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A blast from the past

-Donal Curtin

Friday 14th December 2007

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Most of us have only seen a run on a bank on newsreel footage of the Depression of the 1930s. Who'd have thought that in 2007 we'd be watching British families queuing round the block to get their money out of Northern Rock? Or that there'd be a chain of events starting from American families with mortgages and leading to a clatter of finance companies and managed funds going down in Australia and New Zealand? Here's how it unfolded - and some lessons for the future.

Start with that American family. Lured by booming US house prices, they take out a mortgage they can't really afford (a 'sub prime' borrower). The bank that lends them the money doesn't keep the mortgage on its books, but parcels it up with other ones and sells them en bloc to a clever dick. This clever dick rearranges the income from the mortgage repayments, creating very safe investments (with fairly low yields) that have first dibs on the repayments, and various riskier investments (with fairly high yields) that have lower ranking claims on the money. The clever dick sells these re-sliced investments to fund managers, and the fund managers sell them to you and me. To boost returns, some of these fund managers borrow money to buy these re-sliced investments. The gun is now loaded.

The American family defaults. On its own it's no biggie. But the lending losses have been concentrated in some of those riskier re-sliced investments, which have essentially said, 'hit me with the first losses'. They've also been amplified by the effect of leverage - so much so that small levels of mortgage default, by the time they've been concentrated and amplified, can completely wipe out the value of the money invested in the riskiest versions. As indeed happened with the first high profile casualties, two funds run by the American firm Bear Stearns. The gun has gone off.

Now everyone starts looking suspiciously at everyone else. Because these dangerous investments are now globally dispersed, nobody knows where they are. Everyone starts wondering, who's the next Bear Stearns? So banks stop lending to each other (triggering the Northern Rock crisis, because it relied on other banks for much of its funding). And investors globally head for the safety of the most highly rated boltholes. Runs start, and once they start, they compound each other as each company's liquidity problems spread to the others (the other UK banks wouldn't lend to Northern Rock because they needed the cash for themselves, in case they were next).

Lessons are, supposedly, being learned from this, but not all of them look terrifically valid. The end of finance companies as we know them? Very likely not: they fill a niche, and will still be around when the dust settles. The end of finance company debentures? Not likely either: there's nothing intrinsically wrong with funding yourself from the general public (ask any High Street bank). Flaws in regulation? Maybe, but regulation's been oversold: it's not wonderful at preventing new types of crisis, though it can help prevent reruns of the last ones.

The lessons I'd take away are a bit different.

Some central banks (and the Fed and the Bank of Japan are squarely in the frame) need to realise they helped create this mess by leaving monetary policy too loose for too long. Cheap and easy money creates bubbles, where assets (like Japanese property and shares in the 80s, and US housing more recently) get bid up to silly prices, and it can make an unholy mess when they burst (as we're discovering). There's been a big debate in recent years about whether central banks should pay attention to 'irrationally exuberant' asset prices. This year, I reckon that debate has been settled in favour of 'yes, they should'.

Central banks, as prudential supervisors, also need to stop making pointless distinctions between banks, non-banks, and collective investment vehicles: they're all interlinked, as we've seen. And while most central banks have been good at trying to unblock the liquidity gridlock, some have fluffed the basics of stopping a run. The Bank of England, in particular, has looked (actually was, to be honest) a complete ass. The danger of a system-wide run is that it takes the good banks down with the bad, a point utterly missed by the bank's governor who was against saving the good ones in case it protected the bad. Fortunately the UK government had the gumption to intervene, overrule and guarantee Northern Rock.

And then there's you and me, who could usefully do two things. It's extraordinarily dull and boring advice, but now would be a good time to repeat the mantra of diversification. Spread your money across different firms and different kinds of assets, and you won't have to sweat it out with all your life savings in Bear Stearns, Northern Rock or Bridgecorp.

And the other thing - not blinding rocket science, either - is understand what you're buying when you invest. That nice chap from the brokerage who has a high-income fund: do you really need to know what a CDO or an RMBS is before you sign up? You wouldn't buy ten grand's worth of second-hand car without checking it out (or having an experienced mate do it for you), and you shouldn't buy ten grand's worth of investment with any less care for how it works.

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