10 Years of Austerity

We have spent a decade fixing the system but the problem remains: cheap credit and too much debt

Saturday 15th September 2018 marked the ten-year anniversary of Lehman Brothers’ collapse. There were many epochal moments during the financial crisis, from BNP Paribas’s decision to freeze fund redemptions to the run on Northern Rock in 2007 to the rescue of Bear Stearns early in 2008, but the fall of the Wall Street titan was the one that changed everything.

It was the moment that the credit crunch, which had tipped the West into recession, graduated into a full-blown catastrophe. The moment the world looked behind the shiny mirror of the global financial system to see a whirring Heath Robinson machine glued together with ignorance and trust. Shorn of their ignorance, markets abandoned their trust and the engine fell apart. After that, it was as WB Yeats wrote, “mere anarchy is loosed upon the world”

Once the dust had settled, losses on the American sub-prime mortgages at the heart of the crisis totalled $300 billion. Panic selling had lifted that into $2.5 trillion of writedowns, paralysing banks, freezing lending and claiming untold numbers of businesses and overstretched households as collateral damage. The financial system had scorched the earth.

The story deserves retelling if only to imprint it on our collective memory and there have been gripping books and films on the subject, such as Michael Lewis’s The Big Short and Crashed by the historian Adam Tooze. Only one question really matters: can it happen again?



The short answer is no. The longer answer is that averting a financial crisis does not mean that another gut-wrenching recession can be avoided. The bad news is that some of the same pre-crisis dynamics are emerging. We have spent a decade fixing the system but evading the problem, which was always about cheap credit and too much debt.

It’s unlikely that there will be another financial crisis because the one part of the system to have been fixed has been the liquidity regime. At its heart, the crisis was about a shortage of liquidity, the ready availability of cash or cash-like assets such as government bonds. Ultimately, banks are like any other business. It doesn’t matter how much profit you make, if you run out of cash you’re bust. In 2008, no one had any cash.

Lehman Brothers went under because the US Federal Reserve decided it could not provide “lender of last resort” funding as the bank was judged to be insolvent. Yet a day later, the Fed agreed an $85 billion bridging loan for AIG, a vastly bigger insurer that had to post collateral because the mortgage bonds it had underwritten had gone bad and it, too, was on the brink of running out of cash.

The Fed was not AIG’s regulator and had no remit to support it. Ben Bernanke, the chairman, said later that the Fed was “crossing a line” not simply by rescuing an institution beyond its purview but by taking its subsidiaries as security for the loan, subsidiaries that could have ended up worthless. Lehman was let go because the authorities thought that the market could handle it; AIG was rescued because they knew the markets couldn’t. In both cases, the immediate crisis was one of liquidity as demands were made to post cash and neither institution was able to get hold of any.

It was the same story at HBOS, which was rescued by Lloyds TSB two days after Lehman’s demise; at Merrill Lynch, which was picked off by Bank of America; and both Royal Bank of Scotland and Lloyds in October, when the UK taxpayer bailed them out.

Today UK banks have £700 billion of liquidity compared with only tens of billions in the crunch. The Bank of England has billions more on hand that it will extend against the shabbiest of assets. The authorities will not let the financial system run out of money again.

Which is just as well because risks are building. Douglas Diamond, the University of Chicago Booth School of Business professor who this year won the Onassis prize in finance, points to a “huge build-up in covenant-lite lending” — that is, loans to high-risk companies where the lender waives the checks, and a surge in audit qualifications, which he says are “an indicator of financial carelessness”. There is now four times as much cov-lite lending as before the crisis. Syndicated leveraged loans, symptomatic of the pre-crisis “search for yield” by return-hungry investors, hit a record $788 billion last year. The issuance of synthetic collateralised debt obligations, the worst of the crisis-era financial innovations, quintupled to $100 billion last year. The same warning flares are burning.

The difference is that the risks have migrated. In America, they call it the “whack-a-mole” syndrome, after the game where a mole pops up whenever you whack one down. Regulators have whacked the banking sector, so the risks have popped up in the unregulated shadow banking world of asset managers and hedge funds.

Although risks are not as carefully controlled in the shadow banks, the sector is not as systemically risky as the commercial lenders and tends to have longer funding profiles, so they are better able to sit out a crash. Plus, if they step out of the bond markets, the banks can step in. That’s one reason why regulated lenders globally have had to add $1.5 trillion of capital since the crisis, ensuring that they are solvent enough in a deep recession to support the economy by extending credit to business.

Today regulators have powers to intervene in the shadow banks to keep them liquid, just as the Fed did with AIG. The danger, then, is not financial seizure but a more traditional recession caused by over-indebtedness. A reckoning is coming. Alex Brazier, the Bank of England’s executive director for financial stability, says that corporate bond and commercial property prices are “stretched”, which is another way of saying borrowing costs are too low. If shadow banks, which account for half of UK corporate debt, get burnt, borrowing costs will rise and companies will have to scale back.

The irony is that low rates and quantitative easing, which were vital to staving off a worse crisis, have created the same ultra easy monetary conditions as before Lehmans went under to persist. Globally, corporate and household debt is higher than ever. The actions taken in the past decade may spare us another crisis, but a lot more work is needed to stop the financial system sparking another recession.

Philip Aldrick is Economics Editor of The Times