Two Weeks in September


The Financial System circa September 2008

Roll over the various components of the financial system to see how they were involved in the financial crisis—and, by clicking on them, whether, five years on, some people blame them for causing the collapse.

Insurance Funds Insurance funds, with regulation and their resulting bond-heavy portfolios, are some of the most conservative investors in the market—most of the time…
AIG had an insatiable appetite for risk and had to be bailed out by the US government, but other insurance firms fared relatively well through the financial crisis.
Sovereign Capital Few phrases excite asset managers like ‘sovereign wealth capital’. It should, not least because as these funds grow, they will increasingly fund the asset management system—and everything that relies on it.
Pensions The men and women who make decisions for institutional pension investments worry about four things: asset allocation, portfolio construction, manager selection, and risk management. How they handle decisions in these spheres dictates how much of these pools of capital move.
While few people blame pensions for causing the crisis, they did invest in the asset-backed securities that the system created—and thus are part of a larger system that created and consumed unsupportable financial risk.
E&F/Other Oftentimes the most sophisticated of institutional investors, endowments and foundations invest capital for their sponsoring institutions—and are rarely, if ever, blamed for the financial crisis.
Hedge Funds Alternative investment vehicles increasingly favored by institutional capital, hedge funds can make investors rich—as well as the men and women who run them.
Hedge funds were criticized for short-selling financial stocks during the financial crisis, causing further deterioration of faith in the banking sector at a time that faith was badly need.
Long-Only Institutional Asset Management The bread-and-butter of the institutional asset management sector, long-only allocations populate the portfolio of almost every pension, endowment, sovereign fund, and insurance fund.
Mutual/Money Market Funds The investment vehicles for many individuals’ savings and retirement accounts, money market and mutual funds were the place where households felt the financial crisis most acutely.
Anyone who watched (or read) Andrew Ross Sorkin’s Too Big To Fail will remember the Reserve Fund breaking the buck—not a cause of the crisis, but certainly a sign of how intensely interconnected the financial system had become.
Business Businesses: The third leg of the household-government-business line that supports, and relies upon, the financial system.
Custody Banks The plumbing of the financial system, custody banks do the things that everyone assumes “just gets done”—and thus they are essential to the system as a whole.
While some were forced to take capital from the government, hindsight suggests that this was likely done to give cover to the weaker, more exposed institutions.
Households An economy, in the end, is people. Households and individuals provide the labor and ideas that create an economy—as well as the appetite for capital to purchase homes, cars, and all sorts of other goods.
Someone had to take out the mortgages that supported the alphabet soup of securitization—and some critics assert that irresponsible borrowing, as much as lending, was to blame for the crisis.
Goverment The government is intimately involved in financial markets—a fact that enrages or heartens individuals, often based on their political leanings.
As one pension CIO said: “An excellent editorial in the Wall Street Journal on August 5 makes the argument that the seeds of the crisis were planted inside the Beltway in a series of unrelated decisions, regulations, or laws passed—the consequences of which established the conditions that gave rise to the crisis.”
Investment Banks An indispensable part of the financial system, investment banks (circa 2008) consisted of four main components: proprietary trading, research, M&A, and sales and trading.
“My vote is for the prop trading desks of banks,” said Mark Baumgartner, asset allocation and risk director at the New York-based Ford Foundation. “There was a complete misalignment of the risk/reward tradeoff. There were huge principal/agent problems—creating a totally short-term-focused, heads-I-win-tails-you-lose culture.”
Commercial Banks While the divide between commercial and investment banking blurred after the repeal of Glass-Steagall in 1999, commercial banks, at their roots, are in business to take deposits and extend loans.
“Pure” commercial banks are rarely blamed for the crisis, but… “Wall Street does what it does—move money around, repackage it for end-users, earning fees along the way,” said Erik Knutzen, CIO of Boston-based consulting firm NEPC. “To expect different behavior would be like expecting hyenas to behave differently than they have been for eons on the veldt.”
Financial Markets Simply put, the place—both physical and non-physical—where financial instruments are bought and sold.
Freddie/Fannie Few financial words are said so often with disgust than these two: Fannie and Freddie, the once-popular-but-now-ugly stepsisters that were created with the intent of providing lower-cost mortgages to US borrowers.
Andrew Ross Sorkin: “I’d place the bomb on the ‘x’ between investment banks, Fannie/Freddie, special purpose vehicles, and ratings agencies. I’d put it directly on the crisscross lines that say ‘rate securitized products’ and ‘securitized products.’”
Financial Guarantee Corporations Part of the ‘Bermuda Triangle” of securitization, financial guarantee corporations insured much of the securitized market—further enticing the creation of risky financial instruments.
Some people say that these are the thinking man’s cause of the crisis. As Jim Dunn, CIO of Wake Forest University, said: “I keep coming to Bear Stearns and Lehman as the suicide bombers, failing to make a deal and driving investment bank ‘trucks’ (CLOs/CDOs) filled with government supplied ‘explosives’ (agency-backed paper), causing global investors to flee and go into hiding.”
Special Purpose Vehicles Entities set up with the express purpose of packaging securitized products and distributing them to the market, few words are more poisonous to critics of the financial system as these three: Special Purpose Vehicles.
A case can be made that SPVs were Ground Zero of the financial crisis. “And as to the central cause, it’s very clear that it was securitization,” said former Congressman Barney Frank. ”Forty years ago, people lent money to people they knew could pay them back. Securitization dissolved the lender link.”
Rating Agencies Someone had to give their stamp of approval to securitized products—and rating agencies made big bucks doing so.
Unfortunately, rating agencies weren’t very good at estimating the risk inherent in these securitized products—meaning that investors relying on such ratings usually bought more than they bargained for.
IIlustrations by Harry Campbell