Brian Caplen, editor in chief of the Banker, traces the origins of the financial crisis to 'securitisation' and suggests that most finance journalists failed to predict the crisis because they tend to focus on news events and individual banks rather than macroeconomics.

This chapter is part of a new book, 'Playing Footsie with the FTSE?' edited by John Mair and Richard Lance Keeble, a collection of 20 articles by leading journalists and academics that asks why leading financial journalists and commentators failed to predict the biggest economic crisis in 70 years. It will be published by Abramis on September 28.

One of the bogeymen of the financial crisis was a previously obscure, but latterly highly damaging, concept known as securitisation. I clearly remember the first time securitisation was explained to me back in the 1990s and the kind of questions I raised.

Basically in securitisation the mortgage the bank gave you on your house (or the credit card debt or car loan) is taken off the bank's balance sheet and put into a made-up company that exists only to receive your mortgage along with thousands of other mortgages. You carry on paying your mortgage every month but instead of going to the bank the money goes instead to the made up company to repay bondholders who bought the mortgages from the bank.

Isn't it a bit of cheek, I remember asking the banker who was explaining all this to me, to take my mortgage and give it to someone else? And what happens if I stop paying my mortgage and the bondholders don't get their money back? I was assured that I would never notice that my mortgage had gone into outer space or more accurately the mid-Atlantic as it turned out – and that so far no securitisation vehicle had ever crashed.

There were all kinds of other technical issues surrounding securitisation such as interest rate risk, the different classes of bonds involved and who would get paid out first in the event of difficulties, collateralisation, sampling procedures and default histories. In the first articles I wrote about securitisation, learned professors spoke at length about these risks and we created quite a stir about the efficacy of this new fangled concept.

Moving on to the next innovation…
But as every journalist knows, a story doesn't remain hot for very long. Soon I had stopped worrying about the intricacies and frailties of securitisation and had moved on to the next innovation. My colleagues in the financial press no doubt did likewise and the mainstream press hardly ever touched such an arcane subject. Meanwhile securitisation grew into this massive and unchecked industry. Not only were mortgages, credit cards, car loans and the rest being securitised but so too were the flows from a whole mixture of loans jumbled up together. These were called collateralised debt obligations.

Banks were also selling the credit risk of some of their loans by paying a fee to the taker who then became responsible for paying up if the borrower defaulted. Known as credit default swaps, it was this kind of arrangement that proved so disastrous for the US insurance company AIG. Again, I remember asking some, hopefully, of the right questions about this kind of arrangement at the time. For example, if a company got into trouble, how would this affect the bankruptcy process since the banks having sold the credit risk would not care if the company failed? Why were banks making loans in the first place, if they only either wanted to sell them on or sell the credit risk? Why were other banks and insurance companies buying the risk?

Bankers are good at defending their inventions and most of the answers were based on either the theory of comparative advantage – Bank A has access to a particular type of credit risk on terms that Bank B doesn't so Bank B wants to buy the exposure – or the theory of market efficiency according to which the more that risk is sliced, diced and parcelled out to the party that most wants it, the safer and more efficient the total system will be.

Market approach too glib
Like most journalists I recorded the debate and moved on. Little purpose is served editorially in harping on about an impending disaster that fails subsequently to materialise. And these past years have been lonely times for those of us schooled in Keynesian ideas and who always felt that a pure market approach was too glib, too limiting and just too theoretical to correctly explain what was going on. Time and again I've sat through speeches at multilateral meetings where bankers and politicians alike proclaimed that the market had all the answers. These have been the ruling ideas for nearly three decades and they have gone unchallenged because, for so much of that time, their proponents could claim that it was working well, delivering wealth across borders and who were you, insolent scribe, to question its veracity.

Politicians, it's worth saying, of all colours were as bought into the concept of financial markets always delivering as anyone else, and they had a great interest in this outcome in terms of tax revenues from bank profits and jobs in the City. All this made it much more difficult for critics and regulators to be heard even if someone had been persistently calling the end of the party (and there were a few). Officials of the Bank of England expressed their reservations and European Central Bank president Jean Claude Trichet was particularly outspoken on the incorrect pricing of risk, just before the onset of the crisis. All these thoughts and comments were faithfully recorded by journals such as the Banker but no action was taken.

The Icelandic case is particularly instructive. Iceland was being described in the press as a hedge fund, not a country, way before it crashed and at the Banker we invited all the bankers and leading officials to a roundtable to discuss the country's apparently risk-adverse financial sector way back in June 2006. Councils who held their money in Icelandic banks claiming not to have known the risks just were not reading the financial press.

I think what fooled journalists, regulators, politicians, risk managers more than anything about the crisis, however, was the impact these new instruments and structures could have when they were built up and leveraged on a mass scale. Some of us did write articles about the build-up of leverage but mostly it was considered a matter for individual banks. Few of us spotted how markets were mushrooming and the financial sector as a whole was becoming wildly out of proportion to the real economy it was supposed to be serving.

Speculative to the point of the absurd
Credit derivatives at one stage became a $60 trillion market, about twice the size of world gross domestic product (GDP), which seems speculative to the point of the absurd (although actually, despite all the worries, it seems that in the end most of the contracts settled). Banks were leveraging up their capital 30 times, banking assets had expanded to three and four times the GDP of even relatively large countries like the UK, banking stocks as a percentage of total stock market capitalisation were accounting for a larger proportion than every other industry with shareholders expecting, and long used to, above average returns. Most of us missed all this because we tend to focus on news events and individual banks rather than macroeconomics which doesn't tend to make much of a story.

Massive liquidity was being pumped into the markets as a result of the build of Chinese foreign exchange reserves. These were being used to make huge purchases of US treasuries (and still are) crowding out other buyers and bringing down yields. There was a desperate search for yield. A prophetic book by Charles Dumas and Diana Choyleva, entitled 'The bill from the China shop: How Asia's savings glut threatens the world economy', appeared as far back as 2006 and was reviewed by the Banker as an interesting idea.

That liquidity had to go somewhere and its usual destination, over the 20 years I have been writing about financial markets, was the emerging markets countries with high political risk and weak policies. This time, however, the liquidity wave found the emerging market within the United States: the sub-prime borrower. Again, the warning sign was the massive growth in a market that by definition should have been a minority sport and ancillary to the mainstream but cracks in the sub-prime market did not go unreported.

In fact, the crisis in the US sub-prime market must surely count as the most well-predicted downturn on record. Journalists and analysts were writing about the likely problems a year or 18 months ahead of its unravelling. But, again, what was missed was the scale of some banks' involvement. They were also using a structuring method that on paper should not have been risky but turned out to be calamitous.

Suddenly we arrive back to all those basic questions about securitisation that were asked a decade ago and subsequently forgotten. No one was keeping an eye on the quality of assets being put into these securitisations that were being originated by third-party brokers in the US. The brokers did not care whether borrowers could repay as they were handing the asset on. To save money the big banks putting together the securitisations had reduced the number of individual mortgages they looked at to assess their robustness. And the rating agencies who were making huge profits out of rating securitisations had no historical default rates to assist them in their verdicts. They chose to artificially construct them.

Sorry to sound like a parrot, but if you flip back through your old Banker magazines you will find an article written by a credit analyst taking apart rating agency methodology for rating sub-prime securitisations. In the interests of balance and fairness, we also invited a rating agency to reply and defend its position. It makes for a rather technical read and no doubt even some of our readers sighed and moved on to articles with a bit more pace and colour (such as 'Team of the month').

Bankers not unduly concerned
The bankers were not unduly concerned because their million dollar risk management systems said that everything was fine. Many of them were borrowing huge amounts of money in the markets and then investing it in the triple A tranches - i.e. the highest rated and safest part of the securitisations - to gain a slight yield pick up. They were not invested in the lower quality bonds or the equity and their risk management systems told them that markets would have to go through an unheard of number standard deviations for them to ever come unstuck. Clearly it was impossible.

So guess what? That's exactly what the market did do and suddenly securitisations were collapsing left right and centre and, in a turning of the concept on its head, coming back on to the balance sheet of the banks that originally put them together to take them off balance sheet. This was not supposed to happen, but sometimes the banks did this in a desperate bid to salvage their already battered reputations. All this most of us in the financial press did miss, but then a financial crisis on this scale is a once in a century event, so you could have lived a whole life predicting it and never seeing it.

Now politicians and regulators are busy trying to put in place systems to prevent the next crisis. Some of their ideas seem quite half-baked, but even if they weren't I guarantee that everyone will miss the next crisis too - due around the year 3000. We all know now about securitisation and its pitfalls. But the next crisis is not going to involve securitisation or bonuses or mark-to-mark accounting or poor corporate governance procedures. By definition the next crisis is going to occur in a shape or form that no one has thought of and regardless of whatever regulations are put in place.

Need for regulators with political clout
Remember that banks, by their very nature as profit maximising institutions, will always attempt to get round the regulations anyway. Securitisation, after all, was a way of expanding a bank's assets without providing the additional capital that regulators would have insisted on if they had been left on balance sheet. The only salvation is to have regulators who are savvy enough and have sufficient political clout to insist on different responses according to particular problems. Some countries such as Canada, Australia and Spain did have such far-sighted regulators who managed to save their national systems.

But expecting humble scribes to put all these complex concepts together, as well as name the day and form in which the whole thing will all come tumbling down - and run a decade-long campaign for regulatory change and oversight - is probably asking a bit too much.