"The City Uncovered" presented a logical and sometimes frightening account of how the global banking crisis unfolded. Ex CEO of Northern Rock, Adam Applegarth and Dick Fuld of Lehmans Brothers were presented as the villains of the piece, but as this incredible story unfolded it became clear that Davis believes that villains existed at almost every level in the complex and fragile house of cards that is global finance. From the bankers and the ratings agencies, to the customers and the regulators and even to rocket scientists, no-one appeared totally blameless.
And you know what? I agree with him. My generation became accustomed to cheap credit. I've had huge self-certified mortgages, I have credit cards with staggering credit limits. I have a sizable interest only mortgage. I have very little savings (bar the ever eroding capital in my house). And I don't think I've done anything wrong, I've not broken any laws. I have simply made use of the credit I was offered. But do I have an obligation to understand how banks can make this money available to me? Should I have stepped back and wondered how they can lend me huge sums, with me only paying the interest? Or should I have expected the banks and their regulators to protect me from their greed? In truth only a very few people understood exactly what was going on in the wholesale markets. Even fewer fully understood how debt was being securitized and sold on.
Davis's narrative presented a clear explanation of the chain of events that unfolded to cause this crisis. For the sake of posterity, I'm going to record them here in as simple a terms as possible.
The origins of banking date back to China via Venice and Marco Polo. On returning from his travels he explained how paper was used in place of cumbersome assets such as gold. This revolutionary invention suddenly made it much easier to trade. Instead of paying for items in gold, paper could be used as a guarantee or a bond. This in turn made it much easier to borrow and lend. The Christians in Venice felt prevented from lending (and earning interest) as this was implied as incorrect in the bible. So, it became the responsibility of the Jewish community in Venice to become the bankers. They would borrow at a certain interest rate and lend at a higher rate - making the margin as their profit. This concept quickly spread throughout Europe and America and formed the basis of the banking industry as we know it.
Fast forward to the US in the 1850's. Two German brothers, The Lehman's began a simple trading business, the explosive growth of the cotton industry lead them to begin accepting cotton as a form of payment. This spawned their second business as cotton traders. Their business grew to form one of the worlds first and biggest investment banks.
Meanwhile on the other side of the Atlantic in Newcastle, England the company that was to become Northern Rock opened for business. Their model was far removed from Lehman's. Northern Counties Permanent Building Society, began accepting deposits from local people. They would save until they could afford their own home. They were in effect a classic retail bank - taking savings from local people at a certain interest rate and loaning to other local people (to buy their own homes) at a higher rate. Northern Counties Permanent Building Society operated in this way for over 100 years.
So as retail banks went about their business of taking deposits from retail customers and loaning this money back to them in the form of mortgages, investment bankers were busy trying to figure out how they could get a piece of this pie. The solution - securitization, or CDO's (Collateralized Debt Obligations). These complex financial instruments enabled investment bankers to underwrite mortgage debt, package that debt up into a financial instrument and sell these debts to investors. This made sense to the retail banks, because now the mortgage debts that had traditionally sat on their balance sheets as a risk, were now no longer their problem. It made sense to the investment banks as they were earning huge returns on these CDO's. The problem with being a retail bank was that you relied on your customers deposits - your growth was restricted. Because CDO was such a profitable product for investment banks they began to lend to retail banks to fuel their lending - this is known as the wholesale money market or inter bank lending. In return the investment bank would securitize the mortgage loans and make big returns selling these products to investors.
Because securitization was such a profitable product, investment banks were keen to loan as much as possible in order to sell on the CDO's. They turned their attention to people who they had traditionally never loaned to before - the poor. In effect, this was the turning point. Instead of the CDO being a by-product of lending, the CDO was now THE reason to lend. It was suddenly possible for people with poor financial credit worthiness to borrow money. The fire was now raging out of control and yet very little could be done. This cycle of borrowing and lending and re-borrowing and re-lending, meant that banks were making huge profits. Banks shareholders were happy, borrowers were happy, banks were happy and ratings agencies were happy because of the huge fees they were making. There was no turning back.
As the range in the quality of these loans became wider, so the products became more complex. Banks would now package different qualities of debt together in their CDO's, selling triple A rated loans with no problems, but finding themselves saddled with more risky debt. Still this wasn't a major problem as long as borrowers continued to meet their obligations and the value of the underlying assets didn't drop. Unbeknown st to all those happy home owners and credit junkies, the situation was now so precarious, that the slightest change in economic conditions would bring a total collapse in the global financial markets.
This slight change was the slowing of the US housing markets. As loan defaults increased, concerns were raised over the quality of debt that banks had on their books. This led to an almost immediate collapse of the Interbank lending market. It was now simply a question of time before the cries of help were to be heard.
That cry of help came from Northern Rock, who had built their business model around borrowing from banks in the short term via the overnight money markets and loaning (at a higher rate) in the long term . Using this model, they had grown their share of the UK mortgage market from 2% to 17% in less than 5 years. As it became harder for Northern Rock to borrow they very quickly became unable to service their debt. Their capital reserves disappeared in a matter of days and they requested emergency funding from the bank of England. Panic spread throughout their customer base and the first run on a UK bank in over 100 years ensued.
As the situation gathered momentum, now it was the turn of the investment banks to feel the wrath. Their business models, which had so heavily relied upon income from CDO's, were now unsustainable. Bear Sterns was the first to go, aided by the US government, and with their share price hovering at all time lows, they were quickly bought by JP Morgan. The attention then turned to Lehman Brothers. With their capital based eroded and no deal to save them Lehman's were declared bankrupt on September 14 2008 - an institution with a proud 150 year history had vanished forever. If there was panic before this landmark event, then what ensued was global pandemonium.
Suddenly no institution was safe, Merrill's, Goldman's and Morgan Stanley in the US and LloydsTSB, HBOS, Barclays and RBS in the UK were now in grave danger of going to the wall. Mass panic lead to huge stock market volatility which in turn caused further problems for these banks as suddenly their capital bases were eroded further. Only the intervention of global governments and the pumping of billions and billions of dollars into the banking system prevented a global meltdown. We are by no means out of the woods; the global banking system still sits precariously overlooking the precipice and ther are no doubt more obsticles ahead.
