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A Decade And A Year On: Revisiting The Financial Inferno of 2008

When deciding what topic would form centrepiece of my next article, I asked myself the usual questions:

  1. What topic is currently relevant?
  2. Is it a topic that everyone talks about?
  3. Paradoxically, is it also a topic which very few truly understand?

Having recently read Bernanke’s, Paulson’s and Geithner’s “Firefighting the Financial Crisis And Its Lessons”, I convinced myself that the global crisis of 2008 provided a solid “yes” to all of the above.

Ginevra Bizzarri picture
Ginevra Bizzarri TCLA Writer

Its relevance:

On a pure “curiosity” level, I thought that it would be interesting, a decade (and a year) on, to analyse and understand how our economy and its regulations have evolved since the heyday of the crisis. Do we live in a safer (financially speaking) environment today, compared to the one of 2008? If so, how have we gotten here?

On the other hand, on a more specific, “commercial awareness” related level (which is realistically the real reason why most of you have chosen to put yourself through this article), the financial crisis and questions surrounding it could very well come up in interviews. The ups and downs of the economy, as well as its inner workings, directly affect the work that law firms do, and interviewers want to see that you understand this. I remember that at my first ever interview, the partner straight-up asked me “How did the financial crisis happen? Do you think our economy could potentially face another one?”.

Basically, no punches pulled.

At the time, I remember my brain turning to mush as I attempted to piece together a somewhat coherent answer. Needless to say, I failed, and the feeling of complete cluelessness I felt back then, stung so bad that I still remember it today. What I’m trying to convey is, if you don’t want to be me circa 2017, then read this (very long) article.

Its popularity:

People love to talk about the financial crisis. Whether its interviewers who enjoy prying you, or whether its FT column writers who constantly regurgitate the topic in whatever shape, way or form, what happened in 2008 was so unprecedented, so complex and so completely detached from the realm of anyone’s imagination that people are still fascinated with it. So again, if you want to delve into the magic world of securitisation, CDOs and credit default swaps, keep on reading.

How well the topic is understood:

Just like the word “private equity” (see my other article), this is a buzzword that is constantly thrown around and which needs demystifying, the “financial crisis” of 2008 is also a topic which is very talked about but, as I found, not very understood. If we think about it, not even the people who at the time arguably caused the crisis (the bankers) could fully explain to themselves how and why that whole mess had come to be. Most of us, or at least me before this article, have a pre-prepared vague explanation that we blurt out every time we get asked so that we don’t sound dumb. But really, what do we actually know?

This article will first explore the various macro-economic, regulatory and human factors which triggered the crisis. It is important to note that whilst alone each of these may have been relatively harmless, when they met and collided together the way they did back in 2006-2008, they created a recipe for disaster.

I’m then going to take a step back to look at the bigger picture, and attempt to explain how the workings of a market as small as the mortgage one (when we think in global terms at least) was able to have such a catastrophic domino effect across not only other markets and sectors in the United States, but across various other continents too.

I will then discuss the heavily debated government intervention which quickly followed suit. Indeed, still today loads of questions linger:

Why did they save AIG and not Lehman?

Why were the credit rating agencies and the bankers allowed to walk whilst millions of people were left without houses, jobs and confidence?

Was this all moral hazard or common sense?

In a world which is already heavily unequal and dominated by big financial players at the apex of the socio-economic food chain, was it right to bailout the very institutions which caused the crisis? Or should policymakers just have let the hand of free-market capitalism push them off the edge of the cliff they were hanging from?

Macroeconomic factors & Irresponsible mortgage lending

If you ask anyone what the biggest trigger of the crisis was, they are likely to tell you “the irresponsible lending of subprime mortgages”. Subprime mortgages are mortgages where the borrower has low income relative to the size of the loan and possesses few assets other than the house being bought.  So essentially, the likelihood of the loan not being repaid is higher than normal.

But how, you may ask, could a bunch of shitty mortgages bring down the whole financial system? Well, the answer is that there weren’t few, but millions. Also, these subprime mortgages were everywhere, quietly brewing in all sectors and corners of the global economy, meaning that when the US housing bubble burst, the whole financial world imploded with it. But again, we’ll get back to that later.

Ok, lets pause and go back a second. It is in fact necessary to understand why this toxic lending trend existed in the first place. In order to do this, we need to look at the former economic climate.

The years before the crisis, saw an unprecedented level of debt-build up in the United States, particularly in the household market where ordinary people and families started to become dangerously overleveraged. This happened because back in 2006, in the US, short-term interest rates were lower than long-term interest rates. As the name suggests, the difference between the two lays in their repayment schedule; short-term loans are repaid quicker (usually within a year) whilst long-term loans run their course over a longer period of time. As a result, lenders view short-term loans as less risky than long term loans, as the former enables them to be repaid quicker. The interest placed on each of these loans thus reflects this risk-reward scenario; short-term loans have lower interest rates whereas long-term loans have higher interest rates as lenders have to bear the risk of their longer-term investment[1].

This meant banks were borrowing short-term in order to lend long-term and reap the profits from this opportunity, and one particularly lucrative long-term loan they focussed on were mortgages.

This opportunity came at the same time of the housing boom, which started in 2002-2003 as home construction was rapidly increasing in the US. As a result, speculation in the housing market ensued. This meant that as prices rose, people bought more houses (both because the lending terms were favourable and because they might have also had the intention of selling it a higher price somewhere down the line). This trend was more than welcomed by the banks who, as mentioned above, wanted to benefit from the higher interest rates on long-term loans and gave out a lot of mortgages, even to people with questionable finances (but again, we’ll get back to this later).

As a result, from 2001-2007 the mortgage debt level per household rose 63% faster than household incomes (essentially meaning that people were borrowing money at a way faster rate than they were earning it). Liquidity seemed limitless and asset values (in this case house prices) seemed destined to keep rising, so banks just kept on giving out mortgages. It is in this manner that bubbles start forming.

Just like gambling and the adrenaline rush that comes with it when you’re on a winning streak; it becomes impossible to just walk away. This is the psychological explanation at the heart of this lending and borrowing mania which permeated the mortgage market.

But how did it all get so bad?

A Brief Detour Into The World of Banks:

As mentioned before, banks borrow short term in order to lend long term. This process is called “maturity transformation” and usually tends to be very beneficial for the economy. Indeed, banks lend out money for legitimate purposes, ie to people in order to buy houses, or to companies to allow them to grow. And if the bank has done its job and has lent money to financially sound people it will eventually be repaid and reap further profits through the interest repayments. However, this process of maturity transformation can also be very fragile. Imagine you are a bank and you lend out more money than what you own (ie you lend out a lot of money that is actually borrowed money) to certain people or certain companies. What happens if one day your creditors wake up, decide they have lost confidence in the markets and demand their money back? Well, you have no money to pay them back with. In the financial world, word spreads fast and other creditors will soon be banging at your doors. Actually, that’s a lie. Whereas before, if they wanted their money back, they literally had to walk to the bank and bang on its doors demanding their money, with digitalisation now they can get it back with a “click”.

This is a classic example of a “run on a bank”.

Now that you understand maturity transformation and its downsides, think about this: banks were lending out far more money than what they had. Stats seem to suggest that a whooping 36 trillion worth of borrowed money was used by banks to finance activities of ordinary people seeking mortgages.

To give you an idea, banks are required by law to have assets – called bank capital – which total up to at least some fraction of the money they lend. This provides a security mechanism for lenders who know they’ll get at least some of their money back if the bank defaults on the loan. Without getting too deep into the details, all you need to know is that, pre-financial crisis, the capital requirements that banks had to comply with were far far far lower than what they are today.

Further, another issue was that it wasn’t only banks who were lending out far more than they should have, but other institutions were joining in on this borrowing-lending frenzy too;  loosely regulated insurance companies, mortgage companies and finance companies all around the world were providing this credit in the mortgage market. Inevitably, all these institutions became highly leveraged.

In a way, this over-borrowing and over-lending would not have been so catastrophic had it been only confined to banks and/or other lending institutions. What I mean is: imagine that banks borrowed short term and then lent out long-term mortgages to a lot of people who then defaulted on their debt and then STOPPED THERE.  Sure, the situation would have been bad, but this tragedy would have only affected the parties directly involved (ie those lending to the bank, the banks and those borrowing from the banks to finance their mortgage).

What actually allowed a small sector of the economy to bring down the rest of it is a phenomenon known as “securitisation”.

How Mortgages Became Tradeable

Once upon a time, banking was not the be all end all job. People who worked in that industry did not even dream they could make the amount of money that every aspiring investment banker today expects. Like the script writers of “The Big Short” like to point out, “in the late seventies banking was a good stable profession, like selling insurance or accounting….and if banking was boring, then the bond department at a bank was downright comatose.” Essentially, banking and bonds were for losers.

Around the same period of time (1960s) mortgage lenders and government officials were desperately trying to attract capital to the mortgage market as mortgage lenders were struggling to meet the growing demand for housing and the mortgage sector would often go through what is known as “cycles of funding shortages”. This happened because each cycle interest rates increased, consequently creating the expectation that they would only keep rising. As a result, this very much disincentivized potential investments in the mortgage market as investors did not want their money locked-up in long-term, fixed rate mortgages which, after interest rates went up, would not pay out as much.

So basically, mortgages were not an attractive investment and no investment bank really wanted to deal with them. That is before Lewis Ranieri, Salomon Brother’s most famous bond trader, took the concept of securitisation, and applied it to mortgages.

Securitization works like this: you take an illiquid asset or group of assets[2] and you transform them into a “security”. A security is a tradeable financial instrument which derives its monetary value from an underlying asset. Various types of securities exist, but the most common are equity securities (eg shares in a company) and debt securities. Here we will only focus on debt securities.

Investopedia tells us that “a debt security represents money that is borrowed and must be repaid, with terms that stipulate the size of the loan, interest rate and maturity date…and generally they entitle their holders to the regular payment of interest and repayment of principal”[3].

What became really popular in the years preceding the crisis were “mortgage-backed securities” (MBS) which, as you can guess, were securities which derived their value from mortgages the claims that lenders had against the mortgagor’s assets.

After the security is created, (and each MBS was created by pooling thousands of mortgages together) shares of MBS’ could be sold to participants in the secondary market. Unfortunately, before I continue, it is time for another brief, yet fundamental detour into the world of…

Primary and Secondary markets

If we are to understand how MBS’ and similar securities were able to affect and bring down the whole financial system, the distinction between primary and secondary market needs to be clear. The primary market groups all the “first-time transactions” such as stock issuing (IPOs) or bond issuing which see investment banks selling/interacting directly to investors. In the primary market investors are usually large institutional buyers who purchase millions of shares at a time. For example, during an IPO, the primary market transaction is between the purchasing investor and the investment bank who underwrites the IPO. Any money made from the sale of shares to investors on the primary market will go to the company. If, however, after a while, the initial investors in the company decide they want to sell their stake, they can do so on the secondary market. Indeed, the secondary market is the place where investors buy and sell securities they already own, and it hosts all transactions of securities which take place post initial offering.

The key differences are:

  1. Any transactions on the secondary market occur between individual investors (as opposed to an investment bank and purchasing investors) meaning that the proceeds of each sale go to the selling investors and NOT to the company who initially issued shares or to the investment bank who originally underwrote them.
  2. In the primary markets, the initial price is set by the banks who determine at what price each share will be offered to investors when the company floats. In secondary markets, the price of securities is purely determined by supply and demand of buyers and sellers. All this makes the secondary market far more dynamic and harder to track, less transparent and more volatile. However, most importantly, the secondary market allows for a huge range of participants to join in. (so keep in mind that these MBS’ were starting to make their way in portfolios of investors from all around the world).

So what Lewis Ranieri did which was genius, was that he took 30-year-mortgages and made them into MBS’ which were being sold in the secondary markets to investors as if they were 5 and 10 year bonds. Essentially, he was the first one to make mortgages TRADEABLE.

“Tranching”

Now that I’ve explained the difference between primary and secondary market and how MBS’ became tradeable, I will touch upon the complex topic of tranching which is, in hindsight, what made the crisis even harder to foresee.

Once the MBS, which combined millions of mortgages, was created and placed in one portfolio, the banks started slicing and dicing up these really big mortgage pools in smaller, more specific mortgage classes called “tranches” with each tranche representing a different risk level. We call these individual tranches “CMO’s” (collateralized mortgage obligations) and the whole process of breaking up an MBS into these smaller CMOs was done by an SPV (a special purpose vehicle).

How SPV’s work

SPV’s are created by investment banks and other corporations who then sell off their assets (in this case mortgages and the subsequently created MBS’ bank) to the SPV.

Then, the SPV (which is still owned by the investment bank but is legally separate from its activities) becomes an indirect source of finance for its “parent” as it attracts independent investors who want to purchase these MBS’.

By doing so, the banks simultaneously take the MBS’ they created off their balance sheets and also get rid of the inherent risk associated with the mortgage as they don’t own the MBS’ anymore.

So, once the SPV purchases the assets (MBS’) from its parent company, it then starts “tranching” them, ie chopping them up and grouping them on the basis of how risky they are.

Each tranche has a different level of risk exposure. The most secure tranches will be the triple rated “AAA” tranches, which will then be followed by double A’s, A’s, double B’s, B’s and so on…

This slicing up via the “tranching” mechanism is done so that specific risk preferences of different types of investors are catered to. So, for example, pension funds will typically invest in triple A rated tranches whilst private equity or hedge funds who conventionally seek out the higher returns will invest in the lower rated tranches. In any case, the investors would receive a proportionate amount of the mortgage payments as their return on investment.

CDO’s

Last, but definitely not least in terms of importance, come the “CDO’s” aka “Collateralized Debt Obligations”. CDO’s have been defined by some as “a mortgage-backed security on steroids”. In fact, whereas MBS’ are securities just made up of mortgages, and CMO’s are just individual tranches of those mortgages, CDO’s are made up of different types of debt (these include corporate bonds, mortgage bonds, bank loans and even car loans!). Like the mortgages, they are then pooled together and bundled into a security which is then sold onto the market as a bond.

In the words of Steve Carrell, whereas MBS’ were “dogshit”, CDO’s were “dog-shit wrapped in cat-shit”. This is because, leading up to the crisis, most investment started creating CDOs that included just the lowest rated tranches of MBS’.

A Quick Summary

Because the last paragraphs were probably the most complex you’re going to get from this article, I believe a quick bullet-pointed recap of how mortgages were dealt with would be useful before we proceed:

  1. Potential homeowners apply for mortgages at banks or at quasi-government agencies like Freddie Mac or Fannie Mae.
  2. These institutions grant these loans.
  3. These loans are then securitized (become MBS’) and pooled together with thousands of other mortgages.
  4. Sometimes MBS’ are sold to investors as a whole.
  5. Other times, these MBS’ then get sold to the SPV’s which then chop the MBS’ into smaller tranches.
  6. These tranches are called CMO’s and are allocated different ratings based on how risky they are.
  7. Once this happens, then CMO’s are sold to different investors as if they were bonds.
  8. Investors will choose whether to invest in a more or less “risky” tranche based on their strategy.
  9. Each month, when people pay down their mortgages, the cash is sent to the investors who purchased the bonds.
  10. CDO’s are debt securities which unlike the two above, pool together different kind of debt. They were sold on the market in the same manner; like MBS’ and CMO’s were divided by their risk class and were meant to provide regular payments to their investors.

Greedy investment bankers

It’s clear that mortgages were being traded and a lot of people in the financial system held them. So what? Well, most of these mortgages were, bad, very bad. In fact, some of the loans given out were so low quality that someone out there was creative enough to rename “NINJA” loans (No Income, No Job, No Asset Loans). They reflected the fact that lenders were greenlighting almost every credit request, regardless of how shady the borrower’s credit history seemed to be. On top of this, these NINJA loans had “teaser rates”. This meant that they initially required low interest rate repayments which then sky-rocketed after a couple of years. It’s kind of like when you see free subscription for 3 months and really want to sign up for it but, upon zooming into the teeny-tiny letters at the bottom of the screen you see that you will then be charged 60 pounds monthly after the trial period if you don’t cancel your subscription.

But why, you may ask, were banks okay-ing such mortgages, and even more importantly, why were investors prepared to buy them??

Well the answer is that “no one was paying attention”. Banks could afford not to care and investors had no idea these were bad investments. This is because once the banks securitized the mortgages and sold them off to investors, they not only were able to record a “plus” on their balance sheets, but they also got rid of the risk. What this means is that although they might have known these mortgages were not good, this didn’t really affect them because even if the homebuyer defaulted somewhere down the line, they lost nothing. All the risk was shifted onto those buying these MBS’, CMO’s and CDO’s. Indeed, by buying into the security, investors were effectively take the position of the lender.

What made all this worse was how the remuneration system in banks worked; employees would get bonuses based on how many loans they could generate, regardless of the loan’s characteristics. You know the saying “quality over quantity”? It definitely did not apply in this case.  This is why these loans that banks were creating, came to be known as “originate to distribute” loans. The more of these they created and got off their balance sheets, the more of these they could underwrite (this goes back to the whole issue of capital requirements we discussed before).

Now onto the second part of the question: why did investors accept to buy these loans off the institutions? Well, because they didn’t realise how risky they were.  On the face of it, over 90% of these shitty mortgages were “triple a” rated, meaning that they were deemed by the market to be as secure as treasury bonds! At this point, another inevitable question arises.

Who rated these mortgages??

Lack of regulation and supervision

Agencies such as Moody’s, Fitch and S&P are in charge of assigning credit ratings, which rate a debtor’s ability to pay back debt. This is why they are called, “credit rating agencies”.

Had they done their job properly, most of these MBS’, CMO’s and CDO’s would have received the grading they deserved (AKA C or below) which basically would have placed them in the “junk” category, thereby ensuring that (almost) no one would have bought them.

However, credit rating agencies turned a blind eye to transparency because they wanted to ensure they were paid their fees. Their fees came from investment banks who were the ones asking to rate these securities in the first place. The logic was the following: if, for example, JP Morgan went to Moody’s and asked for a rating and Moody’s came back to them with B’s, C’s and D’s, JP would ditch Moody’s and go to Fitch. And no one likes to knowingly lose out to their competition. This is why the market was flooded with triple A rated securities.

Further, the situation was even more complex because banks mixed “bad mortgages” with slightly better mortgages or other loans (like in the case of CDO’s), which meant that the risk was sliced and diced up so thin that it became almost undetectable and this whole process made it harder to accurately rate securities.

What made it all worse: Short-Selling, and Credit Default Swaps

In short (pun), when someone “shorts” a security (eg a stock or a bond) it means they are betting on the price/value of that product going down in the future. If they end up being right, they make money from this.

In order to “short”, people bought “Credit Default Swaps” (CDS), which are basically insurance contracts that allow purchasers to be protected if any of the securities they own default. CDS’ were sold by insurance companies like AIG who for a small, regular fee paid to them, ensured that investors who bought CDS’ would still get a certain amount of money back in case one of their securities collapsed.

In the Big Short, the protagonists who had foreseen the crash before everyone else, began shorting these toxic securities, with a particular focus on CDO’s. Some say that even the same bankers who created and sold the toxic securities in the first place started shorting these CDOs.

Because the housing market was considered so secure, the returns offered by insurance companies on these CDS’ were huge! If the bonds went bust, shorters could make up to 20:1 returns.

Furthermore, the twist here was that a lot of the people who were doing the shorting didn’t actually own CDO’s, they just wanted to speculate against them because they knew how bad they were.

To give you an idea of just how obviously bad these CDO’s were, when Ryan Gosling is explaining CDS’ to Steve Carrell and his colleagues he screams :“I am literally standing in front of a burning house and offering you insurance”.

A game of Jenga: How it all came crushing down

Usually, because cashflows come in from different loans (CDO’s/MBS’/CMO’s) and are paid by different borrowers, any single default should be redundant when it comes to the stability of the overall portfolio. However, “somewhere along the lines, these B’s, double B’s and C’s went from a little risky to dogshit”. This meant that even the A’s, double A’s and triple A’s were a scam. Basically, the financial markets were inundated with systemic risk and eventually the apocalypse came.

Around the end of 2007, the teaser rates kicked in, causing thousands and thousands of homeowners to default on their loans. This in turn meant that, initially the subordinated tranches of the CDO’s and CMO’s were absorbing all the losses whilst the upper-level tranches remained unaffected. However, pretty quickly the defaults became so many that the subordinated tranches were unable to cushion all the losses, and  the higher rated tranches went to 0 too.

As a result, CDO and CMO portfolio managers did not have any cash flow with which to pay their bondholders.

This shocked everyone as nobody had foreseen that the default rate would be so high. However, as stated before, no one was paying attention. Banks were so focussed on making mega fees that the amount of subprime loans present in the market was disregarded. Everyone had the utmost belief that the real estate market was as solid as they come. Because at the end of the day, who the hell doesn’t pay their mortgage?

So what happens when even what is supposed to be the most secure investment in the system turns out to be worthless? Well panic ensues. In turn this means investors and creditors become wary and scared of the financial system and the product it sells.

Banks were getting almost no income from their loans, which meant their bank capital decreased and they had to refrain from lending out even more money to people and businesses. On top of this, they had so much leverage hidden away in complex derivatives and off-balance sheet SPVs that they looked far better capitalized than what they actually were.

All this meant uncertainty amongst investors and banks spread. No one knew what they were holding or who they could trust.

In a way, the economy was coming to a halt.

BNP Paribas, Citigroup and Merril Lynch : The first dominoes to topple

Curiously, it was a European bank who started the panic. On 9 August 2007, the French bank announced it had frozen three of its funds (worth 1.6 billion euros) which held securities backed by US subprime mortgages. When a bank “freezes” an account, it is effectively preventing any transaction from occurring in it: any open transactions will be cancelled, and checks presented to it will not be honoured.

Then, Citigroup and Merril Lynch announced two of the biggest write-downs of troubled assets in history. A write-down happens when an asset’s market value has fallen below the value it has on the company’s balance sheet. The company’s income statement has to then be adjusted to reflect these losses and net income is reduced. As a result, because both of them held so many mortgage securities, they found themselves having to write down so many troubled assets that they basically went insolvent.

AIG, Fannie Mae & Freddie Mac: Too interconnected to fail

Three of the institutions which were famously saved by the Fed and Congress were AIG, Fannie Mae and Freddie Mac.

Once the mortgages started defaulting, AIG very quickly found out that it just did not have enough capital to repay all the people who had bought CDS insurance and had now come to claim it. Some argue that the Fed should not have bailed them out. But what would have happened to all the people who had given their money to AIG in good faith? Why should they be affected by bad decisions and gambles some people took in the mortgage sector?

On the other hand, Fannie Mae and Freddie Mac were government sponsored mortgage powerhouses who had lent out more than 5 trillion dollars worth in mortgages. Allowing them to collapse would have meant a complete halt in the origination of mortgages which would have completely crushed an already very unstable housing market, which would have also led to the failure of more firms on Wall Street. So they ended up getting nationalised at great expense.

As explained by Bernanke & Co: “systemic crises are not the time for free market absolutism or moral hazard pluralism because of the serious risk they pose to lending, jobs and income”

Sure, they could have just let the crisis run its course and refused to bail out anyone. But this approach would have actually benefitted no-one.

Lehman Brothers

Lehman was the one investment bank that is famous simply because it did not get saved (for example, Bear Stearns was saved by JP Morgan who bought it and guaranteed for its obligations). In their book, Bernanke & Co are keen to dispel the common misconception that Lehman was made to fail on purpose. I mean, after AIG,Fannie Mae, Freddie Mac AND Bear Sterns had been saved, so why not Lehman?

Congress authorized the Fed to save Fannie and Freddie, whereas it was JP Morgan and Jamie Dimon that came to the rescue of Bear Sterns when they agreed to buy the bank and guarantee for its obligations

On the other hand, AIG had enough solid collateral for the Fed to lend against in conditions the market would accept.

By contrast, no buyer was willing to step in for Lehman and no Congressional authorisation for its rescue was given either. Basically, Lehman was just very, very unlucky

The Role of Law firms in all this:

As aspiring lawyers, it would be easy to fall into the trap where we convince ourselves that the legal profession is immune to recessions. It is technically true that when things go bad, firms put M&A, private equity and the mega deals aside as lawyers are asked to turn their attention to litigation, restructuring, insolvency, bankruptcy or refinancing. This is why full-sector law firms (like W&C, DLA Piper, Slaughter and May) with diverse practice areas and geographies are better set to face these manic situations.

For example, Weil Gotshal & Manges took the lead in the Lehman bankruptcy (the workload was so huge that some say the firm are STILL working on today) and it is said that one the firm’s superstar bankruptcy partners billed up to $950 per hour!

On the other hand Cleary Gottlieb’s litigators defended Bank of America in the very high-profile lawsuit filed by the SEC. One article even said that the firm was so deeply involved with the aftereffects of the financial crisis that its website featured different resources for dealing with the crisis in different, specific regions. Cleary also stepped up for BofA when it came to negotiating the investment bank’s repayment schedule for the TARP funds. Another big US heavyweight who became involved as the lead advisor for the government (specifically the US Treasury) with relation to the TARP programme was Simpson Thacher. So overall, it looks like handsome compensations will always be available for big city lawyers, regardless of the state of the economy.

Nevertheless, in today’s legal market, we would be wrong in believing that every time a crisis comes around, the big law firms will automatically get a big piece of the compensation pie.

In fact, with the rising prominence of alternative legal service providers who are able to offer an army of professionals to carry out low-cost services, big companies are increasingly choosing to spread their work-load across multiple law firms and alternative providers instead of going for the pricey, more traditional options. ALSP’s are able to use automation and AI-powered tools to offer tasks ranging from drafting to project management at a more affordable cost. This is why big law firms should start to invest more in legal-tech and in their relationships with these ALSP’s. This would ultimately enable them to simultaneously enhance the value of their services and justify their prices. De facto, if low-skill, high-volume tasks are able to be off-loaded, lawyers will be able to fully focus on the most complex issues for clients where their expertise is really needed, thus adding value.

Government intervention and TARP

After Lehman went bankrupt, in order to somewhat stabilise the financial system, restore consumer confidence and economic growth and avoid further foreclosures, the US Treasury implemented a full bailout plan known as “TARP” (The Troubled Asset Relief Program). TARP’s primary purpose was to increase liquidity in the now-dried-up markets by buying equity in banks and other financial institutions. The total budget for TARP was 475 billion and it was spent in the following ways (information from the Treasury website):

  • Approximately $250 billion was committed in programs to stabilize banking institutions ($5 billion of which was ultimately cancelled).
  • The U.S. government bought preferred shares in eight banks: Bank of America/Merrill Lynch, Bank of New York Mellon, Citigroup, Goldman Sachs, J.P. Morgan, Morgan Stanley, State Street, and Wells Fargo.
  • Approximately $27 billion was committed through programs to restart credit markets.
  • Approximately $82 billion was committed to stabilize the U.S. auto industry ($2 billion of which was ultimately cancelled).
  • Approximately $70 billion was committed to stabilize American International Group (AIG) ($2 billion of which was ultimately cancelled).
  • Approximately $46 billion was committed for programs to help struggling families avoid foreclosure, with these expenditures being made over time

Are we safer now?

What made the situation even more explosive was that many of the institutions who were borrowing short term and lending long term and therefore acting like de facto banks, were not technically banks. This means they operated outside the investment banking system with no regulation, oversight or safety nets.

Investment banks like Bear Sterns and Lehman, mortgage giants like Fannie Mae and Freddie Mac, insurance companies like AIG and corporate finance branches,  “all engaged in the fragile alchemy of maturity transformation but without effective regulatory constraints on their leverage and without the ability to turn to the Fed if their financing evaporated”.

To rectify this, numerous financial reforms were passed which regulated institutions, forcing them to up their capital requirements and decrease their leverage exposure.  These include the Dodd-Frank and Basel II, III and IV. If you want to read and learn more about them follow these links:

https://www.investopedia.com/terms/d/dodd-frank-financial-regulatory-reform-bill.asp

https://www.advisoryhq.com/articles/basel-i-ii-iii-iv/

The great global de-regulation?

Despite all the rules and regulations in place, the Financial Times recently published an article alerting us to the fact that a global deregulation could have begun. For instance, in the Brexit realm, a very heavily debated topic is whether UK financial services will retain complete access to EU clients post Brexit. Brussels has stated, time and time again, that access will be granted only if post-Brexit UK rules remain “equivalent”, or at least very closely aligned to those of the EU 27. We will have to wait and see what Boris Johnson and his government choose to do. Will they comply with Brussel’s demands or will the UK embark on a de-regulatory agenda?

On the other side of the continent, in the US, the Fed governor in charge of financial regulation and the head of the global regulatory oversight body, are reported to have attended a Congressional meeting and to have stated that, in complete disregard of Basel IV, the overall capital levels at US banks should not rise. The FT quotes them saying they “don’t believe that the aggregate level of loss absorbency needs to be increased”.

The last red flag they pointed out was actually quite an interesting one. Apparently, banks like Deutsche and HSBC, with the blessing of European regulators, are giving a lighter capital treatment to environmentally friendly investments. Sure, tackling climate change is important, is this really the way to do it?

On a more general level, some suggest that endless rounds of QE and ultra-low interest rates have over-inflated the value of everything, from houses straight to PE targets.

Overall, yes banks are safer and sounder now than what they were back in 2008; Credit rating agencies are actually doing their jobs and banks and investors are actually verifying the quality of the products they create and sell. However, although history doesn’t repeat itself, it often rhymes; and because the global meltdown was really the result of carelessness, lets hope that this time round PEOPLE ACTUALLY PAY ATTENTION.

I hope that now, having gotten to the end of this odyssey, you can appreciate why, a decade and a year on, the necessity to revisit the financial inferno which brought various continents, economies and sectors to their knees is stronger than ever.

[1] Note: this does not mean that interest on long-term loans were extraordinarily high. They were just higher than interest on short-term loans and this created an opportunity for banks to borrow whilst also not dissuading ordinary people from borrowing. (This kind of mechanism is at the heart of the banking system.)

[2] Illiquid basically means it’s hard to sell the assets because there is no market for them. In this case as discussed there was no real market for mortgages.

[3] Investopedia

Ginny is a member of TCLA’s writing team. She is Italian, having lived in Milan until the age of 16. Ginny recently completed a Combined Honours in Social Sciences at Durham University, and she is now a future trainee solicitor.

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