7 Finance on steroids

There was a time, within the last three decades, when financial news stayed in the financial press. Banking, thought to be work for conservative, cautious managers, was characterised by the 3-6-3 rule: pay interest on deposits at three percent, lend money at six percent, and tee off at three in the afternoon. But that was all to change.

The role of finance in the global economy grew enormously in the last three decades of the twentieth century, and continued into the current century until around 2008, when the overreach of the financial industry led the global economy entered into crisis, plunging it into a deep and long recession.

There are two big trends to understand here. Since the early 1970s, the growth of wages has stagnated in relation to the real economy, while the growth of debt relative to income has increased vastly. Second, the role of finance in the global economy has become far larger than it was in the early 1970s. The Western world moved away from industrial jobs towards a service economy, exporting those manufacturing jobs to emerging economies. At the same time, the financial industry started to grow.

Banking until the 1970s was generally corporate banking. When ordinary people in wealthy countries needed mortgages, they went to specialist building societies or mutual lenders (in the UK) or Savings and Loans (or ‘thrifts’) or locally-owned community banks in the US. From the late 1960s and early 1970s, corporate banks moved into retail lending, offering current accounts to ordinary people, along with mortgages and then other credit products such as credit cards. In the mid-1970s, a trader in Wall Street bank Salomon Brothers had an idea to make money off these mortgages. Salomon Brothers would buy these loans from banks, package them together, and sell them as mortgage-backed securities to investors, where monthly mortgage repayments would flow steadily towards the holders of these securities. These were useful investments for pension funds or other major funds that needed a steady, long-term return on investments, and the idea transformed mortgage lending. Today, three-quarters of mortgages are securitised. Moving the loans off the books allowed banks to issue yet more loans.

Bank trading in securities grew through the 1980s, helped along by the deregulation of financial markets in London, the world capital of securities trading. Mortgage-backed securities are a type of derivative product, so called because they derive their value from another asset. As investment banks started offering clients derivatives to hedge the risk of changes in interest rates, or exchange rates, the derivates market mushroomed into a market many times the size of the original assets.

Wall Street profits rose from 10 percent of US GDP in the early 1980s to 40 percent of GDP twenty years later, in the early years of the new millennium. Most people suppose that banks engage mainly in lending to businesses, but as economist John Kay noted in his book Other People’s Money, that in fact accounted for only three percent of the business of British banks. The other 97 percent was made of banks trading with other banks or non-banks. Another result of the changes: pay in the financial sector soared in comparison to other professions, and Wall Street began attracting the brightest graduates that otherwise may have gone into other businesses.

But far below the exalted levels of derivatives trading, the economy was in real trouble. Banks had achieved great power and influence, and regulators struggled to keep up with the inventions of financiers, even in the markets they were supposed to monitor. There was another entire world of unregulated derivates sloshing around in the dark beyond the reach of regulators. Who was tracking the relationship between all of these connected loans, securities and derivatives?

With vast profits to be made in trading derivatives and securities, there was a steady demand for mortgages and other loans ,such as credit card and car loans, that could be snapped up and bundled into increasingly exotic products for yield-hungry investors. In the US in particular, independent brokers began selling mortgages to people with no income, as the market became saturated. They were confident they could quickly earn a fee on the sale and then sell on the risky mortgage to a bank. A new practice had arrived in financial services: with the connivance of ratings agencies, banks were able to package extremely risky mortgages with safer loans, and somehow generate a Triple-A rated bond to sell on to some unsuspecting German regional bank with a thirst for returns. It was the type of work one might expect from a professional money launderer who can wash dirty money in with the clean money going through a business in order to wash the traces off the dirty money.

The global financial crisis

But in the middle of the first decade of the new millennium, people started defaulting on mortgages - unsurprising, given that many of them didn’t even have jobs and were hoping that rising prices would enable them to flip their houses for a profit. As these high-risk mortgages, which had been sliced up and hidden inside triple-A rated securities, began to go bad, they began to collapse the supposedly triple-A rated securities, setting off panic in the markets. Banks and funds tried to cover the growing holes in their balance sheets by calling in other loans. But who was ultimately holding these toxic securities? They had been sold and re-sold so many times that banks stopped trusting one another, and interbank lending suddenly dried up. The financial crash of 2007 and 2008 that started in the US and the UK plunged the global economy into crisis. Most economists judged it to have been the worst global recession since the Great Depression of the 1930s.

If anyone had failed to understand the growth in influence of banks, the solution offered by governments to the financial crisis made the situation clear. Banks had become such an big part of the economy that governments, fearful that the collapse of banks would leave to ungovernable chaos and the collapse of the entire global financial system, broadly decided to save the banks rather than let them, or some of them, go out of business. One after another, countries announced programmes to bring banks under national control, or to provide guarantees to bank creditors. The word ‘bailout’ is often used to describe this event, but it’s a poor way to describe what happened. It’s more accurate to say the cost of recapitalising the broken banks was transferred to ordinary people under a policy labelled as austerity, where public spending was cut back in order to pay for the cost of nudging the bank system back to health.

Some writers noted that this was not an isolated event, but the result of several decades of financialisation, where the interests of financiers and banks had grown wildly out of proportion with the common interest - a fact reflected in the growth of the financial media, which delivered a daily feed of rolling numbers and charts that suggested these fluctuating figures were the measure of life itself.

Chapter Eight: The Internet of Money