Monday, December 15, 2008

Starting in America

It is, of course, understandable that the Government should want to preface every statement about the economic climate with the words ‘which started in America’.  Every Government tries to claim credit for the good times, and avoid blame for the bad.  But in current circumstances, I’m not sure that it’s a very useful thing to say – except for buck-passing.

There have been two distinct phases of the current recession, related but distinct.  The first was the rapid and dramatic contraction in financial liquidity.  Everyone knows this happened because of sub-prime.  Which is true, in the same way that the First World War happened because of Gavrilo Princip.  What ‘sub-prime’ is used to mean is a short-hand for the popping of the US housing bubble.  Every country has always had dodgy mortgage loans.  So long as house prices are going up, these don’t matter.  Or at least can be said not to matter.  What was different this time was that the international financial sector had discovered a way to commodify financial products in a way that hadn’t been thought of before.

Almost nobody who has been writing about CDOs and CDSs has any idea of what they are talking about.  I worked for six months drafting the damn things and I only have a hazy idea.  But the simplest explanation of them is that they work on the basis that it is possible virtually to eliminate risk by spreading it extremely thin.  This has turned out, shall we say, not to be the case.  As Mark Steyn once said in another context, if you take a quart of ice cream and quart of dog shit, the result ends up tasting more like the latter than the former.  Toxic assets, even in small quantities, can contaminate an entire portfolio.  To make matters worse, the financial products had been so sliced and diced, repackaged so many times and in ever more elaborate synthetic products that no-one was entirely sure who owned what where.

This is one of the reasons the banks were so slow in announcing their losses – no-one knew what they were.  And their natural reaction was to retrench – that is to call in loans and stop more lending while they worked out what the hell had happened to all their assets.  And this is the point where we all noticed what was going on.  And it’s why Northern Rock went bust.

So we have banks unable, or at least unwilling, to lend.  And since all banks borrow short and lend long, this furring of the financial arteries resulted in a banking cardiac arrest.  The banks were going bust because they had no money.  They couldn’t borrow any more, because, well, no-one had any money.  Sure as hell they weren’t going to buy any more of these damn CDOs that had caused all this mess, but since a hefty proportion of their total assets was in the form of, um, CDOs, and no-one was buying them any more their asset base value was wiped out.  Meaning they needed to borrow money to meet their obligations.  But they couldn’t borrow any money because – you get the idea.

So, we had the banking bail-outs.  There were two ways of doing this – the American way, TARP, which involved the Government buying up all the shitty deals that the banks had done to get themselves into this mess; and the European way, which involved Governments giving the banks large amounts of cash in return for shares – on varying terms.  There are problems with both methods.  The US method doesn’t address the balance-sheet problem (the banks don’t have any damn money) and the European method (at least the British version of it) is going to restrict the banking sector’s private sector lending capability for years.

So the credit crunch was really just a belated realisation that old-fashioned rules on capital adequacy hadn’t stopped being important just because they were being ignored.  And where was a lot of the financial innovation being done?  Right here in the City.  And if Gordon Brown was even a tiny bit intellectually honest he’d say that the credit crunch happened because even though the bankers (and lawyers, and accountants) were a lot cleverer than the politicians, they still weren’t as clever as they thought they were.  He’d then go on to admit that the recession we’re facing was also only caused by the credit crunch in the same way that the credit crunch was caused by sub-prime.

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