The global politics of mortgage securitization : a critical realist account of the European investment in the American subprime mortgage market

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The Global Politics of Mortgage Securitization

A Critical Realist account of the European investment in the American

subprime mortgage market

Author: Maarten Hietland

Supervisor: Prof. Dr. J. Harrod

Second Reader: Dr. D. Mügge

Date: 27-06-2013

Student number: 10408932

Master Thesis Political Science: International Relations

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List of Abbreviations

ABCP – Asset-Backed Commercial Paper

ABS – Asset-Backed Securities

BIS – Bank of International Settlements

CDO – Collateral Debt Obligation

CDS – Credit Default Swap

CESR – Committee of European Securities Regulator

CRA – Credit Rating Agencies

FED – Federal Reserve System

GAAP – General Accepted Accounting Principles

GSE – Government-Sponsored Enterprise

IFRS – International Financial Reporting Standards

IMF – International Monetary Fund

IOSCO – International Organization of Securities Commissions

IPE – International Political Economy

IRB – Internal Ratings-Based

NRSRO - Nationally Recognized Statistical Rating Organization

OECD – Organisation for Economic Co-operation and Development

RMBS – Residential Mortgage-Backed Securities

SEC – (American) Securities and Exchange Commission

SIC – Standing Interpretations Committee

SIV – Structured Investment Fund

SPE – Special Purpose Entity

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Chapter I - Introduction

Introduction

At the annual conference of the reputable magazine ‘Investments & Pension Europe’ the Dutch pension fund ABP was given the reward of being the ‘Best European Public Pension Fund 2007’. Dick Sluimers, chairman of the board of ABP, mentioned that the award

reflected the reputation of the pension fund in the international financial world (APB, 2007). Less than two years later the same pension fund was obligated to construct a ‘recovery plan’ for the Dutch Central Bank (DNB), thereby indicating the ways in which it would reestablish a healthy position in the coming five years. A major part of the enormous losses it had made was due to its investments in the so-called ‘Residential Mortgage-Backed Obligations’ (RMBS) issued by Fannie Mae and Freddie Mac in the USA, totaling 11 billion euro

(Binnenlands Bestuur, 2009). Several banks were sued by the ABP pension fund in the years following the financial crisis, among others Goldman Sachs, JP Morgan Chase, Merrill Lynch/Bank of America, Countrywide, Ally Financial, Credit Suisse and the Deutsche Bank. In 2013 the coverage ratio was still beneath 100%, forcing the pension fund to downgrade the allowances with 0.5% (ABP, 2013).

Scope of research

It was due to the global financial crisis that started in 2007 in the USA and spread towards Europe in the period thereafter, that most people became aware of the existence of several innovative financial products. The average civilian that had taken a mortgage in order to buy a house had never heard of such a thing as a ‘Residential Mortgage Backed Security’. Partially due to the newspapers loaded with information about these financial derivatives the average citizen became informed that all sorts of European corporations (commercial banks, pension funds) as well as public organizations (municipalities, province departments) had invested in the American housing market through these derivatives, as the European banks had for example lost 1.6 trillion in the period 2007-2010 due to toxic assets compared with 1 trillion by US banks (IMF, 2009; Inside Job, 2010). All kinds of investments portfolios were

‘infected’ with these so-called subprime mortgages. At the heyday of the financial crisis about 25% of the subprime mortgage debtors defaulted on their mortgage (Wainwright, 2010, p. 25). This securitization progress started in the ‘70s of last century in the US. Especially since the early ’90s this process of securitization had increased substantially, as private parties were then also offering these structured securities. Next to this, these innovative products also spread to the UK in the 1990s and thereafter to continental Europe (Helleiner, 2011, p. 70). There are roughly two ways in which the ‘exportation’ of mortgage-backed securities

influenced Europe. On the one hand, European mortgage companies were developing RMBS themselves on the basis of European mortgages (for example the Fortis Bank was the first to initiate this in the Netherlands in 1996). The other way it influenced Europe was through the investment by European investors in the American RMBS, especially in the securities backed with subprime mortgages. It was estimated that around half of all the American RMBS were sold to foreigners at the time of the financial crisis, the majority being European hedge funds, banks and pension funds (Roubinhi & Minh, 2010, p. 119). In this thesis attention will be devoted towards this European investment in the American RMBS. More broadly the aim of this thesis is to examine through what way the American issuers of securitized products were able to construct a framework to sell those in Europe. What was the reason that European

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investors had invested almost 1.6 billion dollar in these toxic assets? The analysis falls broadly into the discipline of International Political Economy as it investigates in what way the ‘export’ to Europe of US based RMBS could be seen as a form of US structural power. Structural power, in short, confers the power to decide how things shall be done, the power to shape frameworks within which states relate to each other, relate to people, or relate to

corporate enterprises (Strange, 1988, p. 25). The theoretical foundations of this research will be elaborated in the theoretical framework.

Theoretical approaches

In the field of IPE there is a vast amount of intellectual work that aims to explain the foreign investment in the US financial market, more specifically the securitization market. Several scholars aim to explain this by the capture of the regulatory agencies by private companies. They argue that the limited scope of the regulatory agencies, by focusing solely on banks and insurance companies, made the securitization process flourish. Next to this, in the case there were regulatory responses, they were very market-friendly, and partially developed in accordance with private parties (Porter, 2005; Underhill & Zhang, 2008; Roubini & Mihm, 2010).

Next to this ‘regulatory capture’ approach, attention is paid to the ideational factors (Reinhart & Rogoff, 2009; Langley, 2008; Seabrooke & Tsingou, 2010). These scholars mention that there was a worldwide ‘transnational policy community’ existing of top officials who believed that the securitization process was actually creating a more resilient and risk-free financial environment. These top officials, being both from the US as well as other financial centers (Europe) helped to encourage excessive optimism within financial markets at the pre-crisis period.

Another important theoretical focus comes from the ‘financial geography’ discipline, through scholars as Wainwright (2009) and Schwartz (2009). They argue that the reason for the securitization boom has to be found through a mere historical and sociological perspective. They highlight the societal demand for a more broadened level of homeownership, stimulated by the creation of Fannie Mae and Freddie Mac. They conclude that the everyday politics of expectations and the welfare trade-offs are of great importance in understanding the

underpinnings of the current financial crisis, and specifically the securitization process. They relate, in other words, micro aspects with outcomes at the macro level.

The fourth important approach within political economy in analyzing the evolution of securitization focuses on the Anglo-American interests and power. They see the dollar’s international role and the unique depth, liquidity, and security of U.S. financial markets global finance as the major reason the creditors (such as Japan and Germany) were investing in the USA. More surprisingly, even during the financial crisis and the period thereafter there was no (substantial) foreign withdrawal of money, whereas during most crises a capital flight occurred. Notably, even with the lowered interest rates, the value of the dollar appreciated (Helleiner, 2011, p. 81).

Empirical focus

The focus of this research falls largely into this last theoretical branch of IPE. The most important reason for choosing this theoretical insight is the spectacular investment by European investors in the American subprime mortgage market in the pre-crisis period. All

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three approaches aim to discuss the process of securitization, and reveal some insights about its occurrence, but the Critical Realist approach seems to be best able to explain why the European investment boom occurred in the pre-crisis period. The other three approaches do not give compelling insights as why there may have been such a rapid increase in investment in RMBS by European investors in the last years before the crisis. Especially the last five years before the crisis the Europeans invested substantially in the subprime segment through financial derivatives. The indication of total losses by the IMF stated before indicates that the European investors have lost even more money (1.6 trillion dollar) than their American

competitors (1 trillion dollar) (IMF, 2009). The expectation is that the channels through which structural power is pressed is to reveal the European bias in investment in the American subprime market as well as the sudden increase thereof since the beginning of this century. Hence, the aim of this research is to analyze to what extent US structural power and its position in the global financial market can explain the increasing attractiveness the American securitized products had for European investors. In that manner a more political-economic explanation will be given of these investments, beyond the conventional economic

explanations such as yield and liquidity.

In order to research to what extent structural power can explain the major European

investment in the European subprime segment structural power will be subdivided into three related variables. The first way structural power is anticipated to be constructed is through US governmental pressure for non-regulation regarding securitization in general, and RMBS specifically, in the pre-crisis period. Therefore the negotiation process of Basel II, which started in 1999 and completed in 2004, will be researched. The second variable through which structural power is assumed to be exposed is by the creation of a RMBS market in Europe. It is likely that through international organizations both the government as well the private corporations have pressured for a RMBS market by using the American RMBS as benchmark. That would homogenize the products and enhance possibilities to offset the American

products in Europe and thereby increasing liquidity, indicating structural power. An important aspect herein is the accounting regime. The third and last issue researched is the European policy regarding risk assessment. As the risk assessment market is controlled by the three American credit rating agencies, special hegemonic power is exercised. The expectation is that the European governments have pressured for the development of an EU specific CRA regime, but that this has failed due to American structural power.

The most important reason for conducting a research about the existence of American structural power in the pre-crisis period is the very limited research dedicated to explaining the European investment in the American RMBS market to date. Especially in the discipline of Economics most research takes a ‘global market’ ontological position, thereby neglecting differences in power patterns between different markets (see for example Shin, 2009 and Taylor, 2009). This absence of power constellations incorporation by explaining investment patterns is conceived as a shortcoming by the author of this thesis. Scholars in International Political Economy are more sensible to incorporate power constellations, but focus

predominantly on ideational and transnational epistemic community explanations for the European investment in the American RMBS market (see for example French et al., 2009 and Gowan, 2009). So far, no research has applied a Critical Realist perspective towards the crisis by specifically focusing on the structural power of the US. This thesis has the object to fulfill this intellectual gap.

Hypothesized is that power was (indirectly) exercised through certain institutions and the US hegemonic position that made the Europeans to invest heavily in the American financial

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market. For the analysis the period 1990-2008 will be of our focus. The time path begins in 1990 as this was the year commercial enterprises were allowed to become involved in the secondary mortgage market. For example, in 1992 already one third of all residential

mortgages financed by commercial banks were securitized (Seabrooke, 2001). 2008 is taken as the last year of the analysis as that year the financial crisis became truly global. Our aim is to analyze US structural power in the period prior to the financial crisis. The effects of the global financial crisis and the period thereafter on US structural power or vice versa are not of central focus in this research.

Central question

The part above has shown the aim and angle of this research thesis. The central question distilled from the introduction above is as follows:

To what extent and through which channels can the presence of US structural power in international finance explain the expansion in size and volume of investments in the high risk

US RMBS by European investors in the pre-crisis period? Structure

To answer this research question this research paper will be structured as follows. In the following chapter the methods of inquiry, the conceptualization of the appropriate concepts and the various forms of data used in this research will be set forth. Thereupon the literature surrounding structural power in international finance will be discussed and the theoretical approach of this paper will be explained thoroughly. Also the distilled hypotheses will be given. Before the empirical research chapters, the history and the (technical) characteristics of securitization will be discussed. In the core part of this research the empirical analysis will be explicated. The link between the theoretical insights and our empirical observation will be discussed in the sequent chapter. The last part of this research reflects on the research question and informs the reader with recommendations for further research.

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Chapter II - Methods of Inquiry

Introduction

In this chapter basically two important aspects are to be discussed. At first the methods of inquiry used in this research will be presented and explained. This will include an overview of the data used and an explanation thereof. Thereupon the concepts that are of great importance will be outlined and placed in the context of this research.

Methods

In this research the theoretical insights given by Susan Strange regarding structural power will be analyzed. More specifically, the existence and functioning of structural power in the

financial sector will be researched. It is argued by Critical Realists, that power is not only conferred through the possession of resources, but as well through the construction of frameworks and structures in which other states and actors have to operate. This form of power is not as apparent as relational power, but is least as important in understanding international relations (Strange, 1988, p. 25). In this research the empirical focus will lay on the European investment in the American subprime market in the pre-crisis period (1990-2007). This case is chosen for several reasons. The most important reason is the large amount of European money invested in this subprime market, which has risen significantly in the last years before the crisis. There is no clear explanation given so far for this remarkable event, and the concept of structural power seems to have explanatory power. Next to that, the discipline of Economics falls short in explaining this investment, as yield or liquidity arguments do not give an adequate explanation of the sudden European investment growth (Colander et al., 2009). The UK will not be included in the analysis of the ‘European

investment’ as the characteristics of this market differ substantially from the other European countries. Especially regarding international finance, the UK seems to be more American-based than from continental Europe. To summarize, the reason for choosing this case is twofold. On the one hand, it is researched to what extent the concept of structural power is still meaningful in the study of IPE. On the other hand, it aims to give a thoroughly

explanation of the (still unexplored) European investment in the pre-crisis period.

This paper is a qualitative research, as one case is analyzed in a profound way. The theoretical concept of structural power is operationalized in three different theses. The first channel through which structural power is assumed to be revealed is through international

(non)regulation. The expectation is that, at the time of Basel negotiations (1999-2004) both the American government and American private companies (banks et cetera) have pressured for non-regulation of securitized products. At that time, American banks and other financial enterprises were already heavily involved in the securitization of mortgages through the shadow banking system (via Special Purpose Vehicles). With a strict regulation, forcing banks for example to put these securitized products on their balance, American banks would effectively be forced to set a step back in financial innovation. In order to research the validity of this thesis, the American interests at the start of the Basel negotiations will be analyzed and the impact this had on the eventual outcome of the accord. In order to do this, the papers of the Basel Committee, the press releases and speeches of the American regulators as well as papers of American banking lobbying organizations will be researched.

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The second way through which structural power is anticipated to come to the forefront is through the creation of a securitization market in Europe, directed by American governmental and private organizations. It is the expectation that both the American government and the private companies have intentionally tried to construct a European securitization market upon American standards. They would have done so, in order to construct a globalized market to have the ability to offset their products (create liquidity). In order to research this more specifically, the development of accounting principles regarding shadow banking systems (SPEs) in Europe will be analyzed. In order to examine this, the influence American

organizations had in Europe as well the influence of ‘advisory policy reports’ conducted by these organizations is analyzed. The last thesis set forth through which structural power is hypothesized to become apparent is the Credit Rating Agencies (CRA). The hegemony of American CRA seems important as these CRA construct the way in which the market is evaluated. These CRA changed investment decisions from ‘reputation and expertise’ towards a numerical screening. This seems to be important for the broad investors’ base that became involved in the American subprime market (Sinclair, 2005). One expects to reveal a pressure from the European governments through the European Commission to construct their own CRA, in order to break American hegemony over both the construction of the financial products and the assessment of the quality thereof. Whenever it is revealed that such a policy existed but was broken by European investors, a strong indication of structural power would be given. A further indication of structural power would be given if the American government deliberately pressured for the hegemony of their CRA in the global RMBS market. In order to research this both the working papers of the relevant European Commission as well as the American policy on this subject will be analyzed. To research the American involvement in this case, the policy papers from the relevant American regulating organizations will be examined.

Conceptualization: SIV, Conduits and SPEs

In this thesis several concepts will be used that do not necessarily have a clear meaning for the reader. In this part the most important concepts will be clarified and defined. An important concept in the securitization process is, is the shell company set up by a bank. A shell company is officially not controlled by the originating bank, thereby leaving it outside of regulator’s control. A situation whereby assets are successfully shifted off-balance (and outside regulator’s control) is called a ‘clean break’ or a ‘true sale’. Also, the shell company is bankruptcy remote, meaning that no claims can be made against these shell companies when the originating bank goes bankrupt. There are mainly three variants of shell companies, being the Special Purpose Conduit (Conduit), the Structured Investment Vehicle (SIV) and the Special Purpose Entity (SPE)1.

The SIV is partially funded by the originating bank through notes. Next to that, the SIV funds itself, for example by selling short term commercial paper in the market (Tett, 2009, p. 97). The notes through which the SIV is funded by the bank is called a ‘credit line’. Normally, this credit line is an obligation by the originating bank to liquidize the SIV whenever the shell company itself is unable to do so. The SIV was anticipated by market participants never to rely on these credit lines, as the SIV seemed always able to raise short-term money in the market. The banks, however, created these credit lines in order to get the highest ratings for their SIV. Strikingly, those credit lines were extended for less than 364 days, as Basel

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In the United States Jurisdiction SPE is common, whereas in Europe SPV (Special Purpose Vehicle) is generally used. In this thesis the term SPE will be used.

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required no capital resources needed to be held against credit lines that endured less than one year (ibid., p. 98). The shelf company that is more closely linked to the originating bank is the Conduit, often referred to as the credit arbitrage conduit or a regulatory arbitrage conduit. Conduits in most cases also have a credit line with the originating bank, meaning that in times the assets of the conduit does not produce enough cash-flow to fulfill the payments towards the investors the bank is obligated to provide liquidity (and to take the first losses). In

comparison with a SIV however, there is less risk involved for the investors as these liquidity lines do exist for all assets. All debt the conduit issues is therefore secured, involving less risk of losses for investors in times of default (Acharya & Richardson, 2009, p. 9). The last shell company to be discussed is the SPE. The SPE is the shelf company used in the more

traditional securitization process. The bank sells a package of pooled assets to the SPE, which creates new asset-backed securities which it sells to institutional investors. The SPE is thus created solely for the purpose of selling the banks’ assets, whereas in comparison, the SIV is created to lend short-term money and to buy long-term, with the sole purpose to collect high returns (Saunders & Allen, 2010, pp. 5-8).

Financial Products

In this thesis several financial products come to the forefront, with different characteristics. In this part the characteristics of several financial products that are important for understanding this research are discussed. In the 90s of last century two core financial products flourished that had a substantial impact on the financial crisis, being Collateralized Debt Obligations (CDOs) and the Credit Default Swaps (CDSs). CDOs are securities backed by real estate. The real estate these CDOs refer to are American housing loans (mortgages), credit card loans and car leasing contracts. These loans are packed together and sold to different investors in

different tranches, ordered according to the risk attached. The exact content of these loans is however made clear further on in chapter five ‘Global Politics of Mortgage Securitization’. These CDOs can be subdivided with regard to underlying real estate, whereby the CDOs only backed with housing mortgages are called Residential Mortgage-Backed Securities (RMBS). When these RMBS are combined with other Asset-Backed Securities (ABS), such as credit card loans or student loans, and are repacked, a CDO is created. When several parts of an already existing CDO, or different CDOs all together, are repacked to create a new product, the CDO is squared, codified as CDO2. For example, all mezzanine parts of several CDOs can be taken (sliced) and reordered into a new risk structure (diced) to create the CDO2. The CDOs are repacked according to the preferences of the investor, until a product is created that matches the risk preferences of several investors. Another product that is important for this research is the ABCP, or the Asset Backed Commercial Paper. This is the product that a Special Purpose Entity sells to investors in order to raise money to finance its collateral. The financial assets that serve as collateral are for example RMBS and CDO (Sinn, 2010, pp. 118-119). The other important financial product that became important in the pre-crisis period is the Credit Default Swap (CDS), a product that insures against the default of another product, such as a commercial loan or a CDO. CDS are however not of great importance in

understanding this research, and an exact knowledge of its content by the reader is therefore not necessary.

Another important concept that is closely related to the financial products above is

securitization. There is some (academic) confusion about the exact meaning of this concept, but it can be described in two ways. The broader meaning of securitization is a process that converts a financial relationship between two entities into a renewed transaction. In this thesis the focus will more narrowly lay on asset securitization. This is a process whereby

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contracts (mortgages, credit card loans, student loans, car loans) are bundled together (and sometimes sold to a shelf company). On the basis of this bundled package of loans bonds are issued and sold to investors. The cash flow that is generated by the originating assets serves as basis for the returns on these bonds. Additionally, these bonds receive a credit rating on the basis of their credit worthiness (Aalbers et al., 2011, pp. 1781-82).

The last concept that needs to be defined is the Shadow Banking System. The shadow banking system consists of shadow banks that are ‘interconnected along a vertically integrated, long intermediation chain, which intermediates credit through a wide range of securitization and secured future techniques such as ABCP, asset-backed securities,

collateralized debt obligations, and repo’ (Pozsar et al., 2010, p. 2). They are counterparts of the ‘normal banking system’ as they are not regulated and do not have access to public sources of liquidity, such as from the FED or the ECB (ibid., p. 2).

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Chapter III - Evaluation of literature

Introduction

Wide academic research has been dedicated to answer the question how the financial crisis has started, and why it spread throughout the globe. In this theoretical part the various

approaches within the domain of International Political Economy are discussed that attempt to analyze the securitization process in general, and the foreign investment in those derivatives more specifically. Additionally, remarks will be made why those approaches will not be of central focus in this thesis and why the Critical Realist approach is chosen in analyzing our case.

Regulation approach

An important research area in IPE sees the incapacity or unwillingness of the governments to regulate the financial sector as the most important reason that the securitization of the

subprime mortgages had such a worldwide impact. There are several aspects of the national and international regulation that these scholars emphasize as being important.

At first hand, the regulation seemed to be insufficient, or, the regulators failed to impose regulations on new financial instruments. There was some international cooperation through institutions, such as the Basel accords2. The focus of these banking regulation agreements was however too narrow, as it focused solely on banks, and used very limited means to achieve their goals, such as the risk-weighted capital reserve requirement. The international regulation therefore could neither prevent nor control the negative effects hedge funds and credit rating agencies had on the financial system. Next to that, the innovative financial products that the financial institutions developed could easily flourish throughout the world, as no institutions had the explicit authority to regulate it. For these scholars, the most important reason for this absent behavior of the authorities was a firm belief in the self-regulated functioning of the market by these regulators (Helleiner, 2011, p. 72).

Other scholars in this ‘regulation approach’ do not blame the absence of the regulation as the prime reason the securitization process scattered, but emphasize the pro-cyclical effects of the international agreements. Wigan (2010, p. 115) for example mentions the (risk-weighted) capital reserve requirement of the Basel I agreements as an incentive for the banks to create off-balance sheets products. With holding their capital off balance, banks where no longer obligated to keep a portion of capital in their reserves. It was especially the capital

requirement banks had to fulfill while keeping mortgages on their balance sheet that

functioned as an incentive to securitize these mortgages (Jablecki & Machaj, 2009, p. 309). With the adjustments made by the Basel II agreements (2007) in order to incorporate market risk, major banks were allowed to internally construct risk management. This caused that ‘effectively and incrementally public authority has been expunged and replaced by uncertain private techniques’ (Wigan, 2010, 114).

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The Basel accords are the international agreements made by the Basel Committee on Banking Supervision, originally consisting of the banking supervisors of the G10 (plus Spain and Luxembourg). The secretariat of the Basel Committee is at the Bank of International settlements in Basel. Up till know, it has produced three accords, referred to as Basel I (1998), Basel II (2004) and Basel IIII (2010) (Blundell-Wignall & Atkinson, 2010).

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Next to the ‘absence’ and the ‘unintended incentive’ argument, the last important reason that the scholars in this approach mention to show that the regulators failed is the regulatory capture by the industry. They emphasize that the influence of the large banks at the

international forum is enormous. It is especially the information asymmetry that fosters this influence. Furthermore, the deliberate ‘apolitical’ character that surrounds these international regulatory institutions, gives the possibility for the industry to ‘capture’ the negotiations. This stimulates the enactment of groupthink, thereby losing the critical perspective (Seabrooke & Tsingou, 2010, p. 231).

Transnational policy community

A second important approach in International Political Economy focuses on the ideational and social relationship aspects of the financial world order. For these scholars there is a certain transnational policy community of experts, technical officials, and private sector actors who dominate the international finance sector (Helleiner, 2011, p. 75). This transnational

community has in particular a positive stand towards self-regulation functioning of the market and stress economic ideas such as the ‘efficient-market hypothesis’. The process of

securitization and the related originate-to-distribute model, for example, was (falsely) conceived as a market solution towards the specific geographical concentration of risk. Important concepts that relate to this approach are ‘epistemic communities’ and

‘intersubjective expectations’. The stages where these elite groups come together are the ‘group of thirty’ or the private ‘Institute of International Finance’ (Seabrooke & Tsingou, 2009, p. 458). Also the revolving doors phenomenon is important in understanding the transnational community, as policy elites are moving back and forth between key financial institutions, regulatory agencies and other governmental occupations (ibid., p. 459). The former Goldman Sachs CEO and later US Secretary of the Treasury Henry Paulson

exemplifies this. An important reason stressed by scholars of this approach for the power of the elites is the ‘permeable boundaries of exclusion’. The elites want to maximize the power they have, and therefore limit the accessibility to the forums in which they act. This leads to a certain closed intellectual discourse through which they interact, featuring a hierarchy of ideas. This explains the inability by the power elite to reform the financial system, as the debates are captured by certain, market self-regulation favoring, ideas (ibid., p. 460).

Montgomerie and Williams (2009) stress the important divide between the masses and the financial elites, which started with the neoliberal reforms from 1979 onwards. The discourse of neoliberalism that has evolved since then, has given opportunities for the elite to

redistribute income through taxation upwards while distributing costs through bail-outs downwards (ibid., p. 102). For these scholars, securitized products are an innovation of financial elites to make profit trading, especially in major financial centers as the City of London. Hall (2009) contributes to this idea by pointing towards the changed nature of the elite. The deregulation period (1980 onwards) replaced the ‘old gentlemen capitalism’ by the investment bankers, especially those from American investment banks. With the new elite the basis where to act upon changed as well. Relationship and trust was be replaced by

transaction and fee (Montgomerie & Williams, 2009, p. 105). The investment bankers are therefore to be seen as the architects of the processes of financialization. The occurred credit crunch has to be seen, argued by these scholars, as a lack of understanding of the system or financial networks by these architects. For Hall (2009), the credit crunch is an epiphenomenon of the banker’s ability to distribute power networks, whereby through the process of

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Cultural Political Economy

Several scholars from other disciplines have collaborated with scholars from within IPE to construct a cultural political economic understanding of the current crisis (Langley, 2008; Schwartz, 2009; Sassen, 2008). In this literature on financialization a new account is offered of present day capitalist dynamics where individuals, firms and the macro-economy are increasingly mediated by new relationships with financial markets (Montgomerie, 2008, p. 234). In contrast to British IPE research, these scholars see the financialization process as a growing social integration of financial knowledge and practice, defining it as socially

embedded. An important aspect to understand the implications of the financialization process is the integration of the households into financial market expansion through the large-scale transfer of household savings flows to institutional investors and extensive household borrowing based on new retail banking techniques (ibid, p. 237). The increased borrowing and consuming on debt has to be seen as the underpinning of financial innovations, structured finance and the broader macro-economic trajectory of Anglo-American growth. The

mortgage-backed securities, developed first in the USA and later on in the UK and continental Europe, have to be understood as an innovation that offered many people a chance to climb up the property ladder. The households were seen as key beneficiaries of the financialization process, because the property and stock market boom offered new investment opportunities. As long as financial markets were able to sell their structured financial products, the lenders had incentives to create new innovative products. As long as households borrowed, what happened accordingly with the increased inequality, lenders were able to generated profits (ibid, p. 247). The main explanation for the financialization process, provided by Cultural Political Economists, lays in the growing inequality. Montgomerie (2009) adds that the reason of the increased indebtedness of the American citizens has to be found in historical-cultural aspects, as with the real wage stagnation in the 1980s most American were not able to finance their lifestyle, which they used to have from the end of WOII onwards, anymore. The

increased indebtedness of the average American citizen therefore has to be understood in historical-cultural terms. That way the gradual shift to financial market growth has to be interpreted as the engine of profitability and competitiveness that had led to further subverting of employment and wage-led growth (ibid, p. 16). Very importantly, for these scholars

unsecured debt did bolster financialization, and not the other way around. Sassen also devotes attention in her work on the financialization process and focuses on ‘insidious lending’, where the priority is volume and not credit worthiness. She thereby focuses on the geographical dimension of subprime and alt-a mortgage lending, especially in the years following up to the crisis, and emphasizes the racial aspects of this securitization process (Sassen, 2008, p. 202).

The Cultural Political Economy (CPE) scholars have an interesting view of financialization that differs substantially from ‘standard’ IPE. For example, Wainwright emphasizes that capitalist actors actively coordinate the movement of capital between different circuits and across space. Securitization therefore is seen as both an idea (homogenizes heterogeneous income streams into standardized products), as a technology (converting the idea into an organizational framework and tradable product) and as an investment entities (how mortgages were structured as to attract demand from foreign investors). The literature of CPE shows therefore that the globalization of securitized products is not a simple process: It requires a series of translations and relies on expertise from epistemic communities in law, finance, mathematics and computing combined with a favorable macroeconomic environment (Wainwright, 2009, p. 385).

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Chapter IV - Theoretical Part

Introduction

In this chapter the theoretical focus of this research will be discussed. At first the two

concepts of power used in International Relations will be examined, relating it with the ideas of Susan Strange. Thereupon a further explanation of structural power will be given,

narrowing it towards its appearance in international finance. In the last part of this chapter the operationalization of structural power in relation with this research will be discussed,

subdividing it in three elements. Additionally, a justification of this selection will be given.

Power and International Relations

The most basic way to describe the study of international relations is to define it as the study of power. Both in the classical texts, those from Machiavelli from example, as in the modern academic texts on international relations, power (and the application of it) is an elementary concept. However, focusing more specifically on the character of power, a wide variety of interpretations of its nature is unveiled. There are many forms of power, in different relationships and through various forms. In the history of social sciences, and International Political Economy more specifically, much time and attention is devoted in defining this concept of power. The most apparent form of power, to speak in the words of Susan Strange, is relational power. This form of power is predominantly used in the mainstream approaches of international relations, and is in its simplistic form defined as follows: ‘The power of A to get to B to do something they would not otherwise do’ (Strange, 1988, p. 24). It seems, through this form of power that US hegemony has been steadily declining from the collapse of Bretton Woods onwards. For the authors that confer to this hegemonic decline thesis, the political and economic turbulence from the 1970s onwards is a clear sign of this occurrence (Seabrooke, 2001, p. 6). According to Keohane, the international cooperation and the related international regime in the post-Bretton Woods period, is to be interpreted as a result of this hegemonic decline. These scholars interpret power as being derived from resources, and they argue that the diminished control in international politics by the United States is a logical consequence when taking into mind the diminished control over resources it nowadays has (Strange, 1996, p. 22). This focus of power, that is very narrowly defined, results according to Susan Strange, in a misunderstanding of the current power constellations, especially in the field of international finance (Strange, 1988, p. 90). There are various authors that have elaborated on the other form of power, on which the key focus in this thesis will lay, namely structural power.

Structural Power

The Critical Realist account of structural power should not be confused with the Marxist interpretation of structural power. For them, structural power emanates from the mode of production, whereby the state is in control of the production as the embodiment in political terms of the authority of class (Strange, 1988, p. 26). In this thesis the focus will be on structural power from a Critical Realist perspective. In this approach, structural power is defined as ‘the power to shape and determine the structures of the global political economy within which other states, their political institutions, their economic enterprises and (not

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Economy can be revealed when focusing on four structures, being security, production, finance and knowledge. In this thesis her theoretical work on structural power through the structure of finance will be referred to.

Structural Power in international finance

One important aspect in analyzing the structural power in international finance is the currency that is used world-wide. For example, the dominance of the dollar as the key currency in the world economy as well as the enduring foreign (in)direct investment in the American

economy shows the structural power of the US. Furthermore, the funding of the US sovereign debt by foreign investors (being inter alia Japan, Germany and China) should, according to Strange, not be interpreted as a sign of hegemonic decline, but as a sign that the structural power of the US is still very evident. In the words of Susan Strange: ‘The damage which the build-up of this deficit has done must not obscure the fact that no other country was in so favorable position that it could draw so heavily on other people’s savings to finance its own overspending’ (1990, p. 267). Helleiner emphasizes that, next to the funding of US external payments deficits through the international role of the dollar, it ensures the role of the country as being the ‘key lender-of-last-resort’ (2000, p. 231). Next to the currency, there is a

continued importance of US financial institutions in the global financial system, driving innovation and change, which embodies structural power: ‘International investors continued to find North American markets particularly attractive because of their openness, minimal regulation and depth. The continued centrality of these markets and institutions to world finance, argued Strange, gave US policy makers an indirect, structural form of power’ (Helleiner, 2000, p. 232). The third main channel that shows structural power is the dominant voting share and veto power that is given to the US government through the International Monetary Fund and the World Bank (ibid., p. 233).

Structural Power and direct financing

That structural power is of great importance next to relational power, as shown in the part above, is very clear in the face of international finance. Structural power also allows, as opposed to the conventional Realist concept of relational power, to overcome the distinction between economic and political power. A third reason for its importance is its incorporation of non-state actors in determining the nature and course of international relations (Lawton et al., 2000, p. 9). In this thesis the theoretical insights given by Leonard Seabrooke in his book ‘US power in international finance’ (2001) will be used. He applied the structural power insights from Susan Strange in his analysis of US role in international finance in the period 1960-2000. An important term Seabrooke uses is fiscal transnationalism which is ‘the ability to tax other states for being part of a more or less stable international order’. By using its structural power to shape other states’ financial systems towards direct financing, the US continues to ‘tax’ its trading partners with little real cost to itself, which is achieved by the sale of US government debt to foreign investors (Seabrooke, 2001, p. 9). Seabrooke argues that for capital, as it seems at first hand, accumulation is of great importance. The more capital you accumulate (take for example the capital accumulation nowadays in China and Germany), the more powerful you are. Seabrooke however asserts that it is predominantly the ability to create capital through credit that extends financial power, and mentions two points

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that must be outlined in this case, being: i) access to resources rather than command of resources is more important; and, consequently ii) the ability to shape preferences is more important than an accumulation of resources (2001, p. 17).

US Structural Power through direct financing

Seabrooke argues in his book that the US is by far the strongest state in international finance, and that is has in fact increased its structural power in the period 1960-2000. One of the main reasons for its extended structural power is the increased importance of direct financing internationally. Seabrooke argues that this ‘socialization of finance’ is particularly important in explaining features of direct financing, such as securitization. Next to the increased sovereign debt of the American state, the average American has increased the amount of its personal debt as well. This made that securitization became an important tool in order to finance this ‘consume on credit behavior’. The relation between direct financing

(securitization) and the increased consumer debt (through mortgages, car loans, student loans et cetera) is however not a one-way causality, it should be conceived as mutual constitutive. Main conclusion in Seabrooke analysis is that this increased importance of direct financing in Wall Street as well as in Main Street (coined interactive embeddedness) has increased the structural power of the United States internationally as well. The behavior of the American state therefore, has to be interpreted as promoting the structures of direct financing throughout the world (Seabrooke, 2001, p. 46).

Structural power and securitization

While Susan Strange has laid the main theoretical foundations for analyzing structural power, and whereas Seabrooke has used this concept in his empirical analysis of US structural power in the 1960-2000, so far no research has been conducted to analyze the relation between structural power and the globalization of mortgage-backed securities. To research the

presence of structural power internationally through securitization, the focus has to be on the architecture surrounding the global spread of securitization. As Strange has set forth, to research structural power the empirical focus has to be on the key bargains and negotiations (Strange, 1988, p. 40). In the remaining part of this chapter the various aspects of structural power that will be of key focus in this research will be discussed. All variables have an influence on the architecture (creation) of the securitization market globally.

Structural power through absence of international regulation

An important aspect through which structural power can be channeled is by international non-regulation of the securitized products. The expectation is that the American government has consciously pressured for enduring absence of international regulation regarding securitized products. In order to promote the globalization of American securitized products an

international market had to be created. With international regulation entangling securitized products it would become more difficult for American institutions to finance private debt through securitization. Also, as the US market had already developed substantially in the ‘80s and ‘90s of last century, international regulation would imply a setback of its lead in

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Structural power through the promotion of a resembling securitization market in Europe

Another important aspect of structural power is the creation of a securitization market globally, and especially in Europe. The creation of a securitization market, where the American corporations could offset their products, is important for various reasons. The expectation is that the American corporations that created securitized products in the US, both private as government sponsored entities, bundled their interests in order to promote the securitization markets globally, for example through international organizations or forums. One also expects to unveil a promotion in the uniformity of products that are to be traded globally: homogenizing and standardizing knowledge of assets. Structural power would imply that the securitized products were constructed by using the already existing American

products as benchmark. An important aspect in this standardization and homogenization seems to be the accounting regime that controls the development of the shadow banking system. Through this standardization the liquidity and acceptance of securitized products as legitimate products would be enhanced. Anticipated therefore is a positive stance and influence by the American government and/or international institutions for the creation of a shadow banking system in Europe, by American standards.

Structural power through the rationalization of creditworthiness assessment

Next to the absence of regulation, the homogenization and related promotion of the shadow banking system, an important variable in constructing structural power is the influence regarding the preference formation of others. The construction of preferences is bounded by the information available. In international finance the quantification of risk and the

authoritative source of judgment thereof is important (Sinclair, 2005, p. 2). The judgment of securitized products predominantly by American institutions would imply hegemonic power over the assessment of risk that would not only externally dominate the market, but shape preferences internally as well. It would be a strong sign of structural power when the

legitimization of the American Credit Rating Agencies (CRA) was promoted by the American government or/and enterprises in relation with the creation of the securitization market. On the other hand, an active policy by the European governments to ‘counteract’ this hegemony on the assessment of risk would further prove the presence of structural power. The

expectation through the idea of structural power is that CRA became, inter alia through the preferences of the various European investors a driving force in the universalization of self-regulating markets and the exoticization of other modes of social interaction, notwithstanding the policy of the European politicians. Through risk assessment by the CRA, no specific knowledge of the issuer, or the market, was needed in order to entrance the market. A

simplification and homogenization of various forms of risk through an arithmetic number3 not only enables the market entrance for various investors, but places the power over the

‘subjectivity of knowledge’ into the hands of a private company. Justification of selected variables

As set forth above, three specific variables are chosen in order to research the appearance of US structural power regarding the mortgage-backed securities market. Justification for the specific selection of the three variables is the following. As explained before, no research has so far been conducted that relates structural power with the securitization (RMBS) market.

3_{Being for example Aaa or Bbb.}

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Research that relates structural power with international finance has for example been directed towards the currency in which international transactions are conducted or the power to oblige other countries to fund the current account deficit of the hegemonic power

(Helleiner, 2000). In IPE Timothy J. Sinclair has devoted much time and energy in

researching the power position of CRA and the increasing importance of them in international finance (Sinclair, 1994; 2005). My choice to relate structural power with CRA therefore relies partially on his epochal research regarding CRA in international finance. The reason to

choose the international regulation (Basel agreements) regarding securitization as the

embodiment of structural power stems from Susan Strange. She has devoted special attention towards the former Basel agreements (Basel I) in relation with US structural power in

international finance (Strange, 1988). The third and last variable that is anticipated to have channeled structural power is the construction of a securitization market Europe with the American market as benchmark, for example through accounting principles. This idea stems as well from the theory of structural power by Susan Strange, related with the following citation: ‘the power to shape and determine the structures of the global political economy within which other states, their political institutions, their economic enterprises (and not least) their scientists and other professional people have to operate’ (Strange, 1988, p. 25). To conclude, all three variables have been selected by the author in a process of constant balancing between the theoretical insights and the scientific work at hand related with international finance in general, and securitization more specifically.

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Chapter V - Global Politics of Mortgage Securitization

Introduction

This chapter serves as an introductory chapter for the empirical chapters following. At first it describes the history of securitization in the United States, and its eventual deterioration resulting in the crisis. Next to that, it analyzes the exact (technical) content of the mortgage-backed securities, and the channels through which the product is constructed. It concludes by giving an overview of the degree as well as the extent to which the European investors were involved in this market at the moment the crisis set off.

History of securitization

A key aspect in understanding the trend of securitization lays in the governmental support for widespread home ownership. As a reaction to the US depression and the related reluctance of lenders to provide mortgages to low-income families, the American government launched an insurance program in 1934 through the ‘Federal Housing Administration’ (FHA). The commercial banks were able to get insurance from the FHA for mortgages with a relatively high default risk, thereby attempting to stimulate the housing market and the issuing of mortgages for the lower-income classes. Next to this institution Fannie Mae was created, a governmental institution that issued mortgages itself by using governmental money. In 1954 Fannie Mae was privatized, although remaining partially sponsored by the state, which gives it the label of a government sponsored enterprise (GSE). In the ’70s of last century another GSE was created, being Freddie Mac, which had the task of furthering the selling of

mortgages to lower-income groups, thereby increasing home ownership (Wainwright, 2009, pp. 376-378). The method they used in order to finance the mortgages they issued was securitization. Normally, a bank that had issued a mortgage to the home-owner had to wait several decades (until maturity) in order to recollect the total amount the banker had lent. This product was therefore highly illiquid. Through the process of securitization, this stream of future payments could be collected immediately. With this immediate collected amount of cash, new mortgages could be issued. These two GSEs bought large bulks of mortgages from private banks and mortgage brokers in the primary mortgage market, repacked those into structured products, and sold them to institutional investors. It thereby created a secondary mortgage market. In 1998 about one third of all mortgages outstanding in the USA were securitized by Freddie Mac and Fannie Mae, whereas five years later this had increased towards fifty percent of all mortgages. By the end of last century almost two-third of all mortgages were securitized. In the words of Gotham: ‘Through this process of securitization a spatially fixed and opaque commodity like real estate is transformed into a transparent assets that diverse buyers and sellers, in different places, can easily understand and exchange’ (2006, p. 235). The two GSEs mentioned before are very important in the American RMBS market, as they issued in 2001 for example 73% of all residential securitization products. Important to note is the character of the mortgages that these GSEs repackage. It is legally forbidden for them to securitize subprime mortgages, and they therefore focus predominantly on the prime mortgage market (ibid., p. 260).

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Liberalization during the ‘90s

The promotion of the secondary mortgage market by the American government furthered during the 1980s. In 1984 for example, the American Congress passed the ‘Secondary Mortgage Market Enhancement Act’, thereby removing the legal restrictions that obstructed investment in RMBS by federal chartered depository institution. That way, the secondary mortgage market was gradually opened for investment banks, mortgage banks, private mortgage insurance companies, pension funds et cetera. In 1992 the ‘rationale’ of the two GSEs changed as well in order to stimulate these institutions to increase the liquidity of mortgage investment, to improve the spatial distribution of investment capital and to provide assistance to the practice of issuing mortgages to low income families (Gotham, 2006, p. 261). Especially these two developments (the 1984 Act and the in 1992 changed ‘rationale’) created the environment for RMBS in the nineties of last century in the United States to flourish. As the institutional character for the development of securitization of the mortgage market had been created by the government, an important policy amendment had been set in place by the Clinton administration. The ‘Community Reinvestment Act’ that was set in place by Carter in order to prevent downgrading of certain neighborhoods, was made more effective by Clinton in 1995. Through this amendment, banks were forced to give mortgages to

households with limited creditworthiness. This act increased the share of US household owning homes from 64% in 1995 to 69% in 2005, as is shown in graph 1 as well. These newly issued mortgages were labeled subprime or alt-A (Alternative A-paper) mortgages, in order to distinguish them from the less risky mortgages.

Figure 1. Share of US Households owning their homes (1965-2009) (Sinn, 2010, p. 107) The increased proportion of risky mortgages on the balance sheet of mortgage banks gave an incentive for them to securitize these mortgages. That way they could free their balance sheet from the risk involved with these products. That resulted in the securitization of residential mortgage credit of about 60 percent of all mortgage credit in 2009 (7.2 trillion dollar), whereof the securitization of new issued mortgages from the period from 2000 was above 90% (Sinn, 2010, p. 113). As private banks were increasingly buying bunches of mortgages from the mortgage banks, the securitization cascade was increasing enormously, as indicated by the ratios above. As it became increasingly difficult to evaluate the quality of the derivate, credit rating agencies (CRA) were becoming more important. In most situations private banks were paying the CRA to qualify their financial products, whereby they were able to sell this

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labeled product nationally of internationally. In effect, CRA consulted these banks in such a way, that banks were able to construct RMBS with the lowest possible quality of mortgages and the highest possible label of qualification, being AAA (Tett, 2009, pp. 100-101).

Technical character of RMBS

In order to understand the pros en cons of residential mortgage-backed securities, the product itself has to be understood. It starts with a mortgage bank (in the USA) or a private bank (in the Netherlands) that gives out mortgages. The bank thereupon has to place the mortgage on its balance sheet. Under the Basel agreements, capital adequacy ratios were implemented. The Basel I agreements, agreed upon in 1988, forced banks to keep a capital ratio of 8% on their weighted assets (where mortgages were normally weighted 50%). When banks securitized their mortgages they were ‘freed’ from this obligation, as the mortgage was no longer on their balance sheet. At first the bank creates a shell company, of example a SPE, an entity to which it sells its assets (the mortgages), and from which it is officially separated. This SPE

thereupon buys the mortgage from the banks and creates securitized products, normally by using the waterfall structure. It takes the principal and interest repayments from several mortgages and places these together in the securitized product, which consists of different tranches with various forms of risk (being Senior, Mezzanine and Junior). The SPE then gives out obligations, where investors with different risk preferences can invest in. The ‘risk-averse’ investor buys senior (AAA rated) bonds whereas ‘risk-seeking’ investor buys junior (BBB rated) bonds. The aim of this waterfall structure is that the least risky AAA notes are paid first whilst the remaining capital flows down to the BBB trance (Wainwright, 2009, p. 375). It therefore fulfills the demand of various investors. Next to that, the risky mortgages can be sold more easily, when combined with the more credit-worthy mortgages. In order to create even more AAA-rated products, mezzanine or junior tranches of ‘normal’ CDOs were bought by SPE, repackaging them with senior mortgages, creating new CDOs with an AAA-rating, called squared CDOs. As the securitized products are not on the banks’ balance sheet (the mortgages are ‘shifted’ towards the SPE), no regulating authority is supervising its

evolvement. It therefore makes up a great deal of the shadow banking system. Bibow (2010, p. 64) summarizes this elegantly: Credit derivatives facilitate the credit creation within this yield-hungry shadow banking system while rating agencies attest to the quality of what is being created, sliced and diced, and wildly distributed through so many hands that everyone feels save ultimate risks must rest elsewhere’. The ‘shift’ of the mortgages from the banks towards the SPE is called a ‘true sale’. Legally, the SPE is decoupled from the originating bank, thereby protected from defaulting risk from the originating bank. The other way around, the SPE is still linked with the originating bank through liquidity or credit lines. In most cases, the SPE has a very limited amount of equity capital and a high leverage ratio, making the risk of insolvency apparent. At the moment the a few mortgage debtors default, the originating bank steps in by providing liquidity. For that reason, the SPE and the bonds it issues are able to get a high rating from the CRA. However, at the moment that no investor is willing to invest anymore in the securitized products of the SPE, the bank is forced by the market to take the securitized products back on its own account, due to reputational risk. This is what happened in most cases during the crisis (Acharya et al., 2012, p. 516).

One of the major problems with the securitization is its reliance on the liquidity of the market. Most European banks, for example, wanted to expose the lowest amount of equity capital possible to these SPEs. To illustrate, a SPE of an normal Dutch bank possessed on average 18.000 euro, whereas it held assets worth €500.000.000 (Thiemann, 2011b). These SPEs financed their long term assets (2 to 5 years) by short term commercial paper (20 to 40 days).

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As the yield of these long term assets was far higher than the short term costs of these commercial paper liabilities, and almost no ‘equity capital’ from the originating bank was used for this business, it was a highly profitable and attractive business (Thiemann, 2011a, pp. 15-17).

Pre-crisis securitization developments

Although the percentage of RMBS products that was sourced by GSE was 76% in 2003, this had decreased towards 43% by mid-2006. It was then predominantly private companies that issued these securitized products, being Wells Fargo, Lehman Brothers, Bear Stearns, JPMorgan, Goldman Sachs and Bank of America. This development, that started by the governmental approval of commercial involvement in the secondary mortgage market in 1984, really boomed from 2000 onwards. Remarkably, they had as well invested increasingly in subprime and alt-A mortgages in comparison with the GSEs, which is shown in figure 2 as well. These subprime mortgages were given to people that had bad payment fulfillment expectations, being primarily issued towards racial and ethnic minorities.

Figure 2. Issuances of below-investment-grade mortgage-backed securities ballooned between 2003 and 2006 (Dodd, 2007, p. 17). One of the major causes for the boom of the subprime mortgage lending in the pre-crisis period was the high short term profits these mortgages yielded. It was unveiled that the compensation structures given for the mortgage issuers stimulated them to give out subprime loans (that carried higher interest rates) to people that actually qualified for prime mortgages (Bibow, 2010, p. 60). It has to be understood that especially the structuring of these mortgages (through the waterfall structure) stimulated the issuance of subprime mortgages. Banks

purchased the ‘senior’ (high quality) tranches and combined them with the subprime mortgages, thereby creating newly high-rated CDOs. That way, these securitized products could deliver a higher yield than other AAA rated securities, such as Treasuries. Without these CDOs the subprime lending would have never reached the high levels it did in the pre-crisis period, as no investors would be willing to invest in it. The highly risky issuance of subprime mortgages reached its peak in 2006 and 2007. Van Duyn reports in the Financial Times (20 April 2010) that of the US $160 billion of mortgage-backed CDOs sold in the second half of 2006, 74 percent had defaulted by October 2009, while of the US $168 billion sold in 2007, 86 percent had defaulted.

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European investment in American subprime market

Especially since 2001 European commercial banks had invested substantially in the American subprime market, being attracted by the high yields these securitized products gave. At the time the housing market bubble burst, European banks had already directly or indirectly built up highly leveraged exposures to US mortgage-related credit risk (Bibow, 2009, p. 29). In the report published by the IMF in 2009 it became clear that the European banks had a big

proportion of the subprime mortgage-related assets on their account. European banks had to accept losses of around US $1.4260 billion whereas American banks had to amortize around US $1050 billion (Grahl, 2011, p. 39). Next to these enormous exposures by the European banks, they were as well highly leveraged. To indicate, at June 30th 2008 the leverage ratios4 of several big European banks were: UBS: 49.9; ING: 48.8; Barclais: 61.3; Crédit Agricole: 40.4; Deutsche Bank: 52.5 (ibid., p. 39). Münchau stated in the American newspaper the Financial Times that an additional indicator from the IMF report for the remarkable European involvement was the calculated amount of capital that was needed to recapitulate the banks in accordance with the mid-1990 levels: $275 billion for American banks and $500 billion for European banks (Financial Times, 26 April 2009). Striking examples of the European

involvement in the American subprime market were the two German banks IKB and Sachsen LB. The IKB bank had only 1.4 billion euro in assets on its balance sheet, but had invested 12.7 billion in special securities, by using conduits offshore and off-balance. The other bank, Sachsen LB, was owned by the German state Saxony, and has as well equivalent exposures in the American subprime segment, through an Irish affiliate (Lander et al., 2009, p. 9). As already set forth in the introduction of this thesis, commercial banks were not the only entities that were hit. Next to the private companies (hedge funds, investment funds), semipublic organizations such as pension funds and government sponsored companies (social housing corporations) and public investors such as municipalities were found out to be heavily involved in the American subprime market.

4

The leverage ratio indicates the totality of liabilities (debt) in relation with equity capital. When the bank’s ratio is for example 50, the bank has 50 times more liabilities outstanding than equity capital (Sinn, 2010, p. 77).

The global politics of mortgage securitization : a critical realist account of the European investment in the American subprime mortgage market