The US Subprime Crisis Goes Global

The crisis that swept through the US in August 2007 is not over yet and the international repercussions will be deep and lasting. When the housing bubble burst in August 2007, it shook financial markets worldwide. This housing crisis is closely linked to a private debt crisis in the world’s most industrialized countries. Clearly this crisis will be with us for several years. With perhaps worse to come.

All the warning signs were there: the boom in housing construction over several years (buoyed up by lower interest rates decided by the Federal Reserve to stem the crisis of 2001-2002) leading to overproduction and a hike in real estate prices which in turn opened the door to speculation. Purchases of new homes have plummeted since the start of 2007 while the default rate for households with mortgages is rising sharply. The weakest link in the debt chain has finally snapped: lenders specializing in high-interest loans to heavily indebted, low or middle-income households (the subprime mortgage market) have found themselves in trouble as the default rate soars (see box). Unfortunately, it is not enough to replace the broken link for the chain to regain its economic momentum. Other links are also likely to give way.

The mortgage lenders (like the banks) made long-term mortgage loans while borrowing for the short term (either from depositors, or on the inter-bank market at historically low interest rates, or by selling their mortgages to big banks and hedge funds). The “problem” is that they made long-term loans to a sector of the population that was struggling to make repayments while the housing glut caused their property (which was the surety for their loan) to depreciate drastically. As the number of defaults increased, these mortgage lenders began to experience difficulties in repaying the short-term loans they had contracted with other banks. And the banks, to cover themselves, refused to grant them new loans or did so at much higher interest rates. In the United States, 84 mortgage lenders went bankrupt or partially ceased their activity between the beginning of the year and 17 August 2007, as opposed to only 17 for the whole of 2006. In Germany, the IKB bank and the public institute SachsenLB, both of whom had invested heavily in the US mortgage market, suffered immediate effects and were only saved by the skin of their teeth.

But the domino effect does not stop there: the banks that bought up mortgages did so by setting up largely off-balance sheet operating companies called Structured Investment Vehicles (SIV) . These SIVs finance the purchase of mortgage loans by selling commercial papers to other investors. Their profit comes from the difference between the remuneration paid to buyers of their commercial papers and the money gained from high-yield mortgage loans converted into bonds (CDO Collateralized Debt Obligations ).

Of course all these complex debt and loan packages do not create real wealth (whereas there is real wealth in the construction industry and its suppliers): they are largely speculative financial operations. The crisis in this shaky “paper” market, however, leads to the destruction of wealth and human lives (failed construction companies, financial ruin and even suicide, loss of employment, repossession of properties).

When the crisis erupted in August 2007, the investors who habitually bought commercial papers issued by the SIVs stopped buying them because they no longer had confidence in the health and credibility of the SIVs. Consequently the SIVs lacked liquidity for buying mortgage bonds and the crisis worsened. The big banks that had created these SIVs had to honour SIV commitments to avoid them going bankrupt. While SIV operations had until then been below-the-line items (which allowed them to conceal the risks they were taking), big US and European banks were now obliged to show SIV debts on their balance sheets. Among these were Bank of America, Citigroup (the leading worldwide banking group), Wachovia, Morgan Stanley and Merrill Lynch, Deutsche Bank and UBS (Union des Banques Suisses). Between August and October 2007, US banks alone took on at least 280 billion dollars of SIV debts , with serious bottom-line consequences. Several major banks such as Citigroup and Merrill Lynch at first tried to minimize their level of risk exposure, but their losses were so considerable that they could not conceal them for long. Chairmen were ejected, but not without a golden parachute. Merrill Lynch’s chairman Stan O’Neal received 160 million dollars as compensation for his untimely departure! On the contrary, the CEO of the bank Goldman Sachs, Lloyd Blankfein, established the record for the highest bonus in 2007: 68 million dollars, for record benefits and for the knack of having bought products that derived from the exploitation of the subprime crisis (which contributed to exacerbate the latter, according to some sources). Effectively, these scandalous sums reward anti-social, if not criminal, behaviours.

Indebtedness of households, defaults on mortgages and much more

In the United States, repossessions of mortgaged homes reached 180,000 in July 2007, over twice as many as in July 2006, and have passed the one million mark since the beginning of the year, that is, 60% more than just a year ago. It is estimated that there will be 2 million repossessions in 2007.

Indebtedness in American households has reached an extraordinarily high level: 140% (in other words household debts amount to almost one and a half times their annual income). Mortgage debts of households represented 95% of their income in 2005 (compared to 63% in 1995). This illustrates the enormous proportion of home-buying in household debts and consequently, the extent of the crisis that started in 2007. It will last many years.

Few economic commentators make the connection between the increasing number of mortgage defaults and the fact that American workers work on average longer hours per week to earn less money. This is the result of creating a more flexible and precarious labour market as part of the employers’ offensive . A large section of North American employees have seen a real drop in income over the last few years. The rise in interest rates imposed by the Federal Reserve since June 2004 has finally made mortgage repayments far too heavy in relation to household income. In fact the rise in payment defaults is not restricted to the real estate sector: it now concerns loans and credit cards .

Double standards

The August 2007 crisis had spectacular effects both in the United States and in Europe. “On Friday 10 August, in Europe and in the United States, an incredible thing happened: in 24 hours banks became too mistrustful of each other to do any mutual lending, forcing the central banks to step in massively. In 4 days, up to 14 August 2007, the ECB [European Central Bank] pumped nearly 230 billion euros of liquidities into the market.” The US Federal Reserve acted likewise. The dynamic response of the US and European monetary authorities thus prevented multiple bankruptcies. From the 13 December 2007, in a joint action, on a scale never witnessed before, the ECB, the Federal Reserve, the Bank of England, the Bank of Canada and the Swiss National Bank (supported by the Bank of Japan) again pumped enormous liquidities into the interbank market, a sign that the crisis is not over yet.

The response of the US and European political and financial authorities to the liquidity crisis which began in August 2007 is a far cry from the response imposed on the Indonesian authorities by the IMF, supported by these same governments, at the time of the Asian crisis of 1997-1998. In the first case, the US and European authorities saved the banks by placing liquidities at their disposal, whereas in Indonesia, the IMF enforced bankruptcy on dozens of banks by refusing to let either the Indonesian Central Bank or the IMF itself lend them liquidities. This ended in a social disaster and a huge increase in the internal public debt because the debts of the failed private banks were transferred to the Indonesian State. Another glaring difference: to stem the crisis, the US monetary authorities have since August 2007 lowered interest rates (as they did between 2001 and May 2004), whereas the IMF demanded that the Indonesian government increase interest rates, a factor which considerably aggravated the crisis . Double standards for the North and South

International contamination

In September 2007 the US crisis affecting the financial world abroad became even more visible when Northern Rock, a major British bank specializing in mortgages, was suddenly unable to honour its engagements.

This bank was contracting short-term loans on the interbank market and making long-term loans on the real estate market. The breach of confidence among banks led to a sudden rise in the London interbank offered rate (LIBOR). This directly hit Northern Rock, whose borrowing rates increased unexpectedly. An emergency loan from the Bank of England saved Northern Rock from bankruptcy. This breathing space was of short duration however, and Northern Rock is now for sale. It could even be nationalised.
The real estate crisis and the private debt crisis are interconnected

The present crisis is not limited to real estate: it directly affects the debt market. Over recent years the private debt owed by companies has dramatically increased. New financial products have become more widespread, namely the Credit Default Swaps (CDS). CDS are bought to protect against the risk of the non-payment of a debt. The market for CDS has multiplied by a factor of 11 in the last five years . The problem is that these insurance contracts are sold without any regulatory control from the public authorities. The existence of these CDS encourages companies to take increasing risks. Believing that they are protected against non-payment, the lenders give out loans without verifying the borrower’s ability to pay. However, if the international economic situation deteriorates, tens or hundreds of borrowers could suddenly become bankrupt, in which case the CDS would become valueless pieces of paper as the insurers would be incapable of honouring their engagements.

The SIVs mentioned previously specialize in selling CDOs (Collateralized debt obligations) that many investors have been trying to get rid of since August 2007. As of mid-December 2007, default repayments of CDOs had reached a sum of 45 billion dollars . Since August 2007, the issuing of new CDOs has stopped as a result of the severity of the crisis.

For its part, the huge market of commercial papers based on mortgage credit and asset-backed commercial papers, worth 1.200 billion dollars in August 2007, has literally melted: a 30% contraction from the beginning of the crisis to mid-December 2007 . As this market still represents 800 billion dollars, its continued downward trend could have serious consequences for the banks, curtailing their sources of funding on a long term basis.

Finally, during 2006-2007, several companies have endeavoured to buy out other companies by contracting debts: this is what is called Leveraged Buy-Out (LBO).
To sum up, over recent years a huge house of cards has been built on accumulated debts. It is now collapsing and the central banks of the most industrialized countries are attempting to patch the breaches and (to) hastily put up some scaffolding to prevent the worst from happening. They might avoid a complete disaster but the damage will be severe in any case.

Several time bombs have been set

In the conclusion to Chapter 5 of Your Money or Our Life, The Tyranny of Global Finance (2005), I raised the question of whether the 2001-2002 crisis in the United States would have long-term consequences:

“Twenty years of deregulation and opening up of markets on a planetary scale have eliminated all the safety barriers that might have prevented the cascade effect of crises of the Enron type. All capitalist companies of the Triad and emerging markets have evolved, some with their own variations, on the same lines as in the USA. The planet’s private banking and financial institutions (as well as insurance companies) are in a bad way, having adopted ever riskier practices. The big industrial groups have all undergone a high degree of financialisation and they, too, are very vulnerable. The succession of scandals shows just how vacuous are the declarations of the US leaders and their admirers in the four corners of the globe.

A mechanism equivalent to several time-bombs is under way on the scale of all the economies on the planet. To name just a few of those bombs: over indebtedness of companies and households, the derivatives market (which in the words of the billionaire Warren Buffett, are “financial weapons of mass destruction”), the bubble of property speculation (most explosive in the USA and the UK), the crisis of insurance companies and that of pension funds It is time to defuse these bombs and think of another way of doing things, in the USA and elsewhere. Of course, it is not enough to defuse the bombs and dream of another possible world. We have to grapple with the roots of the problems by redistributing wealth on the basis of social justice.”

From the 2000-2001 crisis to the crisis in 2007- …

Before the 2000-1 “New Economy” or “dot-com” speculative bubble burst in the US and elsewhere in the world, economists and politicians eager to praise the benefits of capitalism in its neoliberal stage (supported in this by a whole armada of journalists specializing in financial issues) confidently claimed that no crisis could be expected. On the contrary, they maintained that the United States had found the magic formula for permanent growth without crisis. They had to change their tune when recession hit the US in 2001 and stockmarket prices kept falling.

With the resumption of growth these same commentators then claimed that capitalism had found the magic formula to dispel risks related to too high a rate of debt emissions by creating (among other measures) Credit Default Swaps (CDSs). There was a staggering number of reassuring statements and papers on risk spreading.

Yet official bodies such as the BIS (Bank for International Settlements), the IMF, or the WB knew that this meant playing with fire. These institutions’ reports published before the August crisis include scenarios that do not rule out the possibility of a crisis but the prevailing message they conveyed was that effectively, thanks to the new debt security engineering, risks had been spread and major accidents were unlikely. In its 2007 report published in June, two months before the crisis broke out, the BIS noted: “The episodes of market turbulences . . . may have reflected market participants’ latent nervousness that the balance of risks tends to be skewed towards the downside when times are good. In the near term, however, few market participants appear to be overly concerned about a sudden and widespread deterioration in credit quality.” The crisis that started in August gave them a rude awakening.

Criticism was heaped on scapegoats. “The conduct of some mortgage brokers was shameful and called for nation wide regulation of the home lending business”, the US Treasury Secretary Hank Paulson said in the Financial Times. Few economists writing in financial papers share Wolfgang Münchau’s criticism of the policies pursued by the Washington government and the Federal Reserve: “I believe that the explosive growth in credit derivatives and collateralised debt obligations between 2004 and 2006 was caused by global monetary policy between 2002 and 2004,” and further “The channel through which negative real interest rates can translate into a credit bubble will remain open”.

In big banks and private financial bodies there was heavy turbulence and a certain amount of in-fighting at board level (cf. Citigroup and Merrill Lynch). On 11 October 2007 the Institute of International Finance (IIF), an international association of some 800 banks and other financial institutions (including the most prestigious banks) sent a long letter to the IMF and to the main central banks in which it diagnosed a deep crisis and asked public bank authorities to more closely supervise the international private finance sector.

The neoliberal European Commissioner for the Internal Market and Services, Charlie McCreevy, has very strong words to denounce “irresponsible lending, blind investing, bad liquidity management, excessive stretching of rating agency brands and defective value at risk modelling. Nobody can be proud of some of the ugliness that this credit crisis has exposed.” However, according to the Financial Times, “the Commissioner, one of the EU’s most prominent exponents of free market thinking, will caution against a rush to regulate, saying rules that enforce transparency in financial markets can sometimes backfire, spreading panic and moral hazard across the system”. Of course we cannot expect the European Commission or the Washington government to decide on firm regulations to be applied to the financial corporations that are responsible for the current crisis.

Are the measures adopted by Washington the sought-for solution?

While they momentarily alleviate the impact of the crisis, the measures taken by the US administration (among them a reduction in interest rates in September and October 2007) are not a solution. In a way the reduction of interest rates alleviates the crisis while dragging it on since it merely postpones deadlines. The real estate crisis has indeed started and its consequences will be felt in the long term. Why? Here are several reasons:

1. The market in mortgage lending in the US represents 10.000 billion dollars (that is, over 72% of the gross domestic product) . The subprime market represents 15 to 20% of this market. Consequently, the crisis of subprime and other segments of the mortgage market can only have severe repercussions.

2. There is real over-production in the US housing industry compared with demand.

3. A great number of building projects are under way. In the months and years ahead hundreds of thousands of new homes will come onto the market. A building firm can hardly abandon a site in progress. In short, these new buildings will be added to what is on offer in an already depressed market. A production slowdown in the building sector will have long-term consequences for the economy at large: layoffs, and fewer orders to building suppliers.

4. For several years, there has been a tendency to “go out and buy” since home owners and shareholders have been feeling rich due to the fact that their assets had substantially increased thanks to the rise in real estate prices and to the recovery of the stock market (after the 2001 slump). Now the opposite effect is underway: the value of real estate property is plummeting and the stock markets are uncertain. Households are likely to respond by buying less, which will make the crisis worse.

5. The major banks, pension funds, insurance companies and hedge funds have numerous bad debts on their books. Since August 2007 institutions such as Citigroup, Morgan Stanley, HSBC, Merrill Lynch and UBS have been trying to minimize their declared losses but have repeatedly had to admit to new losses, which has led to a steady fall in their share value and to the firing of several executive officers. Other institutions will no doubt be affected. It is not impossible (let’s be cautious) that financial institutions will find themselves in a similar situation to that of the Japanese banks when the real estate bubble burst in the 1990s. They needed some fifteen years to get back into the black.

6. The steady fall of the US dollar is undoubtedly a good thing for exports to the United States, and allows the US government to pay back its enormous external debt with a devalued currency. But it also has major drawbacks. A weak dollar makes Treasury bonds and stock market investments less attractive to foreigners who normally invest a large part of their capital in the United States. Less capital is likely to flow in (at a time when it is much needed to narrow the deficit) and more capital is likely to flow out.

The Washington government and the board of the central bank are faced with a real dilemma. If they lower interest rates further, the consequences will be equivocal: it would reduce the immediate risk of bankruptcies and make the fall in consumption less dramatic, but it would also make investments in the US much less attractive and reduce the pressure for sounder company and household accounting. If on the other hand they increase interest rates, the consequences would be the exact opposite with investments in the US becoming more attractive but household consumption falling and companies being faced with increased cash flow problems.

7. The banks and other private financial institutions in need of liquidities sell shares (including their own) on the stock market, causing a strong decrease in stock market capitalisation of the financial sector. Considering the losses that the financial institutions have to finance and the drying up of their usual sources of funding (especially the commercial papers), it is possible that the downward trend continues.

This crisis shows the abject failure of the neoliberal capitalist model. The directors of the private financial institutions are directly responsible for the current crisis. There is little doubt about this, which the business press has acknowledged . The governments of the main industrialised countries, the directors of the main central banks, the directors of the BIS, of the IMF and the World Bank are directly guilty. Many segments of the debt market are made up of edifices that are now crumbling. Those responsible for the crisis and their accomplices will again try to pass the cost of the cleaning up and the rescue operation to the people via the mobilisation of public funds originating mainly from the taxes that they pay. Among the people, those whose savings and future retirement depend on investments from the stock market, of the purchase of CDOs and other financial products will have to tighten the belt too. As long as finance ministers of this world are at the wheels of this neoliberal globalization, it will be the people who will pay the cost of crisis management. The solutions thus lie elsewhere.

ERIC TOUSSAINT, president of the Committee for the Abolition of Third World Debt (Comité pour l’Annulation de la Dette du Tiers Monde)–Belgium, author of The World Bank: a never-ending coup d’Etat Editorial VAK (Mumbai-India), 2007. Currently being prepared for publication in Great Britain, Canada and South Africa (Pluto Press / Between the lines / David Philipps) with the title The World Bank : A Critical Primer; author of Your Money or Your Life. The Tyranny of Global Finance, Haymarket, Chicago, 2005 (published in 8 languages); co-author with Damien Millet of Who owes who?, Zedbooks, London, 2004 (published in 9 languages).

Translated by Judith Harris and Christine Pagnoulle, Diren Valayden in collaboration with Elizabeth Anne