To understand the financial crisis, read this book

Book Review

If you only read one book about the financial crisis, read “The Fall of the House of Credit” by Alistair Milne, a professor of financial economics at Loughborough University in Leicestershire, UK, north of London.

This book, which I have just discovered, will not satisfy your blood lust to make the bankers pay, but it is the best explanation I’ve seen of what happened to the credit markets in 2007-2008.

The other 40 books I have read on the events of 2007-2008 typically analyze the mortgage markets or the unfolding of the crisis. These are valuable parts of the story but do not explain how US subprime became a worldwide financial earthquake.

“The Fall of the House of Credit” is one of only two books I know that dissect the freezing of the credit markets – which is where the destructive panic occurred and where reforms need to focus, but don’t.

The other book is Yale University Prof. Gary Gorton’s “Slapped by the Invisible Hand,” which is equally insightful but harder for the average reader to understand.

“The Fall of the House of Credit” tells how a small sector of the housing market caused the financial crisis of 2007-2008, why the Federal Reserve and the US taxpayer had to bail out the banks, why countries worldwide were impacted, and why lending today is depressed.

In brief, Milne contends that the financial crisis was caused by giant investment and commercial banks that borrowed short term, mainly on the repurchase market, and invested that money long term, mainly in U.S. mortgages. This became a crisis in 2007 and 2008 when the short-term lenders suddenly called their loans.

To RepoWatch readers, this is a familiar story. But giving the story comprehensive, cohesive treatment in book form – and in a book that targets the average reader, not the specialist – is a huge plus.

From Milne:

I have set myself the goal in writing this book of explaining the banking crisis and to outline how it can be resolved in a manner which does not oversimplify but can be ready by any concerned citizen. This decision – to write for a general not a specialist audience – has posed considerable challenges. I have had to explain in straightforward language how the new credit instruments and credit markets at the centre of our financial problems operate. I have also had to provide an account of the evolution of the crisis, from its early beginnings with the weakening of US house prices in the second half of 2006 to the dramatic collapse of confidence in global banks in autumn 2008, which does not assume specialist knowledge but covers all the key developments in sufficient detail to explain not just what happened but also why it happened in this way.

Milne wrote his book between July 2008 and March 2009, which was remarkably early to form a coherent story for a crisis that peaked in October 2008.

My own background and experience impelled me to write this book. I know the new credit instruments well, from teaching courses at a leading UK business school on credit products and credit risk management, covering topics such as mortgage-backed securitizations, credit default swaps, and collateralized debt obligations. I have worked on problems of bank risk management and regulation for more than a decade. The earlier part of my career was spent in macroeconomics, during which, among other responsibilities, I worked on monetary policy and also researched and analysed the UK housing boom and bust of the late 1980s and early 1990s. This places me in an ideal position to explain both the details of how the new credit markets and instruments work and the bigger picture of how they led the industry and the wider economy into crisis.

Milne’s goal in writing the book is to convince citizens and policymakers that the best way to get out of the crisis and avoid another Great Depression is to flood the financial markets with money, so the banks can stay in business and keep credit flowing.

This is an approach adopted by the Federal Reserve – to considerable criticism, and with less emphasis on making a profit than Milne might like – but not yet embraced by the European Central Bank.

The problems originated with the bubble in US house prices, but have since turned into a global banking and financial crisis more severe than any since the 1930s. This is now producing such a sharp reversal of bank lending – the “fall of the house of credit” referred to in my title – that the world is now facing the deepest and longest-lasting economic contraction since the great depression of the 1930s. If politicians and policymakers fail to respond appropriately, the present downturn could turn out to be even worse than that terrible economic tragedy.

Milne acknowledges that his position will be unpopular with some.

A central concern of this book is with the perennial debate that arises in every financial crisis and is at the heart of this crisis. On the one side are those who insist on punishing the wrongdoers, allowing financial institutions to fail and forcing shareholders and others to bear the consequences of their own decisions. On the other side are those, such as myself on this occasion, who urge government or collective support for weak financial institutions in order to prevent a financial crisis causing much wider economic damage.

Milne urges central banks and governments to strengthen the troubled banks by buying their stock and insuring the value of their assets for a fee. Taxpayers are going to be on the hook anyway. They might as well try to make sure the banks survive and ensure the taxpayers a profit.

The right way to protect taxpayers is to be unstinting in support as early as possible.

This is not a bailout, Milne contends. These steps should be taken not because banks are weak but because banks are worth more than people think.

The idea is not to give banks money but rather to invest in banks in order to obtain a return.

Milne argues that the problem facing the banks is not low-quality assets. Instead,  it’s that investors have lost confidence in the banks and will no longer give them the repo loans and other financing they need to stay in business. This credit panic is what Gorton calls a “Run on Repo, which he compares to depositors running on banks 100 years ago.

As RepoWatch readers know, the run on repo was the seminal cataclysm that drove the Federal Reserve and the Bush and Obama administrations to pledge trillions of dollars to support the financial markets during the crisis.

Panic and collapse of confidence … explain why losses on a relatively small segment of bank lending – US sub-prime mortgages – accounting for less than 2 per cent of the worldwide bank assets, first shook and then destabilized the entire industry.

In the US, the official commitment in 2008 and 2009 to spend whatever it took to stabilize the markets ultimately meant that much less money was needed than had been pledged, as Milne predicts.

To prevent such panics in the future, Milne recommends that governments sell banks “relatively expensive” disaster insurance to cover their assets, and that banks become much more transparent, less complex and better capitalized. The disaster insurance would be compulsory when assets are financed by short-term funding,  it would get more expensive as the bank’s short-term funding grows, and it would be transferable if the bank sells the assets.

In future we need either to wean banks off short-term funding or to provide protections that will maintain that funding even when the going gets tough.

Officials occasionally discuss such reforms, but little action has been taken. The Dodd-Frank Act did give regulators the right to limit short-term borrowing, but did not require it.

Yet prevention is more important today than ever, as the Dodd-Frank Act makes it much more difficult in the future for the US government to take the dramatic actions Milne recommends.

More transparency is important, Milne writes.

… the positions of every institution should be made very transparent to the outside world. Portfolios should be tracked and widely publicized on a product -by-product basis, so that everyone is aware, perhaps with some delay, when an institution takes an extreme position. That way there would be an alert to the dependence of banks worldwide on the insurance written by, say, AIG or the extreme positions in restructured CDOs of both Merrill Lynch and UBS.

Short-term borrowing

The core argument of Milne’s book is that “a policy of holding safe but illiquid long-term structured credit securities, financed using short-term borrowing, created a bank funding crisis that was the principal mechanism creating the credit crisis.”

-The “long-term structured credit securities” were the products of securitization, where financial institutions pooled mortgage and other loans and created securities backed by those loans. In theory, the financial institutions sold these securities to investors, but in reality they kept many themselves.

-The “short-term borrowing” was mainly repo, asset-backed commercial paper, unsecured commercial paper, and securities lending, with repo having by far the largest volume.

The combination of the two caused the credit crisis, when beginning in 2007, short-term lenders panicked, raised their prices and called their loans. This starved the banks of credit, without which they cannot operate, especially the investment banks.

Understandable doubts arose about the quality of sub-prime mortgage and other loan-backed securities. This, however, was not what undid the banks. What has brought many of them to their knees were large investment and trading portfolios of the safest tranches of these securities, financed using short-term borrowing.

This use of short-term borrowing occurred largely on a “parallel” banking system dominated by investment banks, commercial banks, and trusts. The parallel banking system grew dramatically in the past 15 years to compete with traditional FDIC-insured banking, Milne writes. This parallel system has largely collapsed, even though much of its lending was prudent, and that collapse has sharply reduced the supply of credit to consumers and businesses.

Milne says he prefers the term “parallel” banking system to the more widely used “shadow” banking system because “the problem was not opaqueness or lack of transparency of the instruments but the unstable funding structure.”

A major cause of the current global financial crisis has been maturity mismatch – too much short-term borrowing in order to finance long-term bank loans. There were serious fundamental problems as well: rapid credit growth and a deterioration in standards of loan assessment, resulting in banks holding many low-quality assets. But these fundamental problems do not explain the depth of the current crisis, which has been greatly amplified by investor panic and withdrawal of these short-term funds.

While arguing that financial markets need to be propped up so credit will keep moving, Milne does not let banks off the hook.

There were … very serious deficiencies in the regulation, risk management and governance of some banks and other financial institutions. Any list of poorly managed firms would include UBS, Citigroup, Merrill Lynch, AIG, Fannie Mae and Freddie Mac in the United States together with the Royal Bank of Scotland and HBOS in the United Kingdom. Excessive risk taking by these and other large firms greatly contributed to the severity of the crisis.

Milne says economists generally accept two key explanations for the crisis but emphasize one over the other: (1) the problem is poor asset quality and too much bank borrowing, and (2) the problem is loss of confidence in the banks. He says the first explanation is preferred by politicians, policymakers, journalists, and some economists, while he and other economists emphasize the second explanation.

About the first group:

They focus on deteriorating standards of credit underwriting, unsustainable increase in asset prices, relaxation of supervisory oversight, expansion into new business activities without proper controls, excessive “leverage” – that is, too much borrowing in relation to the value of their asset portfolios – and excessive risk-taking, perhaps exacerbated by undesirable remuneration arrangements which offer substantial rewards for making a big win. In short, they think that this is a crisis of poor-quality bank assets and too much borrowing by banks in order to hold those assets.

About the second group:

The second group – where I place myself – emphasizes a different set of problems – the excessive reliance on short-term borrowing and the resulting maturity mismatch, the weaknesses of “mark to market” accounting rules for many of the new assets when there is no market, (Editor’s Note: Milne does not advocate abandoning mark-to-market accounting, however.) and the panic withdrawal of short-term funding that has created widespread market illiquidity, resulting in undervaluation of assets and the dislocation of money markets where banks normally borrow in the short term. In short, this is a crisis of confidence in the banks, whose assets are not as bad as many suppose, but who are no longer able to borrow short- or long-term and so are forced to cut back sharply on their lending.

Further key points

Milne debunks some conventional wisdom about the securitization process. He writes that:

-These securities are not as mysterious as they’re often said to be, because much information about each security is publicly available, through Bloomberg, ABSNeT, Global ABS Portal, or elsewhere, 
-Most of the securities are still performing well, in spite of the crisis, and
-The main reasons banks created these securities was not to transfer risk by selling them to investors. Banks created these securities to get cheap funding, for example by using them as collateral for repo and asset-backed commercial paper loans; to have a product they could easily sell when they needed cash; and to reduce the equity capital that regulators required them to have, since regulators viewed the securities as safer than the underlying loans.

The central problem is not with the instruments themselves but with the flawed funding strategy, the maturity mismatch where banks have borrowed in the short term to hold long-term securities, and the resulting exposure of banks to the withdrawal of short-term “hot money.”

Milne says his favorite book about the US subprime lending portion of the crisis is “Chain of Blame: How Wall Street Caused the Mortgage and Credit Crisis,” by Paul Muolo and Mathew Padilla. (Full disclosure: Muolo is a friend of mine and a co-author with me of “Inside Job, the Looting of America’s Savings and Loans.”)

Milne shows how panic and withdrawal of short-term funding also played a significant role in the panic of 1907, the Asian crisis of 1997, and the collapse of Long-Term Capital Management hedge fund in 1998.

He shows the danger posed by repo collateral, because at any time repo lenders can issue a margin call, demanding more collateral.

A fund using such repo leverage is then hit by a “double whammy,” not only the loss of money because the $100 million asset falls in value from, say, $100 to $96, but also an additional margin call because the haircut is increased from $5 to $10. The fund must now come up with an additional $9.

Milne shows that the housing bubble was driven by financial institutions seeking profits, including mortgage giants Fannie Mae and Freddie Mac, not by homeowners.

It was this increased demand from Wall Street banks, seeking out high-yield mortgages for inclusion in their arbitrage structures, which led to the dramatic increase in sub-prime and other alternative originations through mortgage brokers. This competition for volumes led in turn to both the widespread decline in underwriting standards and a house price boom.

This competition for volumes and profits drove financial institutions to create about $600 billion of restructured CDOs, which are tranched securities backed not by loans but by other sub-investment-grade tranched securities. This structure “was responsible for much of the excess of the credit boom,” Milne writes.

These restructured CDOs were a small part of an industry that had $7.2 trillion in mortgage-backed securities outstanding at the end of 2007 and another $3.7 trillion in other asset-backed securities, according to Milne, but they turned out to be the industry’s Achiles heel.

… the entire asset class may need to be almost entirely written off, a spectacular and, for the rating agencies, extremely embarrassing fate for $600 billion of securities much of which had attained the safest possible AAA ratings.

Not surprisingly, given that “The Fall of the House of Credit” was completed only a few months after the peak of the crisis, Milne says he feels there are a few gaps. For example he told RepoWatch he could have said more about the investment of European banks in US securitization products and how this transmitted problems from the US to global financial markets; and he could have said more about the role of the Reserve Primary fund “breaking the buck” in triggering the run on US money market mutuals following the failure of Lehman Brothers.

Mary Fricker
Editor, RepoWatch