(This is an archived extract from the book Patterns of Power: Edition 2)
Technology has speeded up the movement of money in the financial system, so shares can change hands more often and their price is less linked to a company’s performance. Financial traders indulge in ‘momentum trading’ – the practice of buying financial products whose price is rising, which further increases the prices and creates short-term gains until the bubble finally bursts. This practice leads to instability.[1]
Price bubbles have occurred for hundreds of years; the Dutch tulip market in 1637 was an example,[2] and more recently the 'dot-com' bubble in 2000 triggered a brief collapse in stock markets.[3] The financial crisis in 2007-8 was triggered by a collapse in the American housing market:
· ‘Sub-prime’ borrowers, defined as those who were likely to default on their loans, were encouraged to buy houses regardless of the risk. In a rising market, when they couldn’t meet the repayments, they could sell the house at a profit – and both lender and borrower gained. When house prices fell, though, the borrowers often just walked away from the debt; if their financial deposit when buying the house had been small, they had little to lose.
· The lenders (Fannie Mae and Freddie Mac) felt protected from risk by an implied American government guarantee of the loans.[4]
· Some sub-prime loans were bundled into ‘collateralised debt obligations’ (CDOs), which were sold to other financial organisations. Some CDOs were fraudulently sold, as in the Goldman Sachs example cited above.
· Many CDOs received a credit rating of AAA, so even investors who were risk-averse bought them.[5]
· The apparent lack of risk to both lenders and borrowers fuelled a house-price bubble.[6]
When the bubble burst, triggering the financial crisis in 2007-8, several big banks were in danger of collapse. The government intervened to rescue them because several of them were deemed ‘too big to fail’: [7] there would have been excessive damage to the rest of the economy if the financial system were unable to perform its baseline role (3.2.7).
© PatternsofPower.org, 2014
[1] Paul Woolley explained ‘momentum trading’ and its impact on financial instability in Chapter 3 of an LSE publication The Future of Finance, which was available in April 2014 at http://harr123et.files.wordpress.com/2010/07/futureoffinance5.pdf.
[2] The Economist published an article on 4 October 2013, entitled Was Tulipmania irrational? It cited Earl Thompson's theory that the phenomenon "was an efficient response to changing financial regulation". It was available in April 2014 at http://www.economist.com/blogs/freeexchange/2013/10/economic-history.
[3] On 9 March 2010, the BBC published an article entitled Dotcom bubble burst: 10 years on; it was available in April 2014 at http://news.bbc.co.uk/2/hi/business/8558257.stm.
[4] David J. Reiss, of Brooklyn Law School, wrote a report whose title was self-explanatory: The Federal Government's Implied Guarantee of Fannie Mae and Freddie Mac's Obligations: Uncle Sam Will Pick Up the Tab. This report, dated 27 August 2007, was published in the Georgia Law Review, Vol. 42, p. 1019, 2008. It was available in April 2014 at http://dx.doi.org/10.2139/ssrn.1010141.
[5] A 2010 report by Harvard University’s Efraim Benmelech and Jennifer Dlugosz, entitled The Credit Rating Crisis, opened with the following picture:
“By December 2008, structured finance securities accounted for over $11 trillion dollars worth of outstanding U.S. bond market debt (35%). The lion’s share of these securities was highly rated by rating agencies. More than half of the structured finance securities rated by Moody’s carried a AAA rating – the highest possible credit rating.”
The report was available in April 2014 at http://www.nber.org/chapters/c11794.pdf.
[6] The Economist published an article on 24 August 2006, a year before the crash, entitled America's house-price bubble; it pointed out the danger to the American economy. The article was available in April 2014 at http://www.economist.com/node/7830261.
[7] The American government’s rescue of the banks was designated the Troubled Asset Relief Program (TARP). The Congressional Research Service published a report on 24 March 2009, entitled Troubled Asset Relief Program: Legislation and Treasury Implementation, which explained the approach. It referred to AIG as a “Systemically Significant Failing Institution”, describing the one of the selection criteria as it being what is loosely referred to in the media as ‘too big to fail’:
“the institution is sufficiently important to the nation’s financial and economic system that a disorderly failure would, with a high probability, cause major disruptions to credit markets or payments and settlement systems, seriously destabilize key asset prices, significantly increase uncertainty or losses of confidence thereby materially weakening overall economic performance.” [p.9]
On the same page, Citigroup and Bank of America were referred to in similar terms:
“the institution is sufficiently important to the nation’s financial and economic system that a loss of confidence in the firm’s financial position could potentially cause major disruptions to credit markets or payments and settlement systems, destabilize asset prices, significantly increase uncertainty, or lead to similar losses of confidence or financial market stability that could materially weaken overall economic performance.”
This report was available in April 2014 at http://waxman.house.gov/sites/waxman.house.gov/files/documents/UploadedFiles/TARP_Implementation.pdf.