The crash wasn\’t derivatives and it wasn\’t big banks: as Spain shows

I\’m coming over rather Dean Baker today. For it is he who has been pointing out that no, the great crash did not come about because of \”toxic derivatives\”. And in the UK it was not a result of the mixing of investment and retail banking. Nor even was it too big to fail banks. As Spain is showing us right now:

The need for intervention comes four years after the UK was bailing out its banks, laden with toxic sub-prime debt. At the time Spaniards were told they had the world\’s best central bank – one that had banned Spanish banks from buying dubious US mortgage derivatives.

But the scramble to rescue Bankia has shed light on Spain\’s own version of toxic debt – the vast amount of money loaned to builders, developers and land speculators during a decade-long property boom.

Spain didn\’t have any of those derivatives. And the big three commercial banks are just fine. It\’s actually the regional, formerly mutually owned, cajas that are in the shit. You know, the ones run as not for profits by hte local politicians taking the very real needs of local industry and society into account?

Now, did the derivatives, the too big to fail etc, have any effect at all? Sure they did, but they didn\’t cause either the crash or the subsequent recession. The pricking of a property bubble did. As we can see because we\’ve got the same thing, the pricking of a property bubble, causing the same problems, the evisceration of the banking system and recession, without the derivatives, the too big to fail or the investment banking bit.

Which, of course, means that all those screaming about investment banking, derivatives etc, are simply wrong. They weren\’t the cause of the problem and banning them won\’t stop it in the future.

Oh, and local, regional, mutual banks run by local politicians with a very real democratic interest in the local economy and industry: they don\’t seem to be an answer either.

40 thoughts on “The crash wasn\’t derivatives and it wasn\’t big banks: as Spain shows”

  1. So Much For Subtlety

    And the big three commercial banks are just fine. It’s actually the regional, formerly mutually owned, cajas that are in the shit.

    How do you know they are fine? What is it about national Spanish bankers that make them so much smarter than regional Spanish bankers? This is not a rhetorical question – there was a difference in the UK between former Mutuals that usually went bust and old school banks that didn’t. Is there something about Spanish people that make them such good bankers but only on a national level?

    That is not a rhetorical question. After all, Santander is one of those big three. Royal Bank of Scotland was brought down in part by its purchase of ABN AMRO. Santander was a partner in that purchase. They have also bought an alphabet soup of British banks and/or Building Societies – B&B, Alliance & Leicester and Abbey. They have also bought a large part of Brazil’s banking sector.

    Are British bankers so much worse than Spanish ones? This is worth asking because Botin, their Chairman, has been charged but not convicted of a range of crimes from insider trading to irresponsible management (I bet many British people thank God that is not a crime in the UK) to stealing the bank’s funds.

    So we have one of the big three that is marked by poor investment decisions, dubious management, and a worldwide acquisition spree. All in all I would suggest that perhaps what the Spanish are good at is obscuring their balance sheets.

  2. Last night, for the first time in a while, I looked at Richard Murphy’s site, fool that I am. And I read this on his twitroll

    Let’s not be silly. The gov’t did not cause the deficit – banks did – and bail out saved them

    So, what’s the UK deficit this year? What are bank bail-out costs this year? How much tax is the government taking from banks and bankers this year?

    However, Spain and the UK are rather different. There was a huge property bubble in Spain, funded by a massive expansion in mortgage lending.

    Most of the lending was by the cajas, which were wholly unregulated during the boom. The big banks were obliged to be a bit more disciplined. All the same, they have lost a lot of money. My (unreliable) information is that they’ve not properly marked down their loan books, they’re just taking the hit in defaults as they occur (hence Santander’s recent losses). Their hope is that they can make enough money overseas to be able to cover the default losses as they occur.

  3. Offshore Observer

    It all comes back to interest rates being held too low for too long. This forced investors to chase higher yields through riskier assets, it also allowed people to borrow far more money to purchase a home (or a second or third home for holidays or “investment”).

    When interest rates went up (only a very small amount – remember B or E rates went from 4.75% to 5.75% between July 2006 and 2007). The bottom fell out of the property market.

    The cutting of interest rates after the dot com bubble was the right thing to do but the BoE should have returned to “normal” rates much sooner, throughout the 1990s were never below 6% and averages 7-8%.

    The whole thing was exacerbated in the Eurozone by giving mediterranean states access to interest rates previously enjoyed by Germany.

    But hey the BoE were so shit at monetary policy we should hand over responsibility for banking supervision to them as well. That sounds like a great idea!

  4. So Much For Subtlety

    Offshore Observer – “It all comes back to interest rates being held too low for too long. …. The whole thing was exacerbated in the Eurozone by giving mediterranean states access to interest rates previously enjoyed by Germany.”

    I think this is my point. The low German-style interest rates allowed the cajas to support a stupid property boom. But interest rates were just as low for the big banks. Which used them to buy up assets all over the world. Maybe a bank like BBVA which invested heavily in China may do alright. But I am not sure that paying over the odds for assets in Latin America – and the Spanish now own large chunks of the Argentinian banking sector for one – looks like a good idea. Nor does buying distressed British assets.

    I maybe wrong. Or on the other hand pretty soon the penny may drop among Spanish investors. Spanish banks have been given big dollops of ECB money already. I think they know something.

    But to return to the original point, yes Spain certainly shows that pretty much all the ideas supported by the Guardian-Left are stupid.

  5. Ummm, yes, the housing bubble burst and that caused the crash.

    But why was there a housing bubble in the first place; becuase a series of poorly understood complex financial products lead banks to believe that mortage loan risk had been moved off their books and diffused optimally through the system. (At least for the UK).

    Imean, I wouldn’t want to see derivatives en mass banned, or fincial innovation crushed totally. But it would certainly have helped the situation if banks hadn’t been allowed to sell products built on ludicrous and virtually un-understandable models which provide a kind od scientific pseudo-certainty about unknowable risks.

    So, yeah, derivatives did have a little to do with it…

  6. Actually, the frightening thing is that the relevant “complex” financial products weren’t very hard to understand at all and the massive contagion/default risk was screamingly obvious if you understod the underlying (simple) statistical models and their inapplicability.

  7. @ Paul B

    “So, what’s the UK deficit this year? What are bank bail-out costs this year?”

    The story goes, that the banks caused the recession, which caused a significant drop in tax revenues, which is the primary cause of the deficit.

    And it is true that a fall in tax revenue is a key contributor to the deficit (along with contined increased spending and, well, the fact that there was a deficit anyway before tax revenues fell).

    It is also true that the banks were part of the reason for the recession.

    The big problem with this story, as well we all know (and Richie too, but he won’t admit it) is that it entirely ignores that tax revenues were massively inflated prior to the recession, as a happy consequence of the policies that the banks (and their parliamentary cheerleaders).

    The banks contributed as much to the boom as they did to the bust, and their only real impact on tax revenues was concerned merely with timing.

  8. PaulB (#2) said:
    “However, Spain and the UK are rather different. There was a huge property bubble in Spain, funded by a massive expansion in mortgage lending.”

    That makes Spain different to the UK?

  9. Let’s not be silly. The gov’t did not cause the deficit – banks did – and bail out saved them

    I remember arguing with a demented lefty – an OU tutor, no less – who seemed to think the current deficit was caused by the bank bailouts a year or two before.

  10. The banks contributed as much to the boom as they did to the bust,

    That’s the other thing the same demented lefty couldn’t understand.

  11. Mat,

    No, not really. It wasn’t the loans that had been moved off Northern Rock’s books that were the problem. It was the ones that were still ON the books because they hadn’t yet been sold on to Granite for securitisation. So arguably if Northern Rock had been able to securitise more of its loans it might have survived – and Granite might not. Which do you prefer, failure of the lender or failure of the securitiser?

    HBOS failed mainly because of very dodgy (probably fraudulent) corporate lending, B&B because the bottom fell out of the buy-to-let market and RBS because it was a basket case. RBS was the only one that could really be said to have failed because of the overheated CDO market driving the US housing bubble – and even then there were other factors, such as its high-risk private equity and leveraged buyout deals and its idiotic purchase of ABN AMRO.

    To say the UK housing boom was primarily driven by securitisation is simply wrong, I’m afraid. The US one was, but the UK boom was caused by other factors – principally, shortage of housing (partly because of very high immigration throughout the 2000s), and also in my view, the low interest rate policy pursued by the BoE.

  12. Richard

    The UK didn’t have a construction bubble. Spain, Ireland and the US all did, and it is the bursting of the construction bubble in each case that caused catastrophic collapse of the property market and bankrupted the banks that were financing the construction.

  13. Although to be fair the initial collapse in the US market was caused by ARM resets on mortgages without recourse…..

  14. TTG

    On the subject of RM and tax receipts, there’s a jolly chart on his latest blog that purports to show that corporation tax receipts have steadily declined since 2001. He achieves this remarkable effect by drawing a straight line through two recessions (the second considerably deeper than the first) separated by a boom and followed by the current stagnation. Not surprisingly, the line slopes downwards……

    Very pretty and totally meaningless.

  15. Mat: Wrong. Securitization of UK mortgages caused no major problems. (Securitization of US mortgages caused a lot of problems for RBS after it bought ABN Amro)
    TTG: Right
    Richard: Yes. UK house prices are only about 10% off their high: there was a house price boom here, but not a bubble.
    Frances: Right

    This has been a global recession driven by the bursting of a house price bubble in the US, which had been inflated by mortgage securitization, and the consequent ending of credit booms around the world. The worst affected countries have been ones over-reliant on their banking sectors (Iceland, Ireland, the UK…) and latterly ones enabled by being in the Euro to have a particularly out-sized credit boom (Greece, Italy, Spain, Ireland).

    Blaming British banks for the recession is sort-of right, but it’s not exactly the banks’ fault that Thatcher and Blair decided to live off them. And blaming British banks for the current deficit is at least one level of indirection too much.

  16. Tim’s instincts may be right to exonerate the banks but he is less than clear where to lay the blame instead .Step forward the British political parties which have been bribing the electorate to vote( in decreasing numbers) for guaranteed
    house price inflation for decades.This lazy dishonest strategy has hit the buffers.
    The parties are now blaming the banks which were only doing their bidding in dishing out cheap credit for an electoral majority of people trying to buy appreciating property assets with depreciating currency.
    If the banks really were that powerful ,they would call the Homeownerist Party’s bluff (whichever branch is in office) and demand a JS Mill Land value tax (the type that is only operational when prices go up) before making any more loans ultimately dependent on land values.
    BTW I am one of these bonehead lefties you mouth off about: we have a long LVT tradition ,having intro’d one in the Thirties.

  17. PaulB (#16) said “UK house prices are only about 10% off their high”

    The Halifax Property Index peaked at £201,081 in August 2007.
    The nominal trough (so far) was March 2009, at £157,066.

    That’s a nominal fall of almost 22%.

    December 2011 was £157,083, by which point the August 2007 high was £232,218 in real terms (RPI).

    That’s a real fall of over 32%.

    In either case, a hell of a lot more than 10%.


  18. Frances (#13), I’m not sure about a construction bubble – can’t find the figures.

    But PaulB specifically said a property bubble which I take to mean prices rather than construction (and, from his 10% claim in #16, I think that’s what he thought he meant as well).

    And (see 18), UK property prices are down 32% from peak.

    I’m not claiming that the deficit is the bankers’ fault, or any crap like that. But to say (as PaulB did) that Spain has had a property crash and the UK hasn’t doesn’t seem to be supported by the data.

  19. The nature of the cajas in spain (politically run by parties and with unions on the board) led to politically-oriented loans, loans to construction companies nbuilding their land banks (this is the real problem, a house can eventually be sold, the land has gone from the price of gold to being unable to give it away), loans to business friends, general bad-banking decisions and personal enrichment and even kick-backs. (Incidentally, the Basque cajas do not suffer the sam problems, just saying like)

    CAM had a former secretary as GM and after bankrupting the business she went, organising a €700,000/year pension. She is being hauled up in court.

    The focus is switching to MAFO the central bank governor. He appears to have been derelict in his supervision duties and is going to take serious sh*t over Bankia.

    The cajas like all financial institutions in developed countries were highly regulated. But if the supervision is poor?

    Santander took the good bit of ABN-Amro. They have a lot of non-performing loans on property but have been covering potential losses at a tremendous rate. I think only 10% of their business is currently in Spain.

    The cajas are not a good advert for Cifers and others. Politicians are not bankers.

    Watch Goirigolzarri at Bankia. If anybody can turn it round he can. He is financially independent (you wouldn’t believe how independent) but probably the sharpest banker in Spain and has a true sense of responsibility and duty to his country and his profession.

  20. Richard: I’m looking at the Nationwide House Price Index which peaked at £184k in Q3 2008 and was at £163k in Q1 2012, a decline of 12%.

    The falls in Spain, Ireland, and the USA have been much larger than that.

  21. Richard,

    There was a large construction bubble in Spain:

    Spanish property prices have dropped by 30-34% since 2007. There’s significant oversupply in the housing market, though, so they unquestionably have further to fall:

    I don’t think we can really claim there is oversupply in the UK housing market – it’s more that credit is now so tight that the pool of buyers has shrunk considerably. And the UK did not have the construction bubble that Spain, Ireland and the US all had. So if there was a UK housing bubble, as opposed to a boom, it was driven by different factors – as I said. In that respect, therefore, Spain and the UK are not similar.

  22. Frances

    “On the subject of RM and tax receipts, there’s a jolly chart on his latest blog that purports to show that corporation tax receipts have steadily declined since 2001.”

    Oh my word… he’s almost out Eoin’d Eoin with that beauty. All that’s missing is a background graphic of George Osborne setting fire to a disabled nurse (with matches supplied by Serco, obviously)

  23. I visted Spain fairly frequently during the 2000s and the sheer quantity of construction activity in all regions was …..impressive. By 2008, it was clear that there were massive problems – half-built hotels and industrial estates with no gangs working on them, rows of completed buildings with no occupants. Frances’s link bears out my small sample impression.

  24. Tought Gang (23), speaking of Dr Clarke, I’ve been trying to post comments at his place pointing out that his grand scheme for building vast amounts of self-financing new social housing doesn’t work because he’s ignored the running costs (like Livingstone’s idea for an electricity company).

    Not surprisingly, they haven’t been allowed on.

  25. Frances (#22), you’re probably right, and that’s a much more reasoned explanation than PaulB’s original claim.

    PaulB (#21), thank you, interesting that one index gives almost twice the fall as the other. The difference seems to be in the peak, where Halifax rose much higher than Nationwide.

    Something to do with the different markets that they’re servicing? I suspect Halifax is more northern & Nationwide more southern, but you’d expect that to give the opposite result.

  26. Richard: the fall in the Nationwide index from peak to trough was 19%, not so different from the Halifax’s 22%.

    The point is that neither of these falls represents the bursting of a bubble – there is more than sufficient non-speculative demand for UK property as shown by the recovery from the trough. The UK property market really is not much like the Spanish property market.

  27. PaulB, then that is an interesting difference between the two indexes – the Halifax one is stil in the trough. Now (April 2012) is still only 2.5% above the lowest point (March 2009).

    That fits – the South (where Nationwide is stronger) doing better than the North (where Halifax is stronger).

    But Halifax is much bigger. Nationwide is less than 10% of the market, Halifax used to be over 20% just on its own, now it’s 28% as part of Lloyds, plus better geographic coverage.

    So I’d tend to go with the Halifax figures. And they show house prices a third down in real terms, and still no recovery from the trough after more than 3 years.

    That’s starting to look very much like the bursting of a bubble.

  28. Also on whether we had a house building bubble in the UK:
    – 185,000 new homes were built in 2006
    – just 109,010 in 2011.
    and we’re still below 2008 and 2009 levels, so no sign of a recovery.

    That’s a drop of over 40% – pretty hefty. If that isn’t bursting bubble levels, it can’t be far off.

    The North West went from building 25,000 new homes a year in 2006 to 5,000 in 2009 – an 80% drop. It’s still less than 10,000 a year now, and I suspect a lot of those are public sector rather than market-driven.


    We have over 1,000,000 finished and unsold flats and houses (maybe it has dropped a little). The banks are starting to sell off repossessed property at fire sale prices (I suppose covering whatever debt was outstanding) and in the process proces have fallen and will (and must) fall more.

    Cheap money from Europe (the politicians are the real villains in this). People were taking out loans for 120% of the (already excessive value) of the property, to buy a car (and not a low-end model). Of course, all the individuals blame the banks. The used to call saying ‘don’t you want a loan?’.

    Part of the problem is also the type of housing (second residences) and the quality of the location (frequently unattractive), but the major problem now is the landbanks built up by construction companies and the loans they used to do so.

    All this links into high unskilled unemployment of kiddies who left school without qualifications at 16 and who were taking home €2,500/month at the height of the boom as little more than hod carriers, and who now have nothing (of course the first thing they did was buy a trendy car on credit) and no prospect of work.

    Immigrants flooded in (not all graduates unsurprisingly) from South America and North and central Africa to do the low level stuff in agriculture.

    25% unemployment. 50% youth unemployment. House values falling, cajas insolvent, and a flourishing black money labour market.

    And now we have the 15M movement back again warbling on about cutting the cuts.

    We live in interesting times.

  30. I’d be interested on the commentariat’s take on this:
    The paper down here recently ran an article describing how banks who have been left half completed developments when the developers have gone bust are financing the completions themselves. It’s claimed, of course, they’ll be the saviour of the building industry, jobs, yada, yada.
    To my mind, completing the development, then putting the houses/apartments into an already way oversupplied property market just means other developers are unable to complete & sell their projects, go bust & leave the lenders with the uncompleted buildings. A circular waste of time & resources. What do we need a building industry for anyway? We don’t actually need much built for the next decade or so. What is needed, plus repair & maintenance would keep the skillsets ‘live’ to train new workers when they are wanted. The time that’s going to take, a high proportion of the labour force who’s jobs are supposed to being ‘saved’ wouldn’t still be active in the industry anyway.
    I’m suspecting this has more to do with bank’s balance sheets & where they are showing the liabilities than sensible business strategy. Am I right?

  31. What’s sensible for the banks, in terms of their on-book development assets, is not necessarily the same thing as what is sensible for the building industry or the wider economy?

  32. Frances; I fear you may have mis-interpreted slightly. I was trying to say that the ability to securitize and sell on mortgages within complex products allowed the banks to extend credit further than it would otherwise have gone. This is, fundamentally, what drove house prices higher as it allowed more and more people to enter the market, grab a mortgage, bid up prices, and so forth…. Sure, loose monetary policy played a role too, but why did we have loose moentary policy? The orthodoxy was that we conqured the buisness cycle with financial innovation harmlessly diffusing risk through the system, and hence could except low inflation and growth for ever. Ultimately, my point is that derivatives allowed a mindset that made the crash inevitable. Becuase of all the pseudo-scientifc pseudo-certainty, and that’s why they need to be regulated; to stop quants with no economics training and economists without the math from hiding bloody obvious idiocies in pretty models.

    Also, like, “principally, shortage of housing” ? How does a fundamental problem lead to a bubble exactly? Given that there’s been neither a significant drop in population, or rise in hosuing stock, why did house prices fall in the first place? There has to be more to the story than that…

  33. Or, more pithily;

    Why was northern rock so willing to catastrophically over-extend itself in the loan market?

    Because it thought it would be able to securitize its loans.

  34. Probably no-one is still reading, and forgive me if I’m rambling, but I’m still trying to refine the thought.

    I guess the model I have in mind is some kind of neo-Keynesian multiple equilibrium kinda jobbie. With the equilibria reached being determined by confidence levels. I guess implicilty I’m suggesting that kinks in SRAS lead to a (some?) short-run equilibria which are above the long run equilibria, and eventually cause a rebound.

    What I’m saying is that derivitives played a large part in driving us into such an equilibria. Causing monetary policy to become too loose and lending to be tooo high, and hence a housing boom.

  35. Northern Rock was relying on short-term borrowing in the interbank market to fund much of its mortgage lending, picking up a useful interest rate spread. This looked like a good business – what could go wrong?

    What could go wrong is that when the mortgage market started going pear-shaped the interbank market declined to roll Northern Rock’s short-term borrowing.

    I see no reason to suppose that Northern Rock would not have followed the same disastrous strategy if mortgage securitization had never been heard of.

  36. Actually for the Northern Rock management it probably wasn’t a bad strategy.

    If everything keeps chugging along, you become a big player and bonuses all round.

    If everything goes pear-shaped then lots of other people will go down as well, so you’ll just be hidden in the mass shambles.

  37. Mat

    What PaulB said. Funding long-term lending in the overnight repo market was Northern Rock’s main problem. And it was HBOS’s main problem too – it was no accident that HBOS was forced into bed with Lloyds within four days of the Lehman collapse. Securitization really had little to do with either bank’s failure.

  38. What’s this then?

    Excerpt follows, but read the whole thing and follow the links if you’re curious:

    Home page – Financing SMEs – Financial instruments – Other financial instruments – Derivatives Markets in Spain

    There are two different types of derivative: organized products and over-the-counter products.

    Organized derivatives are those that are traded, registered, settled and cleared through regulated markets, which have clearing houses and which guarantee users that the transactions will be carried out correctly. The general features of the contracts taken out for this types of derivative are usually highly standardized.

    … OTC products are traded, settled and cleared in non-regulated markets, where the each party assumes the risk corresponding to the counterparty (there is no clearing house). These products occasionally show a certain level of standardization but they are generally characterised by their customized design, dictated by the amount in question, date and other characteristics included in the contract.

    The range of OTC derivatives is enormously varied, as financial innovation leads to the creation of new products. The most frequent OTC products in Spain are as follows:
    Forwards (public debt, currencies and inter-bank)
    Ordinary options
    Swaps (interest rates, currencies, assets and shares)
    Caps, floors and collars. Exotic options (synthetic, lookback, Asian, average strike price, conditionals, different underlyings, etc)
    Swap options (swaptions)
    Protected bonds, warrants, convertible, exchangeable, preferential subscription rights and other products that are structured based on interest rates, currencies and stock exchange quotations of shares and indices.


    MEFF (Spanish Market of Financial Futures) Fixed-Income securities

    This institution is located in Barcelona, and is responsible for managing and supervising the market of derivative products where the underlying are fixed-interest securities or interest rates, in euros as well as in other currencies. It has its own system for settling and clearing transactions. Some of the products traded are:

    Option contracts:
    Bonds for 3 years
    Bonds for 10 years
    MIBOR for 90 days
    Futures contracts:
    Bonds for 3 years
    Bonds for 10 years (the most important product)
    MIBOR for 90 days
    MlBOR for 360 days

    MEFF Equities

    This institution is located in Madrid and is responsible for managing and supervising the options and futures market on the IBEX 35 index and options on shares. As is the case with MEFF Fixed-interest Securities, it has its own system for settling and clearing transactions. Some of the products traded are:

    Option contracts
    Options on IBEX-35
    Options on shares
    Futures contracts
    Futures on the IBEX-35 index

    Both organizations depend completely on MEFF Sociedad Holding, whose headquarters are located in Barcelona and whose function is coordinate both markets. While MEFF Fixed-interest Securities is a purely wholesale market where the majority of participants are more than 700 banks from all over the world, MEFF Securities is devoted to individuals who have a relative stake of more than 60% in the volume traded.

    As their organizers, the main functions of these companies in the derivatives markets are as follows:

    They define the types of contract or derived securities to be traded.
    They establish what brokers can work directly in the market (clearing member).
    They operate as a clearing house between the buyer and the seller always acting as the counterparty. They only buy and sell at the same price.
    They set the guarantees required from brokers assuming future agreements.

    More information

    Spanish Confederation of Savings Banks – CECA

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