I'm aware that most of my posts so far have talked mainly about the way the UK retail banking system works and its role in the financial crisis of 2008. It has not escaped my notice that the US retail banking system is very different, but I must admit that until a recent twitter conversation with Cate Long I hadn't realised just HOW different it is. In particular, the US mortgage market operates in a fundamentally different way from the mortgage market in any other country - and that very different model was at the heart of the financial crisis not only in the US but throughout the Western world.
I'm also aware that some of my blogs get quite technical and they aren't always jargon-free. And the way the US mortgage market works is complex and hard to get your head round without illustration. So I thought I would describe it in terms of something much more familiar. I'm going to talk about sausages.
Imagine there are a hundred small farms all producing various varieties of meat - chicken, lamb, beef, pork. They sell some of their meat locally, but most of it is bought up by two huge processing plants. These processing plants dump all the meat, irrespective of its type, into huge vats, where it is boned, skinned and minced. It is then processed into sausages, which are packed up and sold on to domestic supermarkets and exporters. The exporters repackage the sausages under their own labels, taking some of them apart and creating new sausage-based products such as tins of baked beans with sausages in, tinned sausage stews and frozen sausage pies. Many of these repackaged sausages are exported, particularly to the UK and European countries where sausages and sausage-based products are popular because they are cheap and tasty.
Sounds like a really good, sound international industry, doesn't it? What could go wrong?
The meat that is produced is of course inspected by meat inspectors to make sure it is fit for human consumption before it is sold. And in the past the standards were high and quite a lot of meat didn't pass the test. This annoyed the farmers, because they couldn't get rich from farming, and it annoyed the factories, because they couldn't get enough meat to satisfy their international customers.
One day an enterprising farmer had a moan at the meat inspector about the meat standards and the fact that so much of his meat was only fit for pet food. To his surprise he discovered that the meat inspector agreed with him. So between them they came up with a scheme whereby some of the meat that should be condemned would actually be marked as "fit for human consumption" and sold at the higher price. Not all of it, of course - too much and questions would be asked. But enough to give a nice little boost to farm profits. The meat inspector got a cut of the proceeds, of course.
The farmer told his (equally frustrated) farmer friends about his friendly meat inspector. And the meat inspector told those of his colleagues he knew held similar views to him on the stupidity of meat standards. And before long, several farms were working with helpful meat inspectors to pass on some meat as "fit for human consumption" when it should have been condemned.
Well, the inevitable happened, of course. There was a massive outbreak of E Coli, initially in the UK and then in the US and various European countries. Hundreds died, and thousands more were very ill. Hospitals were unable to cope with the influx of sick people, and nurses and doctors worked around the clock but were still unable to treat everyone. Stocks of medicines ran out. Businesses lost money and many went bankrupt because so many of the workforce were ill. Governments declared national emergencies and asked unaffected countries for financial and medical assistance. It was a major global disasater. But no-one could work out where it had come from.
The obvious culprits initially seemed to be the export firms. After all, they were doing major repackaging and reprocessing operations: maybe some of their practices were a bit dodgy. And investigations discovered that that was indeed the case. Some of the export firms were adding potentially lethal substances to their products to make them look more attractive to housewives. And consumer watchdogs, noticing the pretty packaging, attractive colour and pleasant smell, were giving them top-notch approval ratings, which encouraged more consumers to buy the products. But if that was the only cause, how come people in the US were dropping like flies when all they had bought was sausages?
All the way down the line, companies involved in meat reprocessing were going bust. People just weren't buying sausages and sausage-related products any more. The export market collapsed. It was a major disaster for the industry. So the government stepped in to provide financial support to these companies so that they could find alternative suppliers and rebuild their shattered reputations. The largest amount of support went to the two giant factories.
Government investigators soon realised that although the export companies were making matters worse by their use of toxic substances in reprocessed products, they weren't the source of the E Coli outbreak. So they looked at the two sausage factories. Everything looked alright there - the factories were clean and hygiene standards were good. So they started to look at the farms themselves. And it soon became apparent that all was not well. Some of these farms had poor hygiene and animal welfare standards, others had untreated TB in cattle and there was an outbreak of swine fever in one area. All of these should have reduced or stopped the sales of meat from those farms - but it hadn't. Eventually, after much snooping and undercover work, the investigators started to expose the collusion of some farmers and meat inspectors. Prosecutions followed, of course. Interestingly, in the course of one of those prosecutions it emerged that both the factories had known about the public health risk and turned a blind eye.....they were only too happy to have the additional meat so they could produce more sausages.
The underlying problem was, of course, fraud. But had the meat that should have been condemned only been sold in local markets and not passed on to the factories, there would have been small local outbreaks of E Coli which would have been easily contained and the culprits identified and prosecuted quickly. Because it was sold on to the factories, which mixed it up with good quality meat and repackaged it, it went EVERYWHERE. Every sausage produced by the sausage factories was potentially a public health risk. And there were millions of them, and they were sold all round the world. So what started as a small-scale scam by a few disgruntled farmers and unscrupulous meat inspectors became a global public health disaster. It took years for the economies of the countries affected to recover. And the people who lost loved ones, or who were scarred by their illness, will never recover.
It's a horrible story, isn't it? Fortunately it has not happened. Or has it? Try substituting "mortgage" for "meat", "RMBS" for "sausage" and "financial" for "public health" in the above tale and see what happens.....