9 - Financial indicators and the global financial crash

Summary

In 2007 and 2008, large swathes of the global economy were plunged into the biggest financial crash and economic recession since 1929. Problems surfaced first in countries with large banking sectors and those that had heavily gorged themselves on private-sector debt, especially in the United States and Europe, with some Middle-Eastern and emerging economy flavouring. The trigger for previous major ‘global’ recessions had usually been some sort of shock: an oil price spike, war, inflation, a technological disturbance. This time, collapse was linked to the malfunctioning of the financial system itself. It was aggravated by financial firms engaged in an intense battle to redistribute the fruits of economic activity towards themselves.

There is value in viewing the financial crash through a fresh lens, that of the indicators at the heart of the financial system. We start with the metrics used to measure and manage risk. We proceed to credit ratings, manufactured by specialist agencies to a set of recipes, seasoned with their own opinions, and applied to just about anything of financial interest. Then, we turn to the information generated by markets in financial instruments, such as Asset-Backed Securities (ABSs), and derivatives, such as Credit Default Swaps (CDSs, a form of insurance). With the ‘market’ being increasingly used to manage and regulate financial behaviour, such ‘market-based’ prices were taking an ever more central role. Finally, regulators relied upon a range of indicators of bank capital and (not especially) bank liquidity (i.e. the ability to convert assets into cash at little notice).

We immediately face a puzzle. If financial indicators pointed to dangers and yet were ignored, that would be one thing. However, just before the crash, all the standard financial indicators declared the financial system safe. Credit ratings for financial firms flashed up strings of As. The prices of CDSs (i.e. the cost of insurance) on bundles of loans, especially subprime mortgages, were at record lows. Banks were deemed well capitalized, and regulators were proving adept at looking tough. A Eurozone crisis was even more unlikely, according to the ratings of, and interest rates charged on, the sovereign debt of Ireland, Greece, Spain, Italy, Cyprus and others, and the costs of insuring such sovereign debt against default as expressed in the prices of CDSs on it.