One of the recurring themes in the history of money is that every system for its creation and management contains within itself the seeds of some unforeseen future abuse.There is a widely held belief that the financial crisis of 2008 was caused by the creation of securities backed by American sub-prime mortgages. This is not true, although selling mortgages to people with almost no ability to repay their loans certainly didn’t help. The real cause of the crisis was an arcane activity known as ‘re-hypothecation’.
This piece of financial jargon needs to be explained. Most people, when they buy a house, have to take out a mortgage. Legally, they own that house, but the bank or other lender has the hypothetical right to repossess the house if the borrower falls behind with their repayments. This is hypothecation. If the lender uses the house as collateral for their own financial transactions, this is a simple form of re-hypothecation.
Of course, investment banks, brokers and other financial players don’t pull this stunt with mortgaged houses, but they do something very similar when buying bonds, commodities, futures and other financial products. In fact, according to the International Monetary Fund (IMF), the average number of times that the collateral for an initial trade is pledged to secure further transactions is four, a degree of leverage that would have made Archimedes break out in a cold sweat.
I should underline what this means: if four is the average number of times that the collateral for a trade is re-hypothecated, then the amount of collateral backing the global financial market is 25 percent. This should make everyone nervous, because with this level of under-capitalization, the global financial system is what might politely be termed ‘another accident waiting to happen’. The old practices have not been abandoned, and it is only a matter of time before the crisis of 2008 is repeated, probably with more serious repercussions than last time.
Although re-hypothecation lay at the heart of the 2008 crisis, this activity became possible only after the Glass–Steagall Act was repealed in 1999, thus destroying the wall between investment and commercial banking that had been put in place by President Franklin Roosevelt in response to the Great Depression to protect the savings of ordinary Americans.
Another effect of the Commodity Futures Modernization Act (CFMA), the official title of the legislation that repealed the Glass–Steagall Act, was to deregulate the trade in credit default swaps, collateralized debt obligations and other financial legerdemain. However, despite the obvious connection between CFMA and the financial meltdown that occurred almost a decade later, then Treasury secretary Laurence Summers continues to deny any responsibility for the resulting mess, although the president under whom he served, Bill Clinton, has since conceded that his signing of CFMA was based on bad advice, advice that one must assume came from Summers.
Despite the liberalization of financial markets that occurred in 1999, US Treasury rules continued to restrict re-hypothecation to a maximum of 140 percent of the original collateral. Unfortunately, such a rule did not exist in London, which is why AIG, Lehman Brothers and other American financial institutions carried out most of their transactions there, using UK-based subsidiary companies. Did you ever wonder why Lehman Brothers and Bear Stearns were allowed to fail, while other US financial institutions were given what were effectively cash handouts on the grounds that they were ‘too big to fail’? And did you ever wonder why it took $85 billion to bail out AIG? Surely a firm that was this much in debt deserved to go under, especially given that its losses were a direct result of re-hypothecation in London and not merely a temporary blip.
Allowing an ailing company to fail is the archetypal response in a genuinely free market, so President George W. Bush got it right with Lehman Brothers. He went wrong subsequently because the collapse of Lehman Brothers revealed a complex web of re-hypothecated financial transactions, and the realization that this kind of behaviour was widespread in financial circles induced panic among senior US administrators. The reasoning appears to have been that if Lehman Brothers, a relatively small investment bank with no retail business, was in such a mess, then the collapse of a larger financial institution in a similar pickle would trigger a catastrophe of unimaginable proportions, especially if that institution had a retail banking arm. This was the origin of the ‘too big to fail’ scenario, which merely encouraged more reckless speculation by banks, whose operators could continue with business as usual, safe in the knowledge that they had an implicit promise of rescue if they made catastrophic errors of judgement.
Although he hasn’t said so publicly, President Bush, like his predecessor, must have been given bad advice, and also like his predecessor, that advice is likely to have come from his Treasury secretary, who in this case was Henry Paulson. It should not be forgotten that Paulson, as a former CEO of Goldman Sachs, was one of the people behind the move to convert sub-prime mortgages into products that could be sold to unsuspecting investors, although this doesn’t excuse the Royal Bank of Scotland and other European banks that bought these intrinsically worthless securities and subsequently lost huge amounts when these ‘structured investment vehicles’ went sour. It doesn’t take a financial wizard to work out that an investment offering a rate of return that is above par must entail an increased risk.
Of course, other banks got into difficulties for other reasons. Northern Rock, for example, borrowed on short-term money markets to fund its mortgage business. I would have thought that a child in a kindergarten would instinctively grasp that borrowing short to lend long is not a sustainable business model.
It is a mistake to imagine that the surviving institutions have learned the lessons of 2008. In 2011, Goldman Sachs re-hypothecated assets worth $28.17 billion, but even this staggering total pales into insignificance when compared with JP Morgan Chase, which re-hypothecated assets worth $546.2 billion, and Morgan Stanley, which added $410 billion to the total. Although I cannot find more up-to-date figures, it must be reasonable to assume that this financial skullduggery not only continues to be practised, but is also on a similar scale.
It must have seemed like a good idea when financial systems were globalized in the 1980s, and so it was. Globalized finance meant that international trade was made easier, but in the intervening years, partly as a result of the deregulation of financial services in major markets, the global financial system has become an end in itself, hence the massive proliferation of what are euphemistically called ‘derivatives’. It has become a system for channelling more and more money into fewer and fewer hands. There was a time when a country’s stock market index reflected the overall state of its economy, but the Dow Jones Industrial Average has been at or near record levels in recent months, yet the US economy remains in the doldrums. The only beneficiaries appear to be the country’s big financial players. I have heard Goldman Sachs described as ‘a money-making machine’. It is nothing of the kind; it is a money-grabbing machine. It does not create wealth.
What of the future? The labyrinth of re-hypothecated trading positions, collateral for which is a mere 25 percent of what should be the case, means that the failure of one link in the chain will have a domino effect on financial markets. And any chain, whether actual or metaphorical, is only as strong as its weakest link. The only unknown is the location of that weakest link, but when the crash does come, some financial institutions will not be ‘too big to fail’. They will be too big to save. It may be time to check whether there’s room under your mattress for your hard-earned savings. After all, they won’t be much less safe than if you put them in a bank. And they will earn only marginally less interest.