25+ years experience. CFO/FD | Coach | Trainer
Approachable, results focused.
Output solution driven. Frankly, a business geek.

25+ years experience.  CFO/FD | Coach | Trainer
Approachable, results focused.
Output solution driven. Frankly, a business geek.

Would Corbynomics have prevented the financial crisis of 2007/8?

Jeremy Corbyn has shaken up the UK political scene by winning (with a landslide) the Labour party leadership.  He stands on the far left of the spectrum of politics and offers a distinctly different proposition from the current conservative government.  This article takes a look at the fundamentals of the financial crisis that erupted in 2007/08 and asks if Mr Corbyn had been in power since, say, 1997, would we have avoided the crisis?


What is a financial Crisis?

With regularity we see in the press, both print and online/TV, that the world economy is still adjusting to the Financial Crisis.  Investopedia defines a Financial Crisis as “A situation in which the value of financial institutions or assets drops rapidly. A financial crisis is often associated with a panic or a run on the banks, in which investors sell off assets or withdraw money from savings accounts with the expectation that the value of those assets will drop if they remain at a financial institution.

The crash of 2007/8 certainly had these elements, the effects of which still reverberates around the global economy today.

So what is the financial crisis of 2007/8?

From the introduction of his book – Meltdown, the end of the age of greed – Paul Mason writes: “…Global capitalism, on the precipice of collapse, has been rescued by the state. The alternative was oblivion….”  As introductions go, I quite like that one.

Banks and other financial institutions used complex financial products to speculate for substantial gain. For several years it went very right.  When it went wrong, it went very very wrong. Several banks lost billions of pounds, some, tens of billions. It showed a breath taking lack of understanding of how some of the financial trading practices actually worked, and certainly the risks involved by those actually completing the trades.

This lead to a few banks in America, the UK and Europe going bust or into forced or heavily discounted take overs. It lead to governments having to pump hundreds of billions of pounds into the financial system. It lead to the system almost collapsing.

In a nutshell, how did it happen?

Great question. I’ve no idea, sort of. Reading about the financial crisis consistent themes are mentioned.  The main one refers to what are called derivatives, and how they were used for huge speculative gains by the “financial sector”.  That segment of the economy that includes very specifically investment banking.

A derivative as the name suggests – derives from something else. Its value is related to and depends upon an underlying entity.  That could be an asset or commodity for example.

I think it’s worth noting that derivatives have been used for many years and by the majority of large companies to hedge, or manage, their risk. For example, a company may take an option ( a type of derivative) which gives them the right (but not the obligation) to buy, e.g. currency, at a future date and price, or in this example, exchange rate.

Part of what happened in the financial crisis is  a process called securitization to create something called Collatorised Debt Obligations.  Plus a type  of derivative called Credit Default Swaps, became very popular and were used with sub-prime mortgages as the underlying asset.

Banks issue mortgages to people to buy homes. When the bank customer can’t really afford those homes, those mortgages are called sub-prime.  And somewhat ironically the mortgages rates on them (after a relatively brief teaser rate) are higher than standard mortgage interest rates.  That’s right, customers that can’t really afford the bank repayments are charged more because they are riskier customers.

So the bank on its balance sheet has a list of assets (debtors) that are (relatively) high risk of default.  The evolution of derivatives was to take those individual risky sub-prime mortgages and package them together and sell  on packaged individual risky mortgages as a highly rated investment.  Rated is  key word here. They were rated by the banks in tranches, basically as good, quite good, and watch-out we’re guessing. These investments were then rated accordingly, did I just write accordingly, sorry, I meant bizarrely by the rating agencies as being sound for investment.

A quick aside on the rating agencies –

From Michael Lewis book The Big Short: Inside the Doomsday Machine there is this rather wonderful excerpt on how switched on the rating agencies were:

Even the rating agencies, who they at first assumed would be the most informed source, hadn’t a clue. “I called S&P and asked if they could tell me what was in a CDO,” said Charlie. “And they said, ‘Oh yeah, we’re working on that.’ ” Moody’s and S&P were piling up these triple-B bonds, assuming they were diversified, and bestowing ratings on them—without ever knowing what was behind the bonds! There had been hundreds of CDO deals—400 billion dollars’ worth of the things had been created in just the past three years—and yet none, as far as they could tell, had been properly vetted.

So, pulling individual mortgage debt together and selling it on is called securitization, and the bundle of assets (mortgages) is called a collatorised debt obligation (CDO)

Lets return to Investopedia for the technical definitions:

Collateralized Debt Obligation – CDO

A structured financial product that pools together cash flow-generating assets and repackages this asset pool into discrete tranches that can be sold to investors. A collateralized debt obligation (CDO) is so-called because the pooled assets – such as mortgages, bonds and loans – are essentially debt obligations that serve as collateral for the CDO.

Credit Default Swap – CDS

A swap designed to transfer the credit exposure of fixed income products between parties. A credit default swap is also referred to as a credit derivative contract, where the purchaser of the swap makes payments up until the maturity date of a contract. Payments are made to the seller of the swap. In return, the seller agrees to pay off a third party debt if this party defaults on the loan. A CDS is considered insurance against non-payment. A buyer of a CDS might be speculating on the possibility that the third party will indeed default.

Got that?  Now we are all fully versant wth CDS’ lets turn to Gillian Tett the FT journalist (now editor) that got a lot of kudos for her pre crisis warnings:

This excerpt from Gilliant Tetts highly regarded book Fools Gold:

In December 1997 ….Demchaks team finally unveiled its creation.  The had given it the ugly name “broad index secured trust offering”, shortened to Bistro…….at a stroke, they had managed to remove credit risk from the banks books on an enormous scale….credit derivatives will fundamentally change the way banks price, manage, transact, originate, distribute and account for risk.

 Banks had typically been forced to hold $800 million reserves for every $10 billion corporate loans on their books. Now that sum could be just $160 million. The CDS concept had pulled off a dance around the Basel rules. The feat was so clever that some bankers started to joke that ‘Bistro’ really stood for ‘BIS Total Rip Off’, referring to the Bank for International Settlements (BIS), which had overseen the Basel Accord.

 If defaults on mortgages were uncorrelated, then the Bistro structure should be safe for mortgage risk, but if they were highly correlated, it might be catastrophically dangerous. Nobody could know.

When it refers to Basel, its basically saying the banks came up with a way to avoid the key regulation on how much money/reserves it should hold.

“Nobody could know”.  So CDS – which is noted below by 2007 were trading in such large volumes their value were there or thereabouts at the same level as the entire global economy, and nobody really understood how they would “behave” if house prices moved. Yikes.

And now for some jaw dropping, enormous numbers.

From Paul Masons book:

As countries abolished exchange controls and computer technology took off, so did the scale of foreign exchange dealing: from around $70bn a day in the early 1980s to $500bn a day in 1988 to $3.2tn in 2007

 Derivates trading – The global derivates market stood at $370tn  in June 2006; by December 2007 it had reached $596tn. Foreign exchange futures almost doubled in this period.  Credit Default Swaps had spiralled from under a trillion in 2000 to $58 trillion in 2007.  There was a massive rush of money into derivates and currency trading in the run-up to the crash: for future reference; it will be safe to treat any similar event as a warning of catastrophe.

 In 2007 world GDP was approximately $65tn total value of the companies quoted on the world stock markets that year was $63tn.  Total value of Derivatives was $596tn. Total value of currency traded was $1,168tn.

Think about that for a few moments.  Something (CDS) that was basically never traded 7 years earlier, grew to the point it almost matched in size the value of the entire global economy.

Some more enormous numbers, this time on failed financial institutions as captured by The Daily Telegraph during September 2008.

Sept 15th 2008. Daily Telegraph

Lehman,  left to fend for itself, files for bankruptcy. With  $639bn of assets and $613bn of debts it is the largest US corporate bankruptcy. It is also the first major bank to collapse since the credit crisis began a year earlier. Lehman bonds and loans that were trading at 80 cents to 90 cents in the dollar the week before are now worth little more than 40 cents. About $70bn of Lehmans debt held by other institutions has been wiped out. Holders of that debt face huge potential losses.

 25th September

Washington Mutual, once the biggest US savings and loan bank, becomes the largest victim of the credit crisis. Fears of a run on the bank force regulators to shut it down. With $307bn of assets and $188bn of deposits, it is the biggest bank failure in US history. JP Morgan Chase pays $1.9bn for its assets, securing customers’ savings.

 Sept 29th

Belgium, Holland, Luxembourg nationalise Fortis. 49% stake in each country.

UK nationalise B&B. £50bn

Iceland takes control of Glitnir

US Govt back Citigroup to take over Wachovia – US 4th largest bank

 Sept 30th

Belgium, France Luxembourg –put in £5bn to keep Dexia afloat.

So is it purely down to the bankers?

Well, by the time the crisis unfolded the financial meltdown that ensued is directly tied to poorly executed investment strategies of numerous financial organisations.

However, there are a number of supporting cast, not least rating agencies, regulators and government policy that facilitated the gambling in the first place. There were some very specific moments when the banks lobbied regulators on both sides of the Atlantic to allow the full flow of capitalism and leave it to its own devices. Oh dear.

Could we have known it could happen?

Oh yes.  There were numerous commentators on the pending doom of the destructive power of derivatives. This includes bankers, business people, journalists and even the odd politician.

Some of the commentary was very clear indeed.  Taking all things into consideration, and quite possibly swayed by his utterly deserved reputation as one of the worlds most successful business people – this quote in Paul Masons book from Warren Buffets 2002 Berkshire Hathaway annual report sums it up quite nicely:

These instruments will almost certainly multiply in variety and number until some event makes their toxicity clear.  Central banks and governments have so far found no effective way to control, or even monitor, the risks posed by these contracts.  In my view derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.

I have no idea if Mr Buffet does a mystic meg column, but if he does I suggest we all subscribe.

Would Corbynomics have saved us?

I really don’t know.  But lets imagine in 1997, instead of a fresh faced Tony Blair being elected, we have a rugged looking Jeremy Corbyn.

What impact may Corbynomics have had on the financial crisis that was to follow a decade later?  Of course it is impossible to know, but what we can observe is what Mr Corbyn wants to do now and we can (reasonably safely) assume he would have had a similar remit back then.

That means nationalised industries, certainly rail, probably energy.  It means the chances of marching off to Iraq are greatly reduced, but what does it mean for the financial services contagion referenced in the majority of this article.

Well, one of the points referenced above was that deregulation played a part. I think it’s a reasonable proposition to say Mr Corbyn would be more pro-regulation than is or was the case.  Therefore perhaps some of the extreme financial speculation would have been stymied long before it exploded the way it did.

However, I don’t think its fair or reasonable to conclude that if “Corbynomics” had been fully installed in 1997 that we would have totally avoided the crisis (much of it was originated in the US) or that the policies would have left UK PLC in a better position than it is now.

Certainly with our national debt already at approximately £1.5tn i’m not sure nationilising industries or other elements of Corbynomics would challenge that any time soon. Fascinating times ahead.