When I left LTCM in 1999, I was dissatisfied with the standard explanations for my former firm’s collapse. Nobel Prize winners talked about the “perfect storm,” the “hundred-year flood,” and a “fifteen-standard-deviation event.” I knew enough about statistics to realize this was the language of normally distributed risk and mean reversion—the language of random walks and efficient markets. My intuition said there was something rotten at the heart of modern financial economics.
In the years following the LTCM collapse, I studied physics, applied mathematics, network theory, behavioral economics, and complexity. After 9/11, I was recruited by the CIA to assist on a counterterrorism project involving identification of anomalies in stock markets. Today, the capabilities our team developed allow the intelligence community to foresee a terrorist attack based on insider trading by terrorist associates. Coincidentally, the analytic techniques I learned and applied at the CIA were the same ones I was using to untangle LTCM’s collapse.
By 2005, I had worked out complexity theory dynamics in finance. The main complexity theory tenets were expounded by physicists years before, and applied in various scientific fields including seismology, meteorology, and biology. Still, physicists were making slow progress in finance because they were unfamiliar with capital markets in general. I had the advantage of approaching physics from a financial background, rather than approaching finance with a background in physics. My main theoretical breakthrough was to apply the concept of scale in finance, and work out scaling metrics such as the gross notional value of derivatives as a way to assess systemic risk. My early theoretical advances were compiled in an article published in the CIA’s academic journal, Studies in Intelligence, in September 2006. That was a special issue of Studies timed to coincide with the fifth anniversary of 9/11. My contribution, and other contents of that issue, remain classified.
My experiences at LTCM in the 1990s, and my inquiries in the early 2000s, gave me a unique perspective on capital markets developments after 2005. The largest banks were getting larger, asset concentration in a few large banks was growing more dense, and derivatives’ notional values were growing dramatically. Between June 30, 2001, and June 30, 2007, the gross notional value of all over-the-counter derivatives held by major banks as reported in a BIS survey grew from less than $100 trillion to more than $508 trillion. Over the same period, the Herfindahl index, a market concentration measure for U.S. dollar–denominated interest rate swaps, rose from 529 to 686, strong evidence that more swaps were concentrated in fewer large banks.
In a lecture series from 2003 to 2005 at Northwestern University’s Kellogg School, I warned audiences a new financial catastrophe was coming, and that it would be more costly than the 1998 LTCM crisis. I was not particularly focused on subprime mortgages. Instead I focused on scaling metrics and density functions, technical terms for the size and interconnectedness of capital markets. I said the system was reaching critical mass, not metaphorically, but literally. I didn’t know which neutron would dislodge other neutrons and start a chain reaction. It didn’t matter. What mattered was we had once again shaped uranium into a nuclear weapon; we had once again put capital markets into a critical state.
When a chain reaction starts in a nuclear weapon, the energy release and fireball formation happen in nanoseconds. In capital markets, the dynamics are the same, but the process takes more time. Financial neutrons move not at the speed of light, but at the speed of humans engaged in adaptive behavior.
The financial fireball that emerged in September 2008 resulted from a chain reaction that began over a year earlier, the week of July 16, 2007. Two hedge funds sponsored by Bear Stearns that specialized in leveraged bets on debt derivatives collapsed into insolvency that week. Bear Stearns tried to organize a self-rescue, but this failed. Counterparties like Merrill Lynch seized collateral that proved illiquid and nearly worthless.
On August 3, 2007, CNBC’s Jim Cramer launched into a live TV tirade against Federal Reserve chairman Ben Bernanke’s ignorance of the illiquidity infecting capital markets. Cramer told colleague Erin Burnett,
I have talked to the heads of almost every one of these firms in the last seventy-two hours and he [Bernanke] has no idea what it’s like out there. None! And Bill Poole [Fed official], he has no idea what it’s like out there. My people have been in this game for twenty-five years and they’re losing their jobs and these firms are gonna go out of business and it’s nuts. They’re nuts! They know nothing! . . . This is a different kinda market. And the Fed is asleep.
A few days later, on August 9, 2007, French bank BNP Paribas suspended redemptions on three funds that invested in subprime mortgage assets.
At the Federal Open Market Committee (FOMC) on June 28, 2007, just prior to the Bear Stearns fund meltdown, Ben Bernanke and the FOMC said, “The economy seems likely to continue to expand at a moderate pace over coming quarters.” Shortly before, on March 28, 2007, Bernanke had said, “The impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained. In particular, mortgages to prime borrowers and fixed rate mortgages to all classes of borrowers continue to perform well, with low rates of delinquency.” The contrast between official ignorance of risk and the ongoing market collapse in the spring and summer of 2007 could not have been more stark.
On August 24, 2007, more than a year before the Lehman collapse, I met with a U.S. Treasury official to warn about the potential for systemic collapse. I presented a detailed written analysis titled “Proposal to Obtain and Manage Information in Response to Capital Markets Crisis.” My written proposal said, in part:
The financial crisis of 2007 has as much to do with a shortage of information as a shortage of liquidity. This paper proposes use of executive authority under IEEPA to obtain . . . position information to be stored in a secure environment and used selectively to manage the financial crisis. . . . No fund would be told what to trade, how to leverage, how to manage risk, etc. The sole purpose is to provide adequate transparency for the proper exercise of the U.S. government’s duty to maintain functioning capital markets which constitute part of the critical national security infrastructure. . . . The prime brokers and clearing banks . . . could be quickly identified and concentration risk in the regulated sector could be ascertained.
The past 30 years have witnessed the disintermediation of the regulated financial sector by the less regulated and non-regulated sectors. . . . Every step in this evolution . . . has involved a diminution in transparency and an increase in risk. . . . When derivatives technology drives an exponential increase in the quantum of risk, the risk-increasing effects of scaling and complexity in a non-linear critical system dominate the risk-reducing effects. . . .
A problem cannot be resolved unless the dimensions of the problem are known to some extent. This proposal does not involve active regulation, bail outs or top down solutions. It is a relatively modest step in the direction of information transparency . . . highly useful to officials charged with maintaining stable markets during times of panic and duress.
My meeting with the Treasury official began cordially. After initial pleasantries, I got to the point. “This crisis is just beginning. The instability has been building for some time. The system has absorbed a few shocks already.” Here I was referring to the October 10, 2005, revelation of accounting fraud and later bankruptcy of Refco, then the world’s largest futures broker, and the September 2006 collapse of Amaranth, a hedge fund that lost $6 billion in one week. At the time, those events seemed prompt-critical to me, yet they weren’t. In both cases there was delayed criticality; markets absorbed the shocks and rebounded. Not every snowflake causes an avalanche.
After observing events from July through August 2007, I was convinced that this crisis dynamic really was unstoppable and would spread widely. Treasury needed to know and act soon.
“You should issue an order requiring all banks and hedge funds to r
eport their derivatives positions to you, in detail, with counterparty names, underlying instruments, payment flows, and termination dates. The information should be in standardized machine-readable form delivered one week from the date the order goes out. Anyone who can’t deliver should go to the top of your problem list. Once you get the information, hire IBM Global Services to process it for you in a secure environment so there’s no leakage. Build a matrix and find out who owes what to whom. Rank the biggest risk concentrations and focus your attention on those names.”
The Treasury official listened politely, and paused before answering. “We can’t do that.”
“Why not?” I expected him to recite a legal impediment. I was certain Treasury had all the authority it needed if it chose to use it.
“This Treasury and White House are free market oriented. We don’t believe in interfering or telling people what to do.”
I answered, “You’re not telling them what to do. They can trade whatever they want. You’re not interfering with anyone’s operations. You’re just getting information. This will end up in your lap eventually; you’re entitled to know what you’re dealing with. It’s just information.”
“It’s not how we do things. It won’t fly.” This was pure Bush administration free market philosophy, without analysis or reflection. Free market approaches do not work for banks because banks are subsidized, insured, regulated, and implicitly guaranteed. Modern banks are the opposite of free market institutions, so different approaches are needed. This seemed lost on the Bush Treasury.
When the meeting was over. I thanked the official for his time. At least I had the meeting and warned someone inside Treasury. The warning went nowhere.
As I walked past the steps of the main Treasury building on Hamilton Place that hot summer day, I glanced at the White House next door and thought, “They’re not ready for this. They think these are unconnected market blips. They have no idea what’s coming.”
Treasury Secretary Hank Paulson spent September 2007 chasing a chimera called Super-SIV, a special purpose vehicle sponsored by the government to strip asset-backed securities from the bank balance sheets. Banks spent years creating special investment vehicles called SIVs to hide risks and avoid capital charges on consumer debt from credit cards and auto loans. Now frightened investors were forcing that debt back onto bank balance sheets by refusing to roll over credit to the SIVs. Paulson’s idea was to pool the bad assets of major banks into one Super-SIV that could be refinanced with implicit government support. The idea flopped and was quietly killed. On December 21, 2007, the major banks that had expressed interest in the Super-SIV issued a statement that said the facility “was not needed at this time.” This statement confirmed that the banks were as blind to the dangers as Treasury.
On October 5, 2007, the Dow Jones Industrial Average reached a new high of 14,066.01, a nearly 10 percent rally from the August 15 low of 12,861.47. Markets were giving an all-clear signal.
Behind the scenes, mortgage losses were piling up and liquidity was evaporating. Banks would report their 2007 losses in January 2008. Treasury feared that impaired bank capital would spook investors and reignite the panic that emerged in the summer. Paulson quietly arranged for a backdoor bank bailout using sovereign wealth funds and foreign banks as fresh capital sources. On November 26, 2007, Citigroup announced the sale of 4.9 percent of its equity for $7.5 billion to the Abu Dhabi Investment Authority. On December 19, 2007, Morgan Stanley announced the sale of $5 billion of equity to the China Investment Corporation. On December 25, 2007, Temasek, a sovereign wealth fund of Singapore, announced it was buying $4.4 billion of stock in Merrill Lynch with an option to buy more. This deal flurry and other similar deals were designed to put on a brave face and convince investors that all was well in the U.S. banking sector. In fact, U.S. banks were rotten to the core, and sovereign wealth funds were played for suckers by Paulson and the bankers. Within a year, tens of billions of sovereign wealth fund money, held in trust for everyday citizens in emerging markets, would go up in smoke. Still, in the short run it was mission accomplished for the Bush administration. Markets entered 2008 with renewed confidence that the crisis was past.
The deceptive calm in the winter of 2008 bore an eerie resemblance to the winter of 1998. The latter crisis also started the summer before and appeared solved by winter, only to reemerge by spring. The 2008 crisis repeated this pattern almost ten years to the day.
In March 2008, the crisis became visible again with Bear Stearns’s collapse over the course of a few days, March 12 to 16. On Wednesday, March 12, Bear Stearns CEO Alan Schwartz told CNBC, “We have no problems with our liquidity and overnight funding. . . . Bear Stearns’s balance sheet, liquidity and capital remain strong . . . and the situation, with time, will stabilize.” Three days later, Bear was broke and its business was absorbed by JPMorgan. The worst positions were buried off-balance-sheet at the Federal Reserve. Only days before, SEC chairman Christopher Cox said he had confidence in capital cushions at major U.S. investment banks.
Again, investors breathed easy, believing banks and regulators had the situation under control. The Dow Jones Industrial Average rallied from 11,893.69 on March 7, 2008, to 13,058.20 on May 2, an impressive 9.8 percent gain. Investors and regulators did not see the underlying critical state dynamics. Each crisis was seen as discrete and manageable. No one connected the dots to see it was all one crisis, emerging in different times and places, yet one general collapse.
By July, the illiquidity wave caught up with Fannie Mae and Freddie Mac, the government-sponsored mortgage agencies, and two of the largest financial institutions in the world. Fannie and Freddie were darlings of Washington politicos, who used them for decades as a source of campaign funds and multimillion-dollar sinecures doled out to political cronies for loyal service to Democratic and Republican administrations. Fannie and Freddie were as corrupt and mismanaged as the banks with which they competed.
On July 24, 2008, Congress passed the Housing and Economic Recovery Act of 2008, which gave Treasury authority to use taxpayer money to prop up Fannie and Freddie. Once again, the everyday citizen bailed out the elites including stockholders, bondholders, and wealthy executives of the twin entities. President Bush signed the bailout legislation on July 31, 2008. Political cronies who personally made hundreds of millions of dollars in prior decades did not contribute to the bailout. That money was theirs to keep.
Like a cock crowing for the third time, the stock market staged a third rally to signal the crisis was over. The Dow Jones Industrial Average rose from a low of 11,055.19 on July 14, at the height of the Fannie and Freddie angst, to 11,782.35 on August 11. This relief rally was weaker than the two before, only a 6 percent gain. Still, it signaled confidence in the solutions repeatedly offered up by government officials. It also signaled that investors, regulators, and bankers had no idea what lay ahead.
I had been informally advising John McCain’s presidential campaign on economics in the late summer of 2008. On August 16, just one month before the Lehman blow-up, I provided the McCain campaign with this written advice using complexity theory–based models. The advice was sent as an email with the subject line “Storm Warning.” The text reads:
Here’s a quick take on the financial crisis:
I’ve said since last summer that it has a funny tempo. We have these periodic spikes in fear and each time we seem to be looking into the abyss. Then some magic wand comes along and things seemed solved, markets calm down and people get a little optimistic again (but still wary because of recent experience).
The tempo seems to be every 3–4 months; not exactly every 90 days but something like that.
We had a panic in Aug–Sept 2007 which was mitigated by Paulson’s “Super-SIV” idea. Oct–Nov were then calm.
We had a panic in Dec 07 which was mitigated by Sovereign Wealth Fund bailouts and new Fed lending facilities. Jan–Feb 08 were then calm.
> We had a panic in Mar 08 which was mitigated by the Bear Stearns bailout and further Fed facilities. Apr–Jun were then calm.
We had a panic in Jul 08 which was mitigated by the Fannie/Freddie housing legislation. Aug has been calm (and I expect Sept will be too). . . .
Every time things calm down, markets feel the worst is over and a sense of complacency appears. But it’s never over. . . .
We can expect another “panic” spike in October 08; very possibly late October when companies report third quarter earnings. This will be about 2 weeks before election day and right after the last debate. Congress will be out of session so there’s no chance for a quick legislative fix. The Fed has used up its bag of tricks and Paulson’s credibility has been hurt because so many of his ideas have gone nowhere. . . .
From the candidate’s perspective, two thoughts:
A. Don’t let complacency on the financial crisis set in. Stay alert for another storm before election day.
B. Be prepared with some leadership-type statements; the candidate should have the economic . . . declaration in his pocket ready to go; time may be short for improvisation and panics are rarely the best time to think clearly. (Emphasis added.)
On Monday, August 25, 2008, I was invited by a senior adviser to the McCain campaign to formally participate on a campaign conference call scheduled for August 27 with McCain’s economics advisory team. I dialed in on schedule; the mood was fairly relaxed. The economists felt that there really wasn’t much to do on the economic front other than stick to their pro-growth message of lower taxes and less regulation.
The Road to Ruin Page 18
