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Global financial system: 'We can take a sledgehammer to the whole thing, if we want to'


30 March 2009

This is one in a series of articles looking at financial regulation and reform, written by Allen & Overy's legal experts.  

View the webcast: Philip Wood on what really caused the financial crisis and what needs to happen now.

Many people are bewildered and confused by the financial crisis, what caused it, why nobody seemed to see it coming, why nobody did anything about it if they did, and what we should do about it now. They look to their leaders - whether the G20 or their national politicians – to explain it, to sort it out, to prevent it in the future.

This crisis began with people's homes. The Gross Domestic Product of the US – that is its annual productivity, how much Americans produce each year – is about a quarter of world GDP. Europe contributes about the same amount.  World GDP is around USD50 trillion. The outstanding amount of the US home loans when the crisis began in the summer of 2007 was about the same as their GDP. So if you think that an asset of that size is worth 100 but actually is only worth 50, which is exactly what happened to the value of people's homes, then your banking system is smashed.

When Enron became bankrupt in 2001, it was then the world's biggest bankruptcy – USD100 billion. It was soon surpassed in a few months by the bankruptcy of Argentina - USD132 billion of foreign debt, comprising about 80 bond issues. In the summer of 2008 an American investment bank – not the largest by any means and nowhere near as big as the large US commercial banks - became insolvent with claims against it of USD640 billion. This was more than six times as large as Enron.

But in the meantime a much, much bigger bankruptcy had occurred. Fannie Mae and Freddie Mac – two US mortgage companies – failed at around the same time and were effectively nationalised. They held or guaranteed nearly half of the US outstanding home loans. That is, half of US GDP.

In Britain the outstanding amount of home loans at the same time was about 80 per cent of the country's GDP.

So this is a crisis about plain ordinary assets, the shelter of the people, the roofs over their heads, where they live, their homes. It is not a crisis about strange financial exotics – hedge funds, or private equity or securitisations or credit default swaps or derivatives, or even stock exchanges. The asset is simple, comprehensible, universal.

The history of this crisis and what caused it has yet to be written. What is clear is that we had a bubble, a bubble which was the same as the innumerable bubbles we have had in the past from tulips onwards, except that it was by the far the biggest. Bubbles are created when collective manias lead to people getting carried away. Their optimism and hope overpowers their reason.  Almost the whole of a society can be involved in the bubble and puff it up - it is a universal credulity when most people, whole societies from the central bankers and politicians and banks down to the poorest borrowers, the citizen, are acting in good faith but believe in something which is not so, believe that at last it is possible to get rich without actually doing anything.

It was not complexity which defeated us – the metrics or the value at risk models or the intricate transactions or the formulae or the financial engineering. All we had to know was that houses were valued at figures far in excess of their real worth – not a very complicated issue, not an issue which required learning in financial theory. The situation was in reality extremely simple. We are just not very good at reality sometimes.

When bubbles like this burst, the debris from the skies envelops everything.

The idea of a bank is fundamentally a good one. When you switch the light on, the light comes on. It comes on because there is a power station which produces electricity, warmth, light and power. There is a power station because it has been financed. It has been financed often by banks. They finance it out of the money of the people, their salaries, their savings, their deposits, their pension payments, their insurance premiums. The people are the real creditors via their banks. They produce the power, the warmth and the light.

When people want a home, they can pitch a tent in the mud by the river and live there till they have saved enough to buy a chateau on the hill. Or they can buy the chateau on the hill now – but with other people's money which they have to pay back and pay interest on it.

It is not unreasonable to want a home. It is not unreasonable to have a system which allows you to do this.

We have it in our power to stop this kind of thing happening again. We can stop it by making sure that money is not too cheap or plentiful, that central banks fix higher interest rates that restrict the amount of credit available to borrowers to buy assets like houses or shares, that we insist that banks have more capital, that we close down their sources of capital like securitisations. We can  stop the free flow of capital across borders. We can do these both good and bad. It is possible to do this by collective will, by waving the legal wand, by political decisions across the planet, by our memory of the disaster. Ultimately we are masters of ourselves, our banks, our money, our behaviour, masters of our destiny – if we want to be. We can get a sledgehammer and smash the whole thing – if we want to.

Before this crisis, the GDP of the world was forecast to rise by two-and-a-half times by 2030 and that forecast may still be correct. If so, there would be two-and-a-half times as much money sloshing around in the world, two-and-a-half times as much volatility, two-and-half-times the potential for bubbles.

The question for us is how much we want to restrict the availability of the chateau on the hill. This is not just a question for G20 leaders. It is a fundamental question for all of us

One thing  is for sure. This crisis will pass. Nobody knows quite when, but pass it will. And we have not lost everything. The houses that have been built are still there, the people who have been lifted out of poverty have more shelter and food, light and water.

The test for the future is whether the past means anything to us and whether we learn its lessons. Or whether history is lost as soon as it is made.

Allen & Overy Special Global Counsel, Philip Wood, has over 40 years of experience in international law. He is the author of over 18 books on international finance and holds a number of distinguished academic positions, including Visiting Professor in International Finance Law at the University of Oxford, Yorke Distinguished Visiting Fellow at the University of Cambridge and Visiting Professor at the London School of Economics & Political Science.

Further information

View the webcast: Philip Wood on what really caused the financial crisis and what needs to happen now.


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