(This is an archived page, from the Patterns of Power Edition 3 book. Current versions are at book contents).
American deregulation in the 1980s and 1990s, as described in an article entitled How Deregulation Fueled the Financial Crisis, greatly increased the possibility of financial instability – removing the protective measures that had been introduced in the 1930s in response to the stock market crash and the Great Depression that followed.
As argued in the book The Bankers' New Clothes, reviewed in Bloomberg for example, banks are under-capitalised: in other words their ‘leverage ratios’ are too high. Shareholders can make very high returns on the capital they have invested. Even with the new 'tighter' regulations agreed as part of the Basel 3 reforms, banks are still only required to hold 3% equity against the total of the loans that they have made – so if more than 3% of their loans fail, the shareholders would lose all their money and the bank would collapse. The fragility of modern banks was vividly illustrated when Barings bank collapsed in 1995 as a result of reckless trading; the BBC reported How Leeson broke the bank.
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. This happened in Britain after Margaret Thatcher’s ‘Big Bang’ deregulation in 1986 –which was reviewed in the BBC article, Margaret Thatcher: How her changes affected your finances. Financial traders indulge in ‘momentum trading’ – the practice of buying financial products whose price is rising, which further increases those prices and creates short-term gains until the bubble finally bursts.
Price bubbles have occurred for hundreds of years. The Dutch tulip market in 1637 was a famous example, as described in The Economist article Was Tulipmania irrational?, although that phenomenon may have been partly caused by a change in financial regulation which meant that the “balance between risk and reward in the tulip market was skewed massively in investors’ favour”. A more recent example, which triggered a brief collapse in stock markets in the year 2000, was described in the BBC article, Dotcom bubble burst: 10 years on.
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. The apparent lack of risk to both lenders and borrowers fuelled what The Economist described (before the financial crisis) as: America's house-price bubble. When house prices fell, 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 felt protected by what David J. Reiss reported as: The Federal Government's Implied Guarantee of Fannie Mae and Freddie Mac's Obligations: Uncle Sam Will Pick Up the Tab.
· 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 in the previous sub-section (3.3.4.2).
· Many CDOs received a credit rating of AAA, so even investors who were risk-averse bought them, as described in the Harvard University report: The Credit Rating Crisis.
· Traders started to bet on the risks of borrowers defaulting on loans by making ‘credit-default swaps’ (CDSs); these were described in The Economist report, Credit derivatives: The great untangling, which also explained their role in the 2007-8 financial crisis.
When the bubble burst, triggering the financial crisis in 2007-8, American and British governments had to intervene to rescue banks because several of them were deemed ‘too big to fail’: there would have been excessive damage to the rest of the economy if the financial system couldn’t perform its baseline role (3.2.7).