In the northern summer of 2005, house prices in the USA stopped rising and went into absolute decline for the first time since the Great Depression of the 1930s. The reasons for this were several. In reacting to an earlier period of recession the US central bank (the ‘Federal Reserve’ or ‘Fed’) had, over the period May 2000 to December 2001, lowered interest rates from 6.5 per cent to 1.75 per cent, historically a very low figure. This reduced the cost of borrowing and bid up house prices. Increased affordability encouraged potential homeowners and investors into the market, and the rising prices and the opportunities for windfall gains encouraged aggressive promotions by real estate agents. In the laissez-faire economic environment of the time and with such low interest rates in play, lending standards dropped below traditional regulatory guidelines, and what became known as sub-prime mortgages proliferated. In early 2004 the Fed reversed its interest rate policy and began raising rates in order to fight an emerging inflation, raising them 17 times from 1 per cent to 5.25 per cent between 2004 and 2006. With these higher rates some new homeowners were plunged deeper into debt. Those with adjustable rate mortgages often found that they were holding a mortgage debt greater than the value of their house: walking out and leaving the house to the mortgagee became the option of choice for many. The scale of this quiet crisis was substantial. In March 2007 the value of US sub-prime mortgages was $1.3 trillion with over 7.5 million first-lien sub-prime mortgages outstanding. In October of that year 16 per cent of all sub-prime loans with adjustable rate mortgages were 90-days delinquent or in foreclosure proceedings. In parallel developments, a speculative bubble1 was emerging in financial markets. Traditionally, High Street banks have operated in the housing market by making loans to purchasers, funded by deposits. The bank holds the mortgage as security against the flow of regular mortgage repayments until the loan is redeemed (in the US usually over a 30-year period). In the ongoing boom in demand for housing credit in the decades following the Second World War, the banks and other lending institutions sought ways to augment their sources of mortgage funds. In the early 1980s the first of what became known as collateralized mortgage obligations (CMOs, and more generally collateralized debt obligations, CDOs) were introduced to the market. By pooling a number of mortgages

and then reassembling their financial elements and splitting them into a number of tranches, banks found that they could market the mortgages as securities in the form of bonds. Commonly the marketing of these securities was not carried out by the High Street banks and mortgage writers themselves, but by investment banks with which they were associated. As financial instruments, CMOs developed rapidly. The scale of their success can be gauged by the fact that in the first six months of 2004, $192 billion in new agency CMOs were issued, bringing the total volume of outstanding CMO securities at that time to nearly one trillion dollars. Ratings agencies such as Standard and Poor’s, Moody’s, and Fitch gave the securities high credit ratings, extending up to the highest AAA rating, the equivalent of US Treasury bills2 and the debt of long-standing and secure corporations. At the centre of this great expansion of financial activity stood the Wall Street investment banks. As banks concentrating not on holding deposits but on financing large scale investments, they were lightly regulated in comparison to the High Street banks, and could be much more highly leveraged.3 Many investment banks marketed CDO products and borrowed against them as collateral. Meanwhile overseas subsidiaries of these Wall Street investment banks sold CDOs to clients around the world, and investment banks in other countries did their best to replicate the Wall Street model in marketing finely engineered financial products. The burgeoning of financial wealth based on this expanded credit led to soaring share prices and the longest bull run ever experienced on the New York stock exchange. When US house prices went into decline in 2005 and mortgage defaults started to appear, the asset backing of the CDOs and the whole hyper-expansion of stock market activity was called into question. Doubts created waves of anxiety which spread out from real estate institutions into many sectors in the financial economy. Companies holding CDOs became uncertain of their value because, unlike Treasury bonds, there was no visible trade in CDOs and no market to establish their value. Estimates of ‘fair value’ were open to wide interpretation, as the slicing and dicing of the original mortgages made such estimates impossible to make with confidence. Uncertainty and fear increased the reluctance of companies to hold CDOs. As confidence ebbed away companies which had borrowed money on the basis of CDOs as collateral were faced with margin calls4 on their borrowings and the necessity of cashing in their holdings of CDOs as prices plummeted. Unable to pay their debts, bankruptcies ensued. As asset prices fell, so did liquidity. Available loans – if they could be found – were denominated at higher interest rates and for shorter times. As liquidity fell, so did investment. As 2007 opened, home sales in the US continued to fall. In February the subprime mortgage industry collapsed, with more than 25 sub-prime lenders declaring bankruptcy, announcing significant losses, or putting themselves up for sale. Shares worldwide fell heavily on fears of further sub-prime losses. In the financial reporting season of October-November 2007 many large international banks admitted multi-billion dollar losses and write-downs of assets: in the USA

Citigroup wrote down losses of $8-$11 billion, Merrill Lynch $7.9 billion, Morgan Stanley $3.7 billion; and in Europe announced losses included Swiss bank UBS ($3.4 billion), Deutsche Bank ($3.0 billion), Credit Suisse ($1.0 billion). All these numbers would be revised to higher values as the ramifications of the crisis and individual exposures became more apparent (BBC News 2008). And the financial devastation continued into 2008. In mid-year the skies cleared briefly, with little in the way of sensational revelations to match those that had gone before. But this was merely the calm before another storm. On 7 September the Director of the US Federal Housing Finance Agency announced that he had taken the government-sponsored home lending institutions Fannie Mae and Freddie Mac into ‘conservatorship’ – that is, they had been nationalized – after both suffered heavy losses ($14.9 billion) and an inability to raise capital. On Sunday 14 September 2008, investment bank Lehman Brothers announced that it was filing for bankruptcy with debts of $613 billion, the biggest bankruptcy in US corporate history. On the same day, it was announced that Merrill Lynch had been sold to Bank of America. In reaction on the Monday, the Dow industrial average on the New York stock exchange suffered a fall of 504 points, its largest in seven years. On the Wednesday the US Fed agreed to provide an emergency loan of $85 billion to the world’s biggest insurer AIG, a $31 trillion company with branches in 130 countries, in return for ownership of as much as 80 per cent of the stricken insurance giant. The discount rate on 3-month US Treasury bills briefly went negative – that is, investors were paying the Treasury to look after their money. On Sunday 28 September it was reported from Europe that a rescue plan had been agreed for British mortgage lender Bradford and Bingley, and that Fortis, the largest bank and insurance broker in the Benelux countries, would be partially nationalized in return for a €11 billion cash injection. On Tuesday 30 September, the Belgian, French, and Luxembourg governments rescued Dexia, the world’s largest lender to local governments, with a capital injection of €6.4 billion. On Sunday 12 October the UK government announced that it was in negotiations with banks HBOS, Barclays, Lloyds TSB, and Royal Bank of Scotland with regard to their recapitalization in return for a significant equity stake. By month’s end whole countries were suffering the onslaught, as it became clear that Iceland, the Ukraine, Belarus, Hungary, and Pakistan were each in discussions with the International Monetary Fund for emergency loans. Russia, Japan, and China all announced multi-billion dollar rescue and stimulus packages. In a matter of months billions upon billions of dollars had been wiped off the money value of assets held not only by banks and financial institutions around the world, but in the value of assets of individuals held in pension funds and investment accounts. But what was dubbed as the Global Financial Crisis (GFC) was also having severe repercussions in the real economy as well. In its year-end economic outlook report the OECD estimated that the number of unemployed in Member countries could rise by 8 million over the following two years (OECD 2008: 3). The World Bank (2008) attested that some developing countries would be hit much harder than the average, and that tighter credit conditions combined

with food price shocks would undermine the abilities of many of these countries to respond to existing poverty.5