Abstract
Robert McCauley maps the capital flows that preceded the 2008 crisis and argues that it was European banks that fuelled the U.S. housing boom. Large official inflows into U.S. Treasury and agency notes should have reinforced a U.S. mortgage market dominated by fixed-rate mortgages. Instead, one observed a big shift to mortgages priced with floating (“adjustable”) interest rates and to riskier, leveraged mortgages that agencies could not guarantee. This banking glut accounts for the parallel real estate booms and busts in Spain and Ireland. McCauley shows that the Irish and Spanish banking systems experienced capital inflows that were huge in relation to the inflows into the United States in the same years.
Revised paper presented to the conference, “The 2008 Global Financial Crisis in Retrospect”, University of Iceland, 30–31 August 2018. The author would like to thank Robert Aliber, Michael Bordo, Claudio Borio, Brendan Brown, Richard Cantor, Jaime Caruana, Guy Cecala, Stijn Claessens, Ben Cohen, Patrick Honohan, Philip Lane, Patrick McGuire, Fernando Restoy, Catherine Schenk, Hyun Song Shin, Marcel Zimmerman, Gyfli Zoega and Daniel Zuberbuehler for helpful discussion and Yifan Ma and Jeff Slee for able research assistance. The views expressed are those of the author and do not necessarily reflect those of the BIS.
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Notes
- 1.
While Irish banks sourced funding in dollars and sterling, they swapped for euros. See Lane (2015).
- 2.
However, a second-order effect of the dollar depreciation on leverage actually encouraged European banks’ to expand their dollar books. In particular, dollar depreciation allowed such banks to borrow and lend more dollars for a given degree of leverage of their stock of capital, which was mostly held in European currencies. See Fukao (1991).
- 3.
Bernanke et al. (2011) recognised the domestic vulnerabilities that contributed to the crisis; Bernanke (2018) has emphasised the role of financial panic, recalling the “run on repo” of Gorton and Metrick (2012). Several prominent economists in the 2000s worried about current account imbalances and their accumulation into net external debt that would prove unsustainable. Summers (2004), Edwards (2005), Obstfeld and Rogoff (2005), and Setser and Roubini (2005), warned of an impending sudden stop of financing that would lead the dollar to plunge and the US economy to enter a recession. Krugman (2007) memorably pictured the dollar reaching a Wile E. Coyote moment and then falling.
- 4.
By contrast, Cayman Island entities owned MBS held in asset-backed commercial paper (ABCP) conduits, designed to keep the assets off the sponsor’s balance sheet. US Treasury et al. (2008, 2009) should have captured these holdings in mid-2007 as foreign. In 2007, European banks sponsored ABCP conduits holding at least $100 billion in US MBS (Moody’s 2007; Acharya and Schnabl 2010, p. 56; Acharya et al. 2013, p. 522). The last column of Table 5.3 thus understates European exposures.
- 5.
Greg Lippmann at Deutsche Bank emailed about the buyers of MBS tranches in February 2007 (US Senate 2011, p. 349): “[T]he other side is all cdos so it is the cdo investors who r on the other side who buys cdos: aaa-reinsurance, ws [Wall Street] conduits, European and Asian banks, aa-high grade cdos, European and Asian banks and insurers….some US insurers, bbb other mezz [mezzanine] abs [asset-backed security] cdos (i.e. ponzi scheme), European banks and insurers, equity some US hedge funds, Asian insurance companies, Australian and Japanese retail investors through mutual funds”.
- 6.
A position could be short over a certain range of prices, but long thereafter. Lewis (2010, Chapter 9) describes how Morgan Stanley took a short position in BBB tranches “netted” against multiple long positions in AAA tranches (sold in part to UBS), with disastrous results.
- 7.
- 8.
The presumption is that UBS’s US affiliate took losses on the $25 billion in US ABS transferred at appraised prices by UBS to the SNB-funded Stabilisation Fund in September 2008 (Swiss National Bank 2010, pp. 83–85). In the BEA data, foreign-owned non-banking finance and insurance firms reported overall losses of $60 billion in 2008. This sum exceeded the net losses of $40 billion recorded by the rest of foreign-owned firms in the financial sector, including depository institutions. Foreign-owned depository institutions reported capital losses of $41 billion (Lowe 2011, p. 98). Much of this loss was presumably accounted for by ING Direct USA, which had boosted returns at its US internet banking thrift, ING Direct, by switching its assets from agency paper to risky Alt-A MBS (Kalse 2009). Asian- and Canadian-owned non-banking affiliates, absent from Tables 5.2 and 5.3, reported capital losses of only $1.7 billion and $5.7 billion, respectively.
- 9.
Within ABS, foreign investors had more than their share of ultimately risky mortgage bonds. Beltran et al. (2008, Table 6) estimate that non-US investors held 29% of $2.2 trillion in securitised non-agency home mortgages. Including amounts in Table 5.5 on the assumption that they were held on balance sheets in the United States takes this share above 40%. This share is well above private foreign investors’ 14% of US Treasury bonds outstanding or 9% of agency bonds outstanding.
- 10.
“‘It was all about securitization, especially subprime loans,’ said Guy D. Cecala, publisher of Inside Mortgage Finance, an industry authority. ‘You had Wall Street saying, ‘If we want to sell this overseas, we have to pick a more international-flavoured index.’ Subprime lenders just started using it overnight, and then it started to spill out into any loan you wanted to securitize’” (Morgenson 2012).
- 11.
Lewis (2010, p. 216), describes the report as “semi-frank” but it is a remarkable document. Management had to assess what went wrong in April 2008, before Lehman’s collapse in September 2008 and the subsequent Swiss government rescue.
- 12.
One symptom of the impulse to growth is that UBS not only kept portions of its own securitisations, as did other underwriters Erel et al. (2014). In addition, it bought the super-senior tranches that other banks underwrote (UBS 2008, pp. 14–15). Lewis (2010, p. 216), reports that UBS bought $2 billion of Morgan Stanley’s long postion super-senior tranches packaged with a “couple of hundred millions dollars’ worth” short position in mezzanine tranches.
- 13.
Martin (2013, p. 197) also reports that RBS doubled its market share in 2006. Perhaps the Citigroup team sought to move because it had already loaded up Citi’s balance sheet. Erel et al. (2014, pp. 405–406) note that “Citigroup recorded the largest amount of write-downs among [US] bank holding companies and its holdings of highly rated tranches, including off-balance sheet holdings, amounted to 10.7% of assets, or roughly $201 billion at the end of 2006”. See Crotty (2013) on risk-taking and bonus-making “rainmakers”.
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McCauley, R.N. (2019). The 2008 GFC: Savings or Banking Glut?. In: Aliber, R., Zoega, G. (eds) The 2008 Global Financial Crisis in Retrospect. Palgrave Macmillan, Cham. https://doi.org/10.1007/978-3-030-12395-6_5
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