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On this day 5 years ago, the glob­al eco­nom­ic cri­sis began. The trig­ger was the deci­sion by BNP to sus­pend redemp­tions from funds that were linked to the US hous­ing mar­ket. Those of us who had been expect­ing a debt-defla­tion­ary cri­sis
and warn­ing about it
for some time (see also here and here) could nev­er have picked the trig­ger itself—that would have been prophe­cy, not prediction—but very rapid­ly it was clear that this was it.

(Click here for this post in PDF)

Fig­ure 1

BNP’s deci­sion trig­gered a liq­uid­i­ty cri­sis in the overnight funds mar­ket: sud­den­ly you could­n’t sell a bond to any­one for any price. The flavour of the day is well cap­tured in this piece—pub­lished on Bank­ing Day—by Gra­ham Hand, who was then an exec­u­tive of the State Bank of New South Wales and Colo­nial First State:

August 9, 2007: “We can’t roll over your paper this morning”

It was the ear­ly evening of Thurs­day, 9 August, 2007, when I received a phone call at home from a Citibank deal­er in Lon­don.

For many years, my organ­i­sa­tion had been issu­ing short-term notes in the Euro­mar­kets to finance a geared fund, and some notes rou­tine­ly rolled over almost every night. It was an excel­lent source of inex­pen­sive fund­ing, some­times swap­ping into Aus­tralian dol­lars at below the domes­tic bank bill rate.

We post­ed issu­ing lev­els at the end of each Aus­tralian day and the Lon­don deal­ers could trans­act at those spreads with­out fur­ther ref­er­ence. At the time of the call, we had over a bil­lion dol­lars on issue in Europe, and this night A$50 mil­lion was matur­ing.

“We can’t roll over your paper this morn­ing. There are no bids in the mar­ket,” the deal­er said.

At first, while unusu­al, this was not alarm­ing, as pric­ing lev­els between issuer and deal­er are sub­ject to nego­ti­a­tion and pos­tur­ing. I asked for more details, and said we were will­ing to pay a few points more if nec­es­sary.

“You don’t under­stand,” he said. “It’s not a mat­ter of price. There are no bids on any­thing.”

And that night, five years ago today, the Glob­al Finan­cial Cri­sis start­ed.

I imme­di­ate­ly turned on my lap­top, and a quick scan of finan­cial web­sites con­firmed what had spooked the mar­ket. BNP Paribas had sus­pend­ed redemp­tions on two of its mon­ey mar­ket funds, and to quote them:

“The com­plete evap­o­ra­tion of liq­uid­i­ty in cer­tain mar­ket seg­ments of the US secu­ri­ti­sa­tion mar­ket has made it impos­si­ble to val­ue cer­tain assets fair­ly, regard­less of their qual­i­ty or cred­it rat­ing… We are there­fore unable to cal­cu­late a reli­able net asset val­ue (NAV) for the funds.”

The US sub-prime cri­sis had come to Europe. The entire bil­lion dol­lars of notes matured over the fol­low­ing months with­out a sin­gle rollover at any price. If ever con­fir­ma­tion was need­ed of the mer­it of diver­si­fied fund­ing sources, this was it.

Ini­tial­ly, there was no way of know­ing if the cri­sis would last a week or a year. The remain­ing $4 bil­lion of our $5 bil­lion bor­row­ing pro­gram was onshore Aus­tralia, includ­ing short-term notes issued into the mar­ket, and direct bank lines. These sources proved more resilient for a famil­iar Aus­tralian name, but spreads widened dra­mat­i­cal­ly, and the local note issu­ing pro­gram halved in size.

It’s no sur­prise that the Aus­tralian Pru­den­tial Reg­u­la­tion Author­i­ty and Aus­tralian bor­row­ers have sub­se­quent­ly focused more on build­ing domes­tic fund­ing bases, while the for­eign pan­ic sup­ports the need for a decent retail bond mar­ket in this coun­try.

Amaz­ing­ly, while the debt mar­kets were in tur­moil, the equi­ty mar­kets con­tin­ued to ral­ly for some months. We knew either the bond or the equi­ty mar­ket was wrong, but we were not sure which.

I recall talk­ing to a bond fund man­ag­er who was gob­s­macked by the ris­ing equi­ty mar­kets, as he had sold every stock he owned. The col­lapse of Lehman Broth­ers was not until Sep­tem­ber 2008, over a year lat­er. Hedge funds had plen­ty of time to short every­thing they could find, and soon Lehman dis­ap­peared, Mer­rill Lynch was res­cued by Bank of Amer­i­ca, and the US Fed­er­al Reserve bailed out JP Mor­gan Chase and AIG, which, in turn, saved Gold­man Sachs. So much for the free mar­ket bas­tions of Wall Street.

At the five-year anniver­sary this week, the debt mar­kets are open for good-qual­i­ty bor­row­ers, but issu­ing lev­els remain his­tor­i­cal­ly wide.

Major Aus­tralian banks issue term deposits at 150 points over the bill rate, a lev­el nev­er seen before.

If any­thing, the financ­ing prob­lem is even more intractable, as it has spread to some of the (for­mer­ly) best sov­er­eign names in the world. While coun­tries can bor­row to save their banks, who can bor­row to save the coun­tries?

I expect that five years from now we’ll still be try­ing to sort out the mess.

* Gra­ham Hand is a for­mer exec­u­tive of the State Bank of New South Wales and Colo­nial First State. He is the author of the bank­ing his­to­ry, Naked Among Can­ni­bals.

Arti­cle By: By Gra­ham Hand*

Gra­ham’s com­ment above that “there was no way of know­ing if the cri­sis would last a week or a year” indi­cates how sur­prised finan­cial mar­kets were at the time, and how lit­tle they under­stood the dynam­ics of credit—even though extend­ing cred­it was their busi­ness.

As some­one who had dis­cov­ered Hyman Min­sky’s Finan­cial Insta­bil­i­ty Hypoth­e­sis some 20-years ear­li­er, and hav­ing real­ized that pri­vate debt had reached unprece­dent­ed lev­els, I ful­ly expect­ed this delever­ag­ing cri­sis to be mea­sured in decades, as Gra­ham now does.

Fig­ure 2

Today marks the half-way point to the first decade of the Less­er Depres­sion (to use the very accu­rate phrase Paul Krug­man coined to describe it). It began, as I pre­dict­ed, when the rate of growth of pri­vate debt began to slow down. There had been big­ger slow­downs in the rate of growth of the debt ratio in ear­li­er recessions—see Fig­ure 3.

Fig­ure 3

But since debt was so much larg­er rel­a­tive to GDP than it had ever been before, the slow­down this time caused a dra­mat­ic drop in aggre­gate demand—see Fig­ure 4.

Fig­ure 4

So it’s “Many Hap­py Returns?” to the eco­nom­ic cri­sis, and before I con­sid­er how many more years it could be with us, it’s time for a laugh. By sheer acci­dent this week I redis­cov­ered the “Mon­ster Crash” put togeth­er by the Tele­phon­ics 4 years ago, and I’ve yet to find any­thing else that so well satiris­es the fol­ly that led to this cri­sis, and the fol­ly that has fol­lowed as large­ly clue­less politi­cians, bureau­crats and con­ven­tion­al econ­o­mists insist on replay­ing the 1930s. Have a listen—the music and the lyrics are price­less.