The Titanic Approaches the Ice Berg
So the most complex system ever engineered by human beings was functioning reasonably well in 2003. What happened?
Several things, actually. The first was extremely low interest rates in the United States and in most of the Western world. On June 27, 2003, the big banks in New York lowered their prime lending rate to 4%, the lowest it had been since 1958. There were many reasons why this happened, but the most important reason was that the financial system was filled with too much money sloshing around in the big institutions. All that excess global liquidity did not flow into your local savings and loan; it flowed into the really big banks with big reputations, mostly in New York and London, the so-called money center banks. In 2003 there was simply too much money and too few good investments. In bankers’ parlance, money was “easy” – easier than it had ever been since World War Two.
After the Tech Bubble popped in late 2000 and early 2001, global investors moved out of the stock market in huge numbers and parked their assets in cash. This extra cash, when combined with the huge surpluses piling up in China, India, and Japan, when combined with the massive tax cuts in the United States that gave wealthy individuals more money to invest, created a surplus of dollars. These dollars literally burned a hole in the pockets of the big money center banks in New York and London. They desperately needed a safe way to earn a return on this cash. Remember, the biggest banks in the world also had the biggest overhead in the world – the most buildings, the most employees, the highest electricity bills, the most expensive dividends to pay, and the most debt themselves – and they could not afford to let all that money sit idle. With interest rates so low, the big banks could not earn enough of a “spread” – the difference between their cost of funds, i.e., the interest they paid their depositors, and the amount of interest they could earn by making loans to businesses. They needed some new ideas.
In the past banks had been able to invest in instruments like government bonds and high-grade AAA corporate bonds, and these investments had returned enough interest to cover their cost of funds, their overhead, and a little profit. But in 2003, interest rates had fallen to historic lows. Many banks big and small could no longer earn enough money with these very safe investments to pay their overhead and continue making a profit. So they began to think about investing their excess cash in new kinds of investments that were not as safe as those they had funded in the past.
But bankers did not go completely daft. They did not walk like lemmings off a cliff. They thought it through very carefully first, as is their nature.
The Best Financial Idea of All Time
A new kind of financial derivative, called a credit default swap, seemed to be just exactly what the financial world needed at that exact moment. Credit default swaps had existed since 1997, but had never been widely used or extensively tested in stressful market conditions. Credit default swaps, abbreviated CDSs, were basically a form of insurance on bonds and other debt instruments. The issuer of the credit default swap – often a big insurance company like AIG, but sometimes a hedge fund or a large investment bank – agreed to pay the bond holder in the event the bond defaulted. For assuming the risk of default, the issuer of the swap charged a fee, initially between one and three percent of the value of the bond or debt instrument for five years of default protection.
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