During the credit boom, financiers regularly talked of ‘special purpose vehicles’ for their operations and so I started to wonder what kind of vehicles these would be. In my imagination, they quickly became ships sailing on the seas of liquidity, transporting wares over time and space.
So attractive was this idea that it quickly grew details. Suddenly, the ships had a crew – the company directors – and there became ports where these ships would sail to and from. Obviously the biggest port was the City of London, which, just as in times of Imperial Britain, was the hub of international trade. Every day vast numbers of ships from all across Europe, the Middle East and further afield would dock and unload their financial goods, ready to then be repackaged and put on ships sailing elsewhere.
And there were treacherous seas. Ever-changing, the seas of liquidity would in places be broad and deep while at others deceptive and shallow. Ship-ripping rocks were an ever-present menace, appearing to cluster around certain places and times. If a heavily-loaded ship were to sail through a patch of limited liquidity, then its end could be sudden and disastrous. Only a few sailors had the knowledge and experience to know where and when was best to sail, but not all shipowners were wise, or wanted to hear the message of experience.
In port, the loading and unloading of the ships was watched by the regulators. Few of the regulators had ever been to sea, and the sailors did not think much of their ability. However, often the regulators and the ship owners would end up drinking in the same pubs in the ports, and while there, telling tales, the regulators could often be persuaded to see the others' point of view.
So what would these ships carry? Over the years, trends came and went, different ports handled different goods. Over the years, the Chinese ports sent out increasing amounts of goods, especially manufactures. In London and New York, the amount and complexity of financial goods grew and grew. Each load was ever more valuable. Incentives increased to load up each ship with more and more.
A rising tide lifts all boats, they say, and in credit world the same rule applies. So when the central banks began pouring in liquidity to the seas after 9/11 all the boats began to rise. Liquidity came from lower interest rates, pushing down the cost of debt and so lowering the price of risk. This was bolstered by banks and investment funds, seemingly free from restrictions to generate new debt-based products, with each iteration leading to greater liquidity.
By 2005, this was sufficient for the shipowners to declare they were almost drowning in liquidity. For the ships, this meant the risks of overloading grew smaller and smaller. Default (sinking) rates fell and the risks taken by ship owners increased. As each overloaded ship returned safely to port, this encouraged the next ship to be loaded up yet further. And the regulators? They had been persuaded that what was good for the shipowners was good for the port. The shipowners had invested in a range of complex measures to assess their risks, and paid rating agencies for their opinion of them. The regulators believed that the shipowners’ actions had helped stop ships from sinking. However, they rarely looked out to sea, but if they had they would have seen levels higher than ever before.
All good things must come to an end. But before it ends, there must be a final orgy of activity. This took place in the second quarter of 2007. Liquidity became so deep that shipowners started to believe they could do anything. The most elaborate structures set sail on the sea with no consequences. But then the consequences began. This started innocuously, a couple of small boats overturned loaded with goods few people knew about. However, by August the rumours grew. Throughout the month, the shipowners' newspaper had trumpeted “crisis” on the front page every day.
People grew worried. They looked out to sea and noticed the levels, though high, were dropping. And each time they looked, the lower the sea became. Suddenly, all those ships at sea were at risk. The atmosphere in the ports grew ever more fearful. By the turn of the year, the situation looked grave. Liquidity continued to slide away. Everyone had become sucked in to the chase of landing just one more load; one shipowner noted that 'if the music is playing, you've got to keep dancing'. But the music was ending, liquidity was ebbing away. Ships overloaded with complexity and risk were left to battle their way back to port. By the middle of 2008, like a pool of rainwater left long in the African desert, there was no liquidity at all.