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Endogenous Developments in the financial sector that led to the 2007-9 crisis

The financial crisis of 2007-2009 was not a typical credit crunch crisis as the ones we have seen in

the modern capitalist era. It wasn’t a crisis solely driven by the irrationality of market participants or

the result of an overvalued market system; it was in fact a much more complex phenomenon. The

development and alternations in the financial sector through the last 20 years is undoubtedly

significant. With the collapse of Keynesianism in the 1970’s and the emergence of Neoliberalism the

economy was to change page from a state-led mechanism to an autonomous factor. Although

favoured by a period of high degree market liberalisation with policies of a laissez faire doctrine, the

financial sector achieved its rapid development and expansion endogenously. Within the

frameworks of the financial system, a new set of institutions emerged to supply the excess demand

for credit without however being compliant to the typical legislative requirements of a commercial

bank; this practise of regulatory and financial arbitrage was performed by the so-called “shadow

banking system”1. Rating agencies, mainly Standard & Poor’s and Moody’s became part of this

system undermining thus their actual role as exogenous regulatory forces2. Moreover, the

construction of new financial products such as asset-backed securities and their exchange in the

over-the-counter markets was a pivotal step towards a volatile financial system that relied heavily

on mortgages handed on non-creditworthy borrowers3; the burst of this bubble system was thus

inevitable.

From the end of the 1990’s up to 2007 the banking system had created an image of euphoria,

where credit was granted with less and less collateral requirements as the demand for loans had

increased dramatically and banks found a way to instantly increase their profits. It’s worth to

mention that commercial banks for example in Greece, which today operate under a capital control

scheme, in 2006 had started issuing ‘holiday’ loans to the public4. From the beginning of the 2007

economic crisis up to 2016 the Greek central bank has recapitalized the domestic commercial banks

thrice as the country was facing the threat of bankruptcy5. In the US, the heart of the global capital

markets, the government had to step in the financial markets and through direct spending to save

financial giants, such as AIG and restore the liquidity shortage that had resulted6. The complex

nature and architecture of this new financial order was depicted by the domino-like collapse of its

branches in contrary to previous typical credit crisis, as the dotcom bubble of 2001. But what really

made this new order so complex and interdependent within its spheres?

As mentioned before, because of the widespread climate of over-optimism in society people and

firms were triggered to borrow money and designed their lives under a fictitious world of credit

money. From their side banks, as profit generating entities wanted to take advantage of this

increased demand for credit and thus supplied loans as much as possible. Nonetheless, commercial

banks were constrained by specific rules concerning the ratio of capital they could lend and the

money they hold as reserves. More to the point, in most countries, with the exception of the UK for

1 McCulley, Paul. "The Shadow Banking System and Hyman Minsky’s Economic Journey." p. 257 2 Wolfson, Josh, and Corinne Crawford. "Lessons from the Current Financial Crisis: Should Credit Rating Agencies be Re- Structured?". p.87 3Palan, R. & Nesvetailova, A. “ Elsewhere, Ideally Nowhere: Shadow Banking and Offshore Finance”. p. 31 4 Από τα εορτοδάνεια στα...τυροπιτοδάνεια. Το πικρό χιούμορ του διαδικτύου για τα δέλεαρ των τραπεζών και την κατάρρευση της "Ισχυρής Ελλάδας".<http://www.mixanitouxronou.gr/apo-ta-eortodania-sta-tiropitodania-to-pikro-

chioumor-tou-diadiktiou-gia-ta-delear-ton-trapezon-ke-tin-katarrefsi-tis-ischiris-elladasnia/>.

5 Papadogiannis, Giannis. "Πώς φθάσαμε και πώς έγινε η 3η ανακεφαλαιοποίηση” <http://www.kathimerini.gr/840305/article/oikonomia/epixeirhseis/pws-f8asame-kai-pws-egine-h-3h-anakefalaiopoihsh> 6 "U.S. Senate vote on Emergency Economic Stabilization Act of 2008". Senate.gov. June 29, 2011.

example, the central bank imposed a minimum level of reserves that commercial banks should hold

from their deposits, known as reserve requirements7. Either as a tool of monetary control or a

measure to protect banks from a serious credit default, this policy was seen by most commercial

bankers at the time as a restrain on their high-demanded services. Consequently, banks had to find a

way, endogenously and without violating the existing regulatory framework, to keep the pace of

their credit supply without having to worry about the level of deposits they hold; the solution was

the creation of an SPV (Special purpose vehicle) controlled by the ‘mother’ bank.8

The creation of SPVs became a very popular trend within the banking sector from the beginning of

the new millennium and reached a plateau the years before the outbreak of the Great Recession. It

was a significant financial innovation that enabled commercial banks to provide their services

without appearing in their balance sheets. What made this practise even more attractive was the

easiness of starting it up and the relatively low costs of constructing and functioning such an entity,

as capital costs were not needed9. To understand the increased influence of SPV’s in the financial

sector, we must consider that in 2013, according to official surveys, over 10.000 of different SPV’s

functioned in Holland10, a relatively small proportion of the worldwide total. The vast majority of

SPV’s were registered in tax heavens, such as Bermuda, and thus operated under the tax laws of

these countries. The latter fact added to the practise of off-balance sheet banking increased the

inability of the regulatory authorities to supervise the actions of credit institutions and consequently

failed to predict and take measures against the financial slump that would soon follow.

One of the most important financial developments in the recent years before the outbreak of the

Great Recession was the creation of new financial products, mainly asset-backed securities.

Although the construction and exchange of these products was designed and operated

endogenously, it is worth to mention that important decisions made in the political field, such as the

Commodity Futures Modernization Act which was signed into law in 2000, allowed for the rapid

expansion of the securities market11. The most prevalent type of asset backed security was the

Collateralized Debt Obligation (C.D.O.), a bond whose payments was subject to the earnings of a

specific collateral. Despite that the firsts CDOs were created and distributed in 1994-5 12, what made

them especially risky for the outbreak of the 2007 crisis, was the type of collateral used. Since the

early 2000’s most CDOs used mortgages as collaterals, many of which mortgages were handed in the

first place to subprime borrowers. Credit rating agencies provided a rating to each branch of CDOs

according to their risk level. It was considered generally a low risk financial activity with a relatively

high return (Average:5-9% per year) in a period with constantly rising house prices13; triggering thus

investors to spend more and more capital on these mortgage-backed assets.

From 2004 to 2007 more than 1.4 Trillion dollars had been given for the purchase of new CDOs. It

was a substantial numerical increase if we consider that in 2000 sales of CDOs reached only 60

Billion dollars14. These asset-backed securities were the perfect instrument for banks to move credit

7 Mankiw, Nicholas Gregory, and Mark P. Taylor. Economics. p.573 8 Mankiw, Nicholas Gregory, and Mark P. Taylor. Economics. p.576 9 Nesvetailova, Anastasia. "A Crisis of the Overcrowded Future: Shadow Banking and the Political Economy of Financial Innovation.". p.7 10 Nesvetailova, Anastasia. "A Crisis of the Overcrowded Future: Shadow Banking and the Political Economy of Financial Innovation.". p.8 11 Reavis, Cate. "The Global Financial Crisis of 2008: The Role of Greed, Fear, and Oligarchs." p.7 12 Palan, R. & Nesvetailova, A. “ Elsewhere, Ideally Nowhere: Shadow Banking and Offshore Finance”. p.31 13 Reavis, Cate. "The Global Financial Crisis of 2008: The Role of Greed, Fear, and Oligarchs." p.7 14Morgenson, Gretchen, and Joshua Rosner. Reckless Endangerment: How Outsized Ambition, Greed, and Corruption Led to Economic Armageddon. p.283.

risk of their balance sheets and pass it to investors or to Special Purpose Vehicles-Entities which they

did not technically own15. More to the point, banks initially bundle up a collection of loans and

create a package of debt from which bonds are created. The SPV which is created by the bank buys

this collection of loans with funds raised by the issue of short-term bonds. After this purchase, had

been completed, these loans have now been removed from the bank’s balance sheet and thus the

latter is no longer legally responsible for them. From now on investors of CDOs had a claim against

the SPV and not the mother bank16. Banks, and other financial entities as insurance companies, also

created and issued CDS (Credit default swaps) through the market, via which they could buy hedge

against the potential default risks of their loan portfolios.17 Through these processes, a very complex

financial system emerged which operated in the shadows not only of regulators but also of investors

that couldn’t have a clear image of the product in which they invested in; consequently, market

efficiency was impossible to prevail and the results were obvious.

With the outbreak of the financial crisis in 2007, the global economic order was put into question

and various heterodox views started to regain attention. From the early 1980’s and onwards, a long

period of the preponderance of liberalism and deregulation governed financial markets. There was a

widespread belief in the power of markets to self-correct and operate without the need of

government intervention. It was based on the concept of the efficient market hypothesis, a theory

suggesting that due to the efficient information available in the marketplace, actors will behave

rationally as asset-prices will reflect real market value18. This theory came under serious

animadversion after the Great Recession especially because of the increasing tendency of financial

institutions, mainly hedge funds through the last 20 years, on engaging in the practise of shadow

banking. As Lo pointed, the limited to non-existing access to information on primary data of hedge

funds lead to the inability of economic agents to credibly measure systemic risk in this field19.

However, the very existence and persistent growth of these institutions depended on a high degree

confidentiality from the side of regulatory bodies and at the same time hedge funds were a crucial

component of the American economy, inevitably leading to a regulatory bias in favour of these giant

profit-makers20.

Based on reliable recent data, the shadow banking system accounts for nearly one third of the

global financial system21. The term “shadow banking” was first used by former manager director of

PIMCO, Paul McCalley in 2010, to describe the system of non-formal bank institutions that provided

the services of real banks22. The practise of Shadow banking has its roots back in the 1970’s with the

expansion of money market funds and through the years has developed to a key component of

financial markets, accounting for more than 10 Trillion dollars in 201023. The fundamental difference

of “Shadow banks” in comparison to a typical commercial bank, was that they were subject to much

less extend on regulations and liabilities and furthermore the former didn’t have access to deposit

15 Farhi, Maryse, and Antonio Cidra. "Crise Du Capitalisme Financier." The Financial Crisis and the Global Shadow Banking System. ¶.9 16 Mankiw, Nicholas Gregory, and Mark P. Taylor. Economics. p.577 17 Farhi, Maryse, and Antonio Cidra. "Crise Du Capitalisme Financier." The Financial Crisis and the Global Shadow Banking System. ¶.10 18 Mankiw, Nicholas Gregory, and Mark P. Taylor. Economics. p.551 19 Reavis, Cate. "The Global Financial Crisis of 2008: The Role of Greed, Fear, and Oligarchs." p.17 20 Reavis, Cate. "The Global Financial Crisis of 2008: The Role of Greed, Fear, and Oligarchs." p.16-17 21 Reavis, Cate. "The Global Financial Crisis of 2008: The Role of Greed, Fear, and Oligarchs." p.20-21 22 Bill Gross, Beware our Shadow Banking System. <http://money.cnn.com/2007/11/27/ news/newsmakers/gross_banking.fortune/> 23 Singh, Manmohan, and James Aitken. "The (Sizable) Role of Rehypothecation in the Shadow Banking System."

insurance, the rediscount rate and the last resort credit line of the FED24. This meant that in case of

default, as in 2007-9, these entities would not be able to secure their assets and investors would

instantly lose their money. Except hedge funds, insurance companies and SPV’s that dominated this

area, great attention must be given to the role of quasi-bank public entities, mainly Freddie Mac and

Fannie Mae, which were designed for and served as liquidity-capital providers for the US real estate

market25; a market highly overvalued and unsustainable, that soon popped like a bubble.

The 2007-2009 financial crisis is also known as the subprime mortgage crisis. Of course, this title

wasn’t given incidentally but rather underlined the role of the US real estate market as a catalyst to

the financial slackness that occurred. The plethora of endogenous agents believed at the time that

investing in the US house market was a quite profitable and relatively safe financial activity26. The

housing price bubble, had started from the 1990’s and up until the mid-2000s had a steady growth

of more than 8 percent annually. Indicative of the plasmatic world in which this whole system was

structured, official data suggests that the average household costed more than 4 times the money it

earned27, creating an unsustainable debt. Hyman Minsky had described this phenomenon as “Ponzi

finance” and he insisted that this was the main reason why capitalist societies are unstable and

doomed in repeated crisis28. More to the point, a Ponzi scheme refers to a situation similar to the

pre-2007-9 crisis period, where people borrow money with the belief that the market prices will

keep going high while simultaneously their current income is not sufficient to repay neither the

interest or the principal of the loan; on the other side, banks gave credit with the assumption that

market prices (such as in the US house market before 2007) will keep growing with the same pace29.

Nonetheless, this wasn’t the case from the end of 2006 and an endogenous driven belief and series

of actions based on the notion of constantly increasing house prices led to a disastrous outcome.

The fictitious nature of a financial system based on non-creditworthy borrowers and overvalued

assets could not have existed, at least in this extent, without the involution of Credit Rating

Agencies. Moody’s, Standards and Pool’s and Fitch are the three rating agencies which dominated

more than 95% of the rating agency market30 and were brought in the spotlight when the blame

game for the financial crisis of 2007-9 had started. Historically, the initial function of rating agencies

was to provide necessary market information to investors and financial corporations, but through

time they extended their services in many other fields, mainly on selling “seals of approval” in the

form of ratings (from a scale of A-D), which turned to be their main source of revenue.31 From the

1970’s and onwards Credit rating agencies had been transformed into the ultimate gatekeepers of

the global financial system and without their approval-rating, agents could not sell their financial

products in the market.32 The development of rating agencies and their engagement in the process

of constructing new financial assets by providing a rating for which they were paid by the issuer,

24 Farhi, Maryse, and Antonio Cidra. "Crise Du Capitalisme Financier." The Financial Crisis and the Global Shadow Banking System. ¶. 8 25 Farhi, Maryse, and Antonio Cidra. "Crise Du Capitalisme Financier." The Financial Crisis and the Global Shadow Banking System. ¶.8 26 Reavis, Cate. "The Global Financial Crisis of 2008: The Role of Greed, Fear, and Oligarchs." p.3 27 Reavis, Cate. "The Global Financial Crisis of 2008: The Role of Greed, Fear, and Oligarchs." p.3 28 McCulley, Paul. "The Shadow Banking System and Hyman Minsky’s Economic Journey." P.260 29 McCulley, Paul. "The Shadow Banking System and Hyman Minsky’s Economic Journey." p.260 30 Wolfson, Josh, and Corinne Crawford. "Lessons from the Current Financial Crisis: Should Credit Rating Agencies be Re- Structured?". p.86 31 Wolfson, Josh, and Corinne Crawford. "Lessons from the Current Financial Crisis: Should Credit Rating Agencies be Re- Structured?". p.87 32Wolfson, Josh, and Corinne Crawford. "Lessons from the Current Financial Crisis: Should Credit Rating Agencies be Re-

Structured?". p.87

opened a big room for corruption and regulatory bias33. A characteristic example of this problem,

was AAA ratings granted for products which were collateralized on subprime mortgages, that under

normal circumstances should have been rated with a D and warn potential investors for their risk

exposure34.

A very important development in the financial sector which had started from the late 1980’s was

the emergence of “over the counter” (OTC)markets. In juxtaposition to typical exchange markets

where financial products are traded openly and prices are driven by market forces, the function of

OTC market was highly obscure35. It was estimated in 2008, that US$ 683.7 trillion in notional values

derivatives were exchanged in this shadow market.36 The limited regulation and supervision over

these markets increased the popularity and tendency to trade derivatives via them. Mortgage-

backed securities, derivatives and CDS were traded uniquely in OTC markets which offered the

perfect framework and conditions for both sellers and investors to act as complete market makers37.

This type of market relied heavily on liquidity and an absence of the latter, as in 2007-9, could prove

catastrophic.

In conclusion, a series of endogenous financial developments and innovation that had its roots in

the 1980’s and reached a peak in the post-dotcom bubble era, gave birth to a financial system highly

vulnerable and endogenously interdependent; making this financial crisis unique in size and effect in

contrast to mainstream bubble crisis. Banks were behind this whole process of constructing a new

financial order, where households would leave above their means so as to continue buying their

products in the same pace. New financial products and markets, enabled these institutions to

increase their volume of activities and function on the sly of regulators. The outcome was an

economy paranormally overheated that was perfectly described by S. Johnson’s quote: “there was

twice as much money looking for investment, but not twice as many good investment”.38 Even the

stronger proponents of laissez-faire economics and the efficiency market hypothesis, such as Alan

Greenspan, admitted that there was much space given for financial players to endogenously profit

and manipulate the system.

Word count: 2531

33 Wolfson, Josh, and Corinne Crawford. "Lessons from the Current Financial Crisis: Should Credit Rating Agencies be Re- Structured?". p.87 34 "Third time's the charm?". The Economist. 35 Farhi, Maryse, and Antonio Cidra. "Crise Du Capitalisme Financier." The Financial Crisis and the Global Shadow Banking System. ¶..32 36 Farhi, Maryse, and Antonio Cidra. "Crise Du Capitalisme Financier." The Financial Crisis and the Global Shadow Banking System. ¶.39 37 Farhi, Maryse, and Antonio Cidra. "Crise Du Capitalisme Financier." The Financial Crisis and the Global Shadow Banking System. ¶.32 38 Reavis, Cate. "The Global Financial Crisis of 2008: The Role of Greed, Fear, and Oligarchs." p.9

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