Few people could have foreseen the mess the world economy would become after the issuance of billions of dollars of subprime mortgages, guaranteed by federal banks. Rupert Wright There is one characteristic about the Great Recession of the past 12 months on which everybody can agree: we all underestimated its severity. It began as a mainly domestic issue in the US, caused by the issuance of billions of dollars of mortgages, guaranteed by the federal agencies Freddie Mac and Fannie Mae.
The loans were subprime, in other words inherently risky, but given good ratings by credit agencies because the risk of default was considered slim. The banks that made the loans then bundled them together, called them "collateralised debt obligations" (CDOs), and sold them to investors around the world. The sales pitch from Wall Street's finest investment bankers was that nothing could go wrong, and even if it did, there was safety in numbers. Investors fell for the patter - everybody from the usually cautious Swiss to the canny Scots.
One of the few countries to avoid a meltdown was Lebanon, thanks to a risk-averse central bank governor who forbade lenders to invest in instruments he did not trust. But he, along with a few academics and natural sceptics, were the exceptions. Nobody expected defaults on such a colossal scale, which was a bit dim because in the US if you fail to pay a mortgage nobody comes after you for the money.
Thus there is no incentive to keep making payments on a property that is now worth a third of what you paid for it. It was clearly a problem, but one that could be contained in North America. "I'm not looking for a worldwide recession," George Soros, the international investor who famously broke the Bank of England in 1992, told the BBC. American bankers were less optimistic. "The problems in the consumer market are spreading," John Thain, the chief executive of Merrill Lynch, told delegates at the World Economic Forum's annual conference in Davos in January last year.
Merrill Lynch had just reported US$16 billion (Dh58.76bn) in mortgage-related losses. "The next area of concern is consumer credit." William Rhodes, the chairman of Citibank, said it would take some time for things to "work their way through the system". Citibank had just reported almost $10bn in write-downs in the fourth quarter of 2007. "In a nine-inning ballgame, I think we're in the fifth inning," Mr Rhodes said. For those who don't follow baseball, he implied that we were only halfway through the game. Neither Mr Thain nor Mr Rhodes had any idea that the worst was yet to come.
Business leaders returned from their annual skiing holiday confident that they could ride out the crisis. But in just over six months, Mr Thain would be out of a job and Merrill Lynch would no longer exist as an independent company. After 100 years, the firm dubbed "the thundering herd" had been carved up and sold to Bank of America (BofA) in a fire sale. Citibank also came close to collapse and Mr Rhodes, a veteran of many banking crises including the Latin America's Lost Decade of the 1980s, had not seen anything yet.
The bad news rumbled on throughout the summer, but on the return of traders at the end of the holidays, the squall turned nasty. Freddie Mac and Fannie Mae needed bailing out by the government when it became clear they were technically insolvent. That soothed the markets, but only temporarily. The focus then turned to American Insurance Group (AIG). According to last year's Forbes Global 2000 list, AIG was the 18th-largest public company in the world. When it was suddenly revealed that a unit of AIG in London had been selling credit default swaps on collateralised debt obligation, in other words guaranteeing what had now become almost worthless, the financial system of the world was at the brink.
One of the biggest traders and holders of these "toxic assets" was Lehman Brothers, America's fourth-largest investment bank and one of the most venerable names on Wall Street. With 26,200 employees worldwide, it had enjoyed a thrilling few years under the leadership of Dick Fuld, a former trader. Mr Fuld had encouraged the firm to specialise in subprime lending and trading. Unlike other firms, notably Goldman Sachs, it failed to appreciate the risks and decided to hold some of the paper, rather than offloading it to gullible investors around the world.
Share traders spotted an opportunity and started short-selling the stock. In the first half of last year, Lehman Brothers stock fell by nearly 75 per cent. As the rumours spread on Wall Street, Mr Fuld was anxiously looking for capital to boost his balance sheet. He thought he had found an ally in the Korea Development Bank, and for a few days the shares reversed their decline. Then, when the regulators and the Koreans would not sanction any deal, the shares fell, losing 40 per cent on September 11.
On Saturday, September 13, Timothy Geithner, the boyish looking president of the Federal Reserve Bank of New York, called a meeting. A spokesman for Lehman claimed BofA and Barclays Bank were interested in buying it. When the meeting ended without agreement and no endorsement by the authorities that they would guarantee its losses, bankruptcy became inevitable. The entry into Chapter 11 on September 15 may have been a personal disaster for the bank's staff, but the shock waves were felt around the world.
"The decline of the Dubai property market can be dated from that day," said one market participant who did not want to be named. What the US authorities had failed to appreciate was that if they were prepared to let one investment bank go to the wall, then who would step in to save the remaining ones? Shares in Goldman Sachs and Morgan Stanley also fell precipitously, as Hank Paulson, the then US Treasury secretary - and a former Goldman man - tried to save the sector almost single-handedly. Politicians were not impressed by his first effort and voted against a huge bailout.
Eventually it became clear that whatever happened on Wall Street would be echoed on Main Street. The US administration was forced to make enormous sums available, and that effort was copied throughout the world. Britain's often beleaguered prime minister, Gordon Brown, was one of the first politicians to appreciate the gravity of the situation and galvanised support from Nicolas Sarkozy, the French president, and Angela Merkel of Germany.
As Christine Lagarde, the finance minister of France, observed: "It's been surprising to me how members of government have been in demand. We're still, rightly or wrongly, regarded as the ones with resources." Nearly $20 trillion was wiped off shares worldwide in September. The value of the US stockmarket plunged by $5.13tn to $13.92tn, more than 25 per cent, while the London market fell by $1.49tn. Among Asian markets, India was the worst hit, registering a 51 per cent drop from January 10 to the end of September.
Banks stopped lending to each other. The credit crunch was everywhere and even the best-known borrowers could find nobody willing to lend them anything. The British and US governments resorted to printing money, although they tried to shield the gravity of the situation by calling it "quantitative easing". Nobody can say how things will turn out, but sterling lost almost 30 per cent of its value in a couple of months. Incredibly, the dollar benefited from all the global uncertainty, but has since marked a steady decline against most major currencies.
Back in Davos, Mr Soros had prophesied a "significant shift of power and influence away from the US in particular, and a shift in favour of the developing world, particularly China". He was correct in that prediction. With its colossal war chest of dollars, the country was in a position to not only weather the storm, but to launch a huge domestic stimulus programme. As Victor Chu, the chairman of First Eastern Investment Group said: "Almost by accident, China got it right."
rwright@thenational.ae
