Money (35 page)

“Same Old Game” indeed—though today it is not just liquidity, but also credit, insurance that the sovereign generously doles out.

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illustration credit 14.1
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It was a world that Walter Bagehot would not have recognised. The doctrine of the central bank as lender of last resort had become the doctrine of the sovereign as loss-bearer of last resort. This innovation of widespread credit support from national treasuries introduced a dramatic new dimension to the political calculus. When the central bank provides liquidity support, nobody, in principle, loses—and the widely shared benefits of a well-functioning monetary system are preserved. When the government provides credit support, however, taxpayers bear a real cost. The question, of course, is who gains? One answer—the one which garnered most attention in the immediate aftermath of the crisis—is the bankers themselves. When the government bailed out the banks, many bank employees continued, at least for a time, to have their jobs and to earn their bonuses. That was politically contentious, but in reality the bankers themselves enjoyed only one part of the taxpayers’ generosity. The banks’ bondholders and depositors—those who freely agreed to fund the bankers’ lending—were also beneficiaries of the sovereign’s unprecedented largesse. When it was refused, as it was to Lehman Brothers, bondholders had to shoulder the losses due to the bad loans that had been made. When it was not, the sovereign relieved them of this unpleasant burden.

Once upon a time, the idea of taxpayers bailing out bank bondholders might not have been politically contentious, because there was little distinction between the two groups. One way or another, via the investments of pension funds and mutual funds, they were by and large one and the same. But in the modern, developed world, two powerful forces have conspired to undermine this convenient correspondence between those who fund the banking system and those who stand to bail it out when things go wrong. The first is increased inequality of wealth and income, which has opened up a divide between the wealthy few who own banks’ bonds, and the more modest majority who do not. Spending public money to protect bank bondholders has become an issue of rich versus poor. The second powerful force has been the internationalisation of finance. In countries such as Ireland and Spain, the globalisation of bond markets
has meant that domestic taxpayers found themselves footing the bill for bank recapitalisation that benefited foreign bondholders. Firing civil servants to pay for bail-outs meant to save their own pension fund is one thing. Firing them to pay out foreign pensioners is politically quite another. When, on 31 January 2011, Anglo-Irish Bank—which had been recapitalised to the tune of EUR 25.3 billion by Irish taxpayers—repaid in full and on schedule a EUR 750 million bond to its investors, the distribution of risks under the new regime of sovereign credit support for banks was on stark display. The total cuts to welfare spending in that year’s Irish budget amounted to a little over the same amount.
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The global public’s dismay at this state of affairs is therefore not due to an unfortunate misunderstanding of how the financial world does, and indeed has to, work. People are right to smell a rat. The crisis of 2007–8 and sovereigns’ response to it revealed a profoundly uncomfortable truth: something has gone terribly wrong with the Great Monetary Settlement. The historic deal struck between the sovereign and the Bank of England in 1694 involved a carefully calibrated exchange of benefits. The private bankers got liquidity for their banknotes. The crown’s writ, unlike their own, ran throughout the land, and money that had its blessing could enjoy universal circulation. In return, the bankers provided the financial acumen and the trusted reputation in the City that enhanced the crown’s creditworthiness. In modern terms, the crown provided liquidity support to the Bank, while the Bank provided credit support to the sovereign. Yet the policy-makers’ response to the crisis revealed a starkly different world. Banks, of course, retained their privilege of issuing sovereign money—and the central bank stood ready to guarantee its liquidity in times of need. But far from receiving support to its credit in return, it was the sovereign that ended up supporting the credit of the banks. The banks—their employees, their bondholders, and their depositors—get both liquidity and credit support. The sovereign—that is, the taxpayer—gets nothing. The crisis revealed that the historic quid pro quo had become a quid pro nihilo: something for nothing.

This was bad enough but there was even worse to come. No
sooner had the crisis exposed with brutal honesty the strange death of the Great Monetary Settlement that had kept the peace between sovereigns and banks for three hundred years, than it unveiled the equally startling revelation that another hoary old veteran of monetary politics was very much alive—and active on a scale never seen before.

The great wave of economic deregulation and globalisation that began in the late 1970s, accelerated in the 1980s and ’90s, and reached its zenith in the pre-crisis years of the early 2000s brought with it revolutions in the organisation of industries from car manufacturing to the supply of electricity, and from supermarkets to film-making. The watchword was decentralisation: the hundreds of activities once housed in a single corporation could be hived off to smaller and more specialised companies, and co-ordinated by the market using supply chains and networks of astonishing complexity and length.
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Of course, some complained that it went too far—that the costs saved by moving customer care to a call centre in Bangalore or Manila were really just offloaded on to the enraged customers on the other end of the line. But overall, few could deny that in industry after industry the result for the consumer was a phenomenal reduction in costs and improvement in choice.

Finance was no stranger to these tectonic shifts in industrial organisation. Until the late 1960s, lending to companies and individuals remained for the most part a simple and familiar business undertaken almost exclusively by banks. The borrower visited the bank; the loan officer scrutinised the request and worked it up for approval; the bank manager signed off on the appraisal; the loan was entered in the bank’s loan book as part of the bank’s assets; and a deposit was credited to the borrower as part of the bank’s liabilities. The whole transaction had only two counterparties—the borrower and the bank—and the bank’s balance sheet was where the management of credit and liquidity risk took place. But for centuries there had
also existed an alternative way of raising money: by selling financial securities—promises to pay such as shares in the equity of a company or bonds paying a fixed interest over time—directly to investors. The equity capital markets—the stock market, for short—had always been a democratic affair. Even quite small companies could issue shares; they were traded on public exchanges; and there was a vast army of retail investors. The debt capital markets, on the other hand, were more exclusive. Borrowing by issuing bonds was “high finance,” the preserve of only the largest corporations, and, above all, of sovereigns themselves. Likewise, the investors in these securities were mostly “institutional investors” such as pension funds, insurance companies, and mutual funds, which aggregated the savings of many thousands of individuals to reach the scale required to play the bond markets. And rather than hawked on stock exchanges like fish in the marketplace, the buying and selling of bonds was done by brokers through their personal networks, like pieces of antique furniture that needed to be found the right home.

Nevertheless, for most borrowers, banks remained the dominant source of debt capital right up until the late 1970s. It was only then that the revolutions in information technology and supply-chain management began to unlock the logic of specialisation and the division of labour in finance as in so many other industries. The debt capital markets, it was realised, represented a vast opportunity to create intermediaries that specialised in individual component activities of banks; and hence the potential for enormous gains in efficiency. Borrowers could continue to come to the bank, and loan officers to scrutinise their requests and knock them into reasonable shape. But the business of actually approving the loans and of monitoring the borrowers could be done just as well—perhaps better—by investors themselves. The bank would merely arrange, rather than implement, the allocation of credit. The loan itself need never appear on the bank’s balance sheet. It would become instead a financial security—a bond—owed by the borrower, and owned directly by the individual or institutional investor. The traditional banking model of doing everything in-house began to give way to a new model of “originate
and distribute”—of specialising in the identification of borrowers and end-investors, while letting others do the screening, warehousing, and monitoring of the loans. The business of financing companies and individuals was beginning a great migration from the world of banks to the world of markets for financial securities distinguished by their issuers’ credit risk—the credit markets, for short.

The shift was most pronounced in the U.S., where securities-based finance had always held a stronger position than in Europe. In the early 1980s, around half of debt capital to U.S. companies was still provided by banks.
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From the middle of that decade, however, the share of finance arranged instead on the credit markets began to rise. The Savings and Loan crisis of the late 1980s and early 1990s gave this shift a major boost. With a large part of the commercial banking sector in repair mode, the credit markets took up the slack. By the end of 1993, they accounted for more than 60 per cent of U.S. corporate debt finance. A decade later, their share reached 70 per cent. And not only the scale, but the scope, of the credit markets was being transformed. When Michael Milken was almost single-handedly creating the market for bonds issued by small or risky companies from his famous Beverly Hills office in the early 1980s, few would have predicted that two decades later issuance of what were then derisively called “junk” bonds would grow to U.S. $150 billion a year, and displace a substantial part of the banking sector’s financing of Main Street U.S.A.
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An even bigger revolution was taking place in the provision of debt finance to individuals. The development of techniques for pooling and securitising large numbers of mortgage, car, and credit-card loans to individuals generated a near-total shift in the organisation of these types of debt from banks to credit markets. It was a dramatic and fundamental change in one of the most basic functions of the capitalist economy. The days when mainstream finance was the business of banks and the debt capital markets were an obscure specialisation were gone for ever. In 1968, Sidney Homer had been able to lay out in three pages of
The Bond-Buyer’s Primer
, his celebrated insider’s guide to the debt markets, all the important U.S. corporate bond issuers in existence.
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There were so few that they all
had their own nicknames, speaking quaintly to the simplicity of the corporate landscape of the day: “Rubbers” for the bonds of U.S. Rubber; “Steels” for the bonds of U.S. Steel; and so on. By the late 1990s, such familiarity was unthinkable. There were now tens of thousands of bonds issued by many thousands of issuers—and when the legal structuring was peeled away, most were no longer U.S. household names but just plain U.S. households.

This was just the beginning. In the 2000s, the business of securitisation—the bundling together of many smaller debt securities to make new, larger debt securities—took off. Mortgages, car loans, corporate loans, credit-card debt—any kind of credit could be packaged up, sliced into tranches, assessed by a ratings agency, and then sold on to a new set of investors. The borrowing of money via the credit markets had once been a simple transaction: a bond issued by a company with assistance from a bank was bought by an individual or an institution. Now it could be much more elaborate. A company could still issue a bond. But rather than being bought by the end-investor, it could instead be acquired and “warehoused” by another company specifically established for the purpose. That company could then issue asset-back commercial paper (another type of debt security) to a special-purpose vehicle (another type of company) whose liabilities would in turn be “warehoused” by a fourth company, whose own debt securities could be bought by another special-purpose vehicle which would use it to back collateralised debt obligations (yet another type of debt security) that would be purchased by a hedge fund and finally used as security for a loan from a money market mutual fund. Only then would the end-investor rematerialise, just in time to buy shares in the money market mutual fund and thereby provide the cash which would in the end wend its way back up the chain to the original issuing company—less fees, of course.
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This enormous increase in complexity left those weaned on Sidney Homer’s
Bond-Buyer’s Primer
perplexed. What was the point of it all? They were summarily dismissed as quaint, old fuddy-duddies. Under the powerful spell of the orthodox, modern theories of finance and macroeconomics, the prevailing wisdom was that these
innovations represented the royal road to everything from lower mortgage rates for homeowners to greater macroeconomic stability. The International Monetary Fund delivered one particularly memorable verdict in 2006. “There is growing recognition,” it said, “that the dispersion of credit risk by banks to a broader and more diverse group of investors, rather than warehousing such risk on their balance sheets, has helped to make banking and the overall financial system more resilient.”
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The new arrangements would moreover “help to mitigate and absorb shocks to the financial system” and amongst their manifold benefits would be “fewer bank failures and more consistent credit provision.”
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But the real shortcoming of such confident predictions was not their over-optimistic appraisal of what they thought the new arrangements in the credit markets were doing. It was the fact that what they thought the new arrangements were doing was not the main story at all.
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