The Economist: Investment: An A-Z Guide

Investment’s past and future
In the summer of 2007 it simply could not get any better. It was not just because stockmarkets throughout the developed world had recovered convincingly from the shocks doled out in the first years of the 21st century after the so-called dotcom bubble had burst. As a result, for example, the FTSE All-Share index of share prices in British companies had risen 118% from the low point to which it had fallen in early 2003. It was also because lesser-known financial indices, which were supposed to point out troubles ahead – those that measured the riskiness of share and bond markets – were behaving about as placidly as was possible.
And why not? After all, the world was growing strongly and the International Monetary Fund had just upped its forecast for global growth for 2007 from 4.9% to 5.2%; inflation, by and large, remained under control; and investors of all shapes and sizes were awash with cash to invest. In other words, there was liquidity by the bucket-load. So who would imagine that the crisis, when it emerged, would begin pretty much as a conventional credit squeeze where borrowers go to the wall because they cannot get the financing they need?
That said, there was something unusual about this crisis right from the start. The borrowers that went to the wall first were banks. The institutions that controlled the flow of credit from lenders to borrowers were the very ones that were unable to get the financing they needed to conduct their own operations. This malign twist in business life was first revealed in the sudden demise of Northern Rock, a British mortgage bank that had shaken off its origins as a building society owned by its depositors and got its shares listed on the London Stock Exchange.
As it turned out, Northern Rock’s errors and shortcomings were typical of much of the developed world’s banks. But Northern Rock was also growing fast – too fast. From being just a regional player in the north-east of England in the 1990s, it got itself into the position in early 2007 where it was providing almost one in five of all new residential mortgages in England and Wales, a higher proportion than any other lender. But only a small amount of the funds it needed for all these loans came from its own branch network. Instead, Northern Rock relied on what is called the wholesale money market, an informal global network of financial institutions that borrow from and lend to each other.
Securitisation surge
Furthermore, Northern Rock used this network in a way that was becoming increasingly fashionable: it raised funds for new mortgages by selling tranches of existing mortgages via a process known as “securitisation”. It would arrange to have thousands of its mortgages poured into a so-called reference pool and from this pool tranches of securities would be created and sold to eager investors. Buyers were keen because tranches could be shaped to meet almost any investment need: low-risk/low-return through to high-risk/high-return and all points in between. Indeed, even the low-risk tranches, the ones with the best quality, could offer comparatively high pay-backs because their intrinsic quality meant they could be combined with debt to lever up their returns.
However, the success of securitisation proved to be its undoing. There was too much of it. At its peak in 2006, 80% of the $600 billion of sub-prime mortgages made in the United States (that is, mortgages to comparatively high-risk borrowers) were securitised. In contrast, the respective figures for 2001 were 50% of $190 billion. At about the same time, banks were lending more via securitisations than through conventional loans that they kept on their balance sheets. As the amounts raised via securitisation rose so standards fell, and, by early 2007, it was becoming clear that sub-prime loans made after 2004 were of inferior quality to those made before. This made buyers of securitised assets increasingly wary as bad debts spread throughout America’s overheated housing market. Tension rose higher when, in the summer of 2007, Bear Stearns, an American investment bank, revealed that two hedge funds it ran had been all but wiped out by losses on securitised mortgage bonds where too many mortgage holders had failed to pay what was due.
So later that summer it was openly questioned whether Northern Rock would be able to raise billions from a securitisation issue that was planned for September. Yet the bank’s acute need for more cash was also well known. It had raised almost £11 billion from securitisations in the first half of 2007, though nothing since May. Meanwhile, its mortgage book had continued to grow quickly, but Northern Rock had little in the way of alternative lines of credit that it could tap and – worryingly – its share price had started to fall fast.
Northern Rock cracks
Then Northern Rock’s retail depositors – the people who had savings accounts with the bank – realised what the UK’s central bankers and finance-industry regulators failed to grasp, or refused to acknowledge: that Northern Rock would not be able to raise further funds via a securitisation so it was effectively insolvent. As a result, they demanded their money back. In a remarkable piece of spontaneous action they formed neat, orderly queues throughout Northern Rock’s branch network and staged the first run on a British bank since Victorian times. And they did not leave till the UK government had guaranteed all of the bank’s deposits, by which time it was effectively nationalised – a state of affairs that was formalised early in 2008.
Where Northern Rock led, others followed – mostly in the United States – culminating in a devastating period in September and October 2008 when the US financial system was closer to a meltdown that it had probably ever been. Within the space of ten days, the US government effectivel

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