on almost anything in world financial markets, from the price of commodities such as wheat or oil to the fluctuations of financial markets themselves.
However, the buying of derivatives was not investing as such; it was a method of insurance, or in broader terms gambling, since nothing material was created, only the gains from a winning bet. Alan Greenspan described it as a means of improving risk management in businesses, offsetting for example future price fluctuations in oil or currency exchange rates, when buying or selling commodities, manufactured goods and services in international markets.
In the years leading up to the crisis trade in derivative had grown at an exponential rate reaching the astronomical sum of one quadrillion dollars that is twenty times the gross domestic product of the entire planet.
Pondok Indah ‒ Dominica