Who is to blame? Start with the Chinese for saving too much money, and the Americans for spending it. The Australian government, regulators and banks cannot escape responsibility either.
Borrowed money paid for a new gilded age in many Western countries between 2000 and 2005. This is the story of how it all went wrong, and who was responsible.
The basic cause was too much easy money, and the reason was the phenomenal growth of China. To boost its exports, China held down its currency against the United States dollar. It then lent its huge pool of US dollar earnings back to US investors and consumers - at rates set low by then US Federal Reserve chairman Alan Greenspan to avoid a recession after the dotcom crash. The US and the rest of the world was awash with cheap money waiting to be lent.
Money looking for somewhere to go pushed up the price of assets such as shares, companies, infrastructure - but most of all US property. It created the first global asset bubble in history. Churning the money around was an overblown finance sector, increasingly a highly profitable end in itself.
The Chinese and the Americans were not the only ones at fault. Other governments, including those in Australia, encouraged share ownership without outlining the risk. Regulators, including the Reserve Bank of Australia and the Australian Prudential Regulation Authority, allowed asset prices to soar. And the banks took full advantage of the easy money, lending too much without taking into account the risks.
However, no one could beat American enthusiasm for debt. In the race to lend money anywhere for anything, any regard for lending risk disappeared. By June last year, CCC-grade junk bonds issued by high-risk companies were selling as cheaply as no-risk US Treasury bonds. For the first time in history, investors in debt were paying to take the risks, one observer noted.
At the leading edge of the credit boom were US sub-prime mortgages, encouraged during the recession-hit Carter era to house America's working poor. By the loose-money Bush years, sub-prime loans had been transformed into an unintended lending free-for-all. The failure of poor borrowers to repay, often a certainty because of the teaser rates used to lure them in, did not matter to lenders because the price of houses was rising constantly.
The big money to be made out of all this lending and borrowing was in the use of credit derivatives - once used to spread risk but seen increasingly as a means to extract even more profit from the debt business.
In late 2006, US house prices finally peaked to embark on a national slide of 20 per cent - or more than 40 per cent in the high-growth sunbelt states - by 2008. Sub-prime loans comprised only 13 per cent of US mortgages but the taint began to spread rapidly. By July last year, agencies started down-rating hundreds of millions of dollars in bonds backed with defaulting mortgages.
The credit crunch began on August 9, 2007, on the other side of the Atlantic in Paris. French bank BNP Paribas froze two of its investor funds holding US sub-prime bonds, saying they were unsaleable and therefore could not be valued.
As the implications for bank finances of a souring of such widespread "assets" started sinking in, the European Central Bank pumped $US150 billion into money markets to pre-empt a sharp rise in lending costs as banks took fright. The US Federal Reserve followed suit, but failed to quell rising panic over securitised bonds and other derivatives.
The problem: banks did not know - and still don't - who was holding dubious and still little-understood mortgage derivatives and other bad bonds and loans. This is known as "counter-party risk" - the fear that the other institutions they trade with cannot pay up. Banks would only lend money into the wholesale interbank credit market - essential to keeping the whole credit system working - at exorbitant rates to protect themselves.
It was this loss of basic trust, and the rising cost of using the credit system, which intensified until it came to a head in the debacles of September and October this year. Risk, in bank jargon, was being "repriced" upwards, with a vengeance.
Investors fled first from banks' off-balance-sheet "special investment vehicles", forcing the banks to take their dubious debt assets onto their own balance sheets, further restricting their ability to borrow or lend.
The investment banks were next to be hit. Deliberately kept lightly regulated, they had borrowed up big to lend and invest compared with the amount of equity capital they actually held. They became too thinly capitalised to carry their own debt loads. Banks, investment banks and other debt-based companies that could no longer raise new capital started the huge process of "de-leveraging": reversing debt exposure by either writing off troubled debt assets, trying to sell them, or just hoarding capital - and starving other investors of the means to buy assets for sale.
In October last year, UBS and Citibank led the world's banks in announcing what would quickly become write-offs of $US500 billion in worthless or unsaleable mortgage debt instruments. The chief executives of UBS, Citi and Merrill Lynch were all forced to resign.
The situation proved worst for banks selling debts, bonds and derivatives as the loans they bought them with became due - or, in the case of hedge funds, investors wanted their money back.
The debt instruments were valued on a so-called "mark-to-market" basis: lucrative when markets were rising daily, and disastrous when they were collapsing. The market for these instruments became "illiquid": prices collapsed as the market disappeared, with buyers too spooked and unable to borrow to buy. This fire sale intensified as each quarterly bank reporting period came around. This hit the liquidity of the banks - and their ability to find ready cash to meet their debts. But asset write-offs and losses, plus months of crumbling share prices had also undermined their capital bases. The issue was no longer just liquidity or ready money - it was the solvency of dozens of banks.
The torrent started by the mortgage collapse had eaten through the thin buffers of bank capital faster than any regulator could have imagined.
Black September and worse
The stage was set for Black September - to be followed by an even worse October.
On September 2, the US government-backed mortgage guarantors Freddie Mac and Fannie Mae, with $US5 trillion in home loans, were nationalised following investor panic.
To generate ever more mortgages, regulators had allowed the pair to invest 40 times their capital in mortgages, compared with a ratio of 10 for regular bank balance sheets, leaving them hugely undercapitalised to face the storm. Financial-sector shares were battered as their shareholders were left to carry the losses.
Thirteen days later on September 15, the US government drew the line on more bail-outs, leaving investment bank Lehman Brothers to fail after huge derivative losses. The collapse had a disastrous effect on short-term money market funds that held Lehman debt.
These funds are normally considered safe institutions that lend money into the banking system overnight. For the first time, they were "breaking the buck", failing to return all the dollars invested. Investment of more than $US400 billion fled the money market. The result was another spiral of liquidity crises for banks increasingly reliant on short-term funding as long-term lending dried up.
On the same day, Merrill Lynch raced against collapse to sell itself to Bank of America. Lehman proved to be the turning point of a far deeper crisis.
Bad debts and losses were also battering the value of credit default swaps, used by investors to insure against borrowers going under (and, by some, to bet on them failing).
American International Group, the world's largest insurer, had written huge amounts of insurance on credit default swaps, mortgage securities and other derivatives. Banks also relied on the insurance cover to value the huge volumes of derivatives they still held. If AIG was forced to fold, credit markets would face a terminal blow.
On September 16, AIG was nationalised with a $US85 billion loan. In a measure of the complexity of such derivatives, the group reportedly underestimated its exposure to credit default swaps by a factor of 10. By November, the AIG rescue package had reached $150 billion.
Two days later, the credit crunch turned to credit freeze as the London US dollar overnight interbank rate spiked from 2 per cent to more than 6.5 per cent. Sharemarkets were leaderless and falling as global central banks pumped in $US250 billion to restart credit markets. Investors were suffering the worst crisis of confidence since the Great Crash of 1929 as fears that nothing was safe took hold.
A silent bank run was under way, not in queues on the street but in the back offices of banks and institutions as they refused to lend to each other. Instead, they hoarded their cash in case more of their transaction partners fell over, damaging their capital further. As interbank lending seized up, the economy was deprived of the credit it needed to function.
On September 19, fearing that a further shock would have unstoppable consequences, US Treasury secretary Henry Paulson proposed what was in effect a sovereign wealth fund in reverse, a $US700 billion plan to buy up worthless debt instruments to be sold when the markets recovered.
But on September 29, in a political stunner, the US Congress baulked at Paulson's rescue plan. At issue was popular resentment, ahead of national elections, that Wall Street was being bailed out while America's Main Street was losing the roof over its head. Wall Street suffered its biggest point loss in history - 770 points - to remind Congress members of the impact of the banking collapse on the real economy - and their electorates.
Congress finally passed the $US700 billion rescue plan on October 1. By then, the US was being criticised for incremental efforts that had not landed a decisive blow on the problem - with doubts rising whether the Paulson strategy of easing pressure on banks by buying up toxic debt from the credit system could be made to work.
De facto semi-nationalisation
Free-market ideology held the US back from the alternative: a direct injection of capital into the banks themselves, or de facto semi-nationalisation.
The weekend of October 11 and 12 was a tense one with meetings of the Group of 20 leading economies and Group of Seven leading industrialised nations in Washington as the world waited for action.
In the United Kingdom, Prime Minister Gordon Brown returned from Washington on October 13 and committed potentially almost a third of the UK's annual gross domestic product - compared with 5 per cent of GDP the US was spending on its bail-out - to strike directly at threats to bank solvency and liquidity. "There is no plan B," Brown warned.
His widely copied proposals tackled simultaneously the three big problems facing banks: a shortage of capital because of the huge losses and write-offs of assets; the inability to finance loans not covered by deposits because medium-term commercial paper markets could not be used; and no overnight liquidity because of the closure of short-term money markets.
Within hours, the Netherlands, Spain, Germany and Austria began committing $US2.6 trillion to guarantee bank loans and take stakes in key banks.
On October 14, the US also bit the bullet on nationalisation. At a meeting in New York, the US banks were told they must take up to $US250 billion in government equity, "for their own good and the good of the country". There was to be no negotiation.
Wall Street saw its biggest one-day rise in 75 years - but it did not last.
A week later, the fear of defaults had spread from banks to countries as diverse as Iceland, Pakistan, Ukraine, Belarus and Hungary that were forced to seek IMF help as hedge funds, banks and mutual funds recalled the heavy lending they had made to emerging economies.
The biggest danger in the 2008 crisis has been - and still is - that deleveraging will spin out of control into runaway "debt deflation" as falling asset prices make debts look bigger and bigger. This could lead to heavily geared borrowers defaulting in waves, 1930s-style.
All the efforts of central banks to keep money and credit flowing through the year have been aimed at preventing this from happening.
The global financial crisis blow by blow
3 October 2007: First Australian casualty: in just 10 weeks, RAMS Home Loans implodes from hot new listing in July to a fire sale to Westpac for $170 million on October 3 as the wholesale funding market it depends on vanishes.
December 2007: Highly geared Centro Properties has trouble rolling over $3.9 billion in short-term debt as crunch digs deeper into Australia.
January 9 2008: World Bank warns the credit crunch will hit the real economy and slow growth in 2008.
February 2008: Macquarie Group and Babcock & Brown suffer big falls. Complicated investment companies like Centro, Allco, Babcock & Brown and others that used cheap debt to buy fast-rising assets find the equation works savagely in reverse too. Allco goes into receivership in November, Babcock & Brown teeters weeks later.
March 17 2008: Bear Stearns, worth $17 billion one year earlier, is taken over by JPMorgan for $240 million. Collapse comes after more than $US1 trillion has been injected by central banks since August 2007 to kick-start credit markets and prices for debt instruments held by banks. Some investment banks recapitalise with Asian and Middle East sovereign wealth money, although this is soon burned up as yet more losses emerge.
April 8: International Monetary Fund estimate of total write-offs of bad debts and derivatives may double earlier estimates to $US1 trillion. The IMF warns damage will be "broader, deeper, more protracted" than anything imagined so far. Out of 50 million US mortgages, 9 million are in default.
June 2008: National Australia Bank survey shows first sharp downturns in consumer and business confidence.
July 2008: The dollar hits a post-float high of US98.49¢ as investors charge into commodities. The boom stokes inflation to make it a double whammy for the global economy.
July 25 2008: NAB announces the biggest Australian exposure to sub-prime crisis, with an $830 million write-off of sub-prime-related assets.
September 7: US government-backed mortgage investors are nationalised as investors panic.
September 15: US government allows Lehman Brothers to go under. Merrill Lynch sells itself to Bank of America.
September 16: AIG, world's largest insurer, is nationalised as prices of derivatives it insured collapse.
September 18: Wall Street slides in biggest collapse of confidence since 1929.
September 19: US Treasury secretary Henry Paulson announces a $US700 billion fund to buy tarnished debt assets.
September 29: US Congress baulks at Paulson rescue plan. Biggest points slide in Wall Street history. The Australian government gives $4 billion backing to non-bank mortgage lending.
September 30: Overnight US dollar LIBOR hits 6.88 per cent.
October 1: US Congress passes rescue plan.
October 8: Seven central banks announce co-ordinated rate cuts. Market panic continues as Chicago VIX index of market volatility - "the fear index" - hits 59.1. It usually trades at 15 to 19. By November 1, it will hit 89.
October 11-12: G7 and G20 meet in Washington as the world waits for action. In Australia, the government announces it will give unlimited guarantees on bank deposits to settle investor fears.
October 13: In the UK, Prime Minister Gordon Brown commits potentially almost a third of annual GDP to strike directly at bank liquidity and the solvency crisis. Other European nations launch similar schemes.
October 14: Federal government announces a pre-emptive strike against recession: a $10.4 billion fiscal stimulus package - half of the surplus. US bites the bullet on nationalisation. Major US banks are told they must take up to $US250 billion in government equity.
October 15: Wall Street's biggest fall since 1987, of 7.87 per cent.
October 21: RBA chief Glenn Stevens says that action by governments means the "likelihood of a global catastrophe has declined in recent weeks".
October 28: US Fed drops interest rate to 1 per cent to help prevent recession, falling from 5.25 per cent in just over a year. Interbank rates continuing to thaw slightly as banks lend government bail-out money - if not their own - to each other.
October 31: On the first anniversary of the S&P/ASX 200's peak of 6828.7 points, the index opens at 4001 points. October sees the biggest loss on the All Ordinaries since October 1987. The dollar hits its lowest point since its 1983 float.
November 4: RBA cuts another 0.75 per cent to saw 200 basis points off the cash rate in three months. It forecasts 1 per cent growth to June 2009 if rates stay at 5.75 per cent - flagging more rapid cuts as a certainty.
November 6: IMF forecasts first simultaneous recession across developed economies since WWII.
November 9: China announces $855 billion infrastructure spending to help keep it at the 8 per cent annual growth rate that will hold up demand for Australian minerals. At stake: $200 billion in future mineral investment for Australia.
November 15-16: Citigroup shares fall 23 per cent in one day as doubts grow over US government handling of toxic debt bail-out package. ASX/S&P 200 falls 22 per cent in preceding 12 days, completing wipe out of share-boom gains since 2004.
Debt, derivatives and destruction
One thing above all else has made this crisis as nasty as it is: the unravelling of huge trading by banks in derivatives, using borrowed money. The complexity of this collapse spread distrust through the whole credit system and froze its functioning.
This is ironic because derivative products were designed originally to ease the process of lending by spreading out risk.
The most well-known derivative involved in the crisis is the collateralised debt obligation, a kind of bond designed to spread the risk of mortgage lending. CDO originators pool mortgages together, split the bundle by different degrees of risk and, in a process called securitisation, sell those bits on to different investors with a share in the repayment stream. Each underlying mortgage may involve up to five or six or more buyers and sellers of the debt. These investors are all connected to each other if the mortgage defaults, although the chain is hard to keep track of. CDOs were not spreading the risk - they were hiding it.
CDOs had been invented in the 1970s to allow banks to fund mortgages for the bulge of US baby-boomer home buyers without straining bank balance sheets. But post-2000, the long period of low interest rates meant finance houses needed to find new ways to make money. CDOs could turn even the most unstable loans into tradeable assets - duly stamped gold-plated AAA by ratings agencies. The most lucrative market of all was high-interest sub-prime credit marketed to those who would never otherwise qualify to borrow.
US Federal Reserve chairman Alan Greenspan backed the view that derivatives and other financial innovations made an ever-expanding financial system actually safer than before, able to function well with little regulation and with less need for reserve capital. The US Congress passed laws forbidding anyone from regulating derivative trade.
Complacency then became recklessness. Trading derivatives for their own account had become hugely profitable for banks. In the case of US and European banks (although not Asian or Australian ones), they borrowed heavily to do so: going into debt to buy debt, using more debt as collateral. Welcome to the world of hyper-finance, where money made money out of money.
The rules also allowed banks to house securitised loans and other derivatives in off-balance-sheet "special investment vehicles" where they did not have to hold capital against them, vastly increasing the amount of debt instruments they could invest in without supervision. This created the so-called shadow banking system.
Until the music stopped, it was all highly profitable. Between 2000 and 2008, the issuing of credit derivatives rose 12-fold to $US3 trillion a year. Many banks raised gearing to 35 to 40 times to play this game - and between 2001 and 2007 they earnt a compound annual growth of 14 per cent compared with global economic growth of 4 per cent.
