It's by now a familiar story of the financial crisis: German and Icelandic bankers keep finding themselves the owners of mortgages on grandmothers' houses in Kansas, and it's hard to decide which side is more befuddled by it. The Federal Reserve yesterday went one step further up the value chain, publishing an interesting discussion paper called “ABS Inflows to the United States and the Global Financial Crisis" and adding some data and nuance to the story of how we got to a world where a banker flapping his arms in Saxony causes a foreclosure in Topeka.
The Fed researchers started out from a popular explanation of the financial crisis, that a “global savings glut” in certain countries (above all China but also other emerging markets, the OPEC countries etc.) inflated an asset bubble in the US as foreign savers searched for safe but yieldy investments. The puzzle with that theory, though, is that the Chinese didn’t really buy subprime ABS. They bought – and still buy – Treasuries, which worked out well for them. Europeans bought the shit:
Asia and the Middle East put almost all of their dollars into Treasuries, while Europe put the bulk of theirs into corporate debt and ABS. And Europe was not a savings glut region – on balance it ran a moderate current account deficit. So where did Europe get the money to buy our toxic mortgages? They borrowed it from the Chinese:
In the run-up to the financial crisis Europe increased its borrowing mainly from the emerging markets (pink bar above, decent proxy for savings glut countries), while it increased securities purchases mainly from the US (purple bar). As the researchers put it:
Hence, the global saving glut countries not only provided financing to the United States directly through purchases of U.S. assets, but also indirectly through purchases of European assets that in turn financed purchases of U.S. assets. Moreover, European liabilities to the saving glut countries were primarily in the form of safe assets such as government bonds and bank deposits, whereas many European claims on the United States were in the form of ABS and other structured credit instruments that later proved quite risky. Accordingly, Europeans had
considerable exposure to the subsequent crisis (as illustrated by the diagram of the “triangular trade” in financial assets). Ironically, in this regard Europe was acting as an international hedge fund, a role that previously had been attributed to the United States.
The paper then looks into the effect of these flows on interest rates, though it's undermined a bit here by limited data and a lot of moving pieces. Ultimately the researchers build a toy model and conclude:
The model suggests that in the years leading up to the crisis, purchases of U.S. Treasuries and Agencies by the GSG countries depressed 10-year Treasury yields on the order of 140 basis points, and the spillovers from this outcome likely lowered ABS yields by some 160 basis points. The model also indicates that, even though much of Europe‘s acquisitions of U.S. ABS were financed by "reverse" flows of U.S. investments into European liabilities, the effect of this exchange was to lower ABS yields by about 60 basis points and Treasury yields by 50 basis points; if we include the effect of European purchases of non-ABS U.S. corporate debt as well, these declines deepen to -160 basis points and -130 basis points, respectively. The combined effect of all of these inflows on U.S. interest rates would have been huge, but of course actual declines in these yields were much smaller, as the supplies of the assets to the market rose substantially as well.
Thus "GSG" (global savings glut) countries, mainly China, did two things to drive European purchases of subprime ABS: they bought European government bonds and bank deposits, giving the Europeans money to put into ABS, and they bought US Treasuries, driving down US risk-free rates and sparking European investors to seek yield in riskier-but-still-AAA securities.
So the story seems to be that Europe borrowed money in classically risk-free forms (bank loans and government debt) in order to lend it in risky but supposedly safe forms (AAA tranches of subprime ABS). The 2008 financial crisis was the result of that, as the Europeans (and Americans) found that their AAA mortgages weren't as safe as they'd thought. Oversimplifying a bit, you could read the Fed's paper to suggest that the 2011 crisis, centered as it is around European governments and banks and symbolized by sovereign debt downgrades, is the next stage of that crisis unwinding - as Europe's internal and external creditors find out that their AAA banks and governments aren't as safe as they'd thought either.