McCain was running as a foreign policy hawk, not as an economic policy maven. He wanted to confront the Democratic candidate, Barack Obama, on the Iraq issue. McCain’s policy was to build on the military success of the Bush surge. Obama wanted to end the engagement and pull out of Iraq. The McCain team was relieved after the Fannie and Freddie bailout. Their view was that the financial crisis was over. This meant the candidate could concentrate on his foreign policy message.
After waiting for an opportunity to interject, I said to the McCain team, “Hey, this financial crisis is not over. You’re not going to make it to election day without an earthquake.” There was total silence on the call. I continued, “We’ve had blowups every few months since this started. Each one is bigger than the one before and they’re not over; you need to get ready for the next one; it’s all people will care about.”
With the McCain economics team listening, I continued. “Here’s what you need to do. Write a speech now; make it a four-point plan. It doesn’t even matter what the points are, just do it. Maybe put in something about a derivatives clearinghouse and transparency. When the panic hits put your guy on the steps of the Treasury and have him read the plan to the media. The American people will be near panic; they’ll find his speech reassuring. It will put the candidate over the top.”
McCain’s call leader said, “Thanks, Jim, but we don’t see this as a problem. The crisis is over; we need to stick to our growth message.” The call wrapped up after that. It was my first and last turn as a campaign adviser. I was not invited back.
The crisis did come to a head on “Lehman Weekend,” September 13–14, 2008. Lehman Brothers filed for bankruptcy on September 15. That day, the Dow Jones Industrial Average fell more than 500 points, a 4.4 percent plunge. The results were disastrous for McCain. He knew little about economics, yet his campaign needed to act. McCain seemed distracted and confused. On September 24, 2008, McCain shocked Republicans when he suspended his campaign to return to Washington to deal with the crisis. McCain insisted on a meeting with President Bush to discuss a response. With only six weeks to election day, the Bush crisis team could not appear to favor one candidate over the other. Bush invited both McCain and Obama to the West Wing Cabinet Room on September 25 for a crisis consultation. The Obama team did not know more than McCain about crisis dynamics. Still, they were smart enough to keep cool, say little, and project calm. McCain appeared nervous, ashen, and close to panic himself. With markets in free fall, the American people noticed the difference.
Since the 2008 election, conventional wisdom is that McCain’s undoing was Sarah Palin’s selection as his running mate, an event pressed into popular imagination in the 2012 HBO movie Game Change. This fits an inside-the-Beltway view of Palin as a policy lightweight and an albatross around McCain’s neck. Yet data do not support this narrative. The day before Lehman’s bankruptcy, McCain led Obama 47.4 percent to 45.3 percent in the RealClearPolitics average tracking poll. Two days after Lehman, the candidates were tied at 45.7 percent each. The next day, Obama pulled ahead, 47.1 percent to 45.2 percent. Obama never trailed in the polls again. The tipping point to Obama’s victory was not Palin, it was Lehman.
My warnings to the Bush Treasury in 2007, and the McCain campaign in 2008, about the coming collapse failed. Bush and McCain were not alone in their inability to comprehend insights offered by complexity theory. Policymakers from Paulson to Bernanke, and CEOs from Merrill Lynch’s John Thain to Lehman’s Dick Fuld, were as dazed.
On September 29, 2008, ten years to the day after the LTCM bailout, Congress rejected the Paulson-Bernanke TARP bailout bill designed to use taxpayer money to prop up big banks. The next day, the Dow Jones Industrial Average fell 777 points, an 8 percent plunge, the largest one-day point drop ever.
Two days later, on October 2, The Washington Post published my op-ed “A Mountain, Overlooked: How Risk Models Failed Wall St. and Washington.” This was my first public effort to use complexity theory to explain the ongoing financial collapse. In the op-ed I wrote:
Since the 1990s, risk management on Wall Street has been dominated by a model called “value at risk” (VaR). VaR attributes risk factors to every security and aggregates these factors across an entire portfolio, identifying those risks that cancel out. What’s left is “net” risk that is then considered in light of historical patterns. The model predicts with 99 percent probability that institutions cannot lose more than a certain amount of money. Institutions compare this “worst case” with their actual capital and, if the amount of capital is greater, sleep soundly at night. Regulators, knowing that the institutions used these models, also slept soundly.
Lurking behind the models, however, was a colossal conceptual error: the belief that risk is randomly distributed and that each event has no bearing on the next event in a sequence. . . . Such systems are represented in the bell curve, which makes clear that events of the type we have witnessed lately are so statistically improbable as to be practically impossible. This is why markets are taken by surprise when they occur.
But what if markets are not like coin tosses? . . . What if new events are profoundly affected by what went before?
Both natural and man-made systems are full of the kind of complexity in which minute changes at the start result in divergent and unpredictable outcomes . . . that . . . cannot be modeled with even the most powerful computers. Capital markets are an example of such complex dynamic systems.
The Washington Post takes an extremely rigorous approach to guest op-eds. My contribution on complexity theory coming at the height of the crisis was published only after a series of conference calls with Vincent Reinhart, a former monetary economist for the Federal Open Market Committee and expert on market bubbles. Reinhart was acting as a referee for the Post’s editorial board. I discussed my theories with him from a hotel room in Budapest where I was traveling at the time. It was the middle of the night there. I was able to answer his technical queries, and after a few tweaks to words and phrases, the Post published my piece. I’m certain the op-ed had no impact on the public policy debate at the time. Still, I welcomed the chance to go public after several failed private warnings.
The next day, October 3, 2008, Congress passed the TARP legislation. President Bush signed it into law within hours. Market participants, journalists, and everyday Americans were shocked at how the system spun out of control in a matter of weeks from Lehman, to AIG, to TARP. Now new rumors said more bailouts were needed. TARP helped to truncate the free fall in capital markets. Yet the problems were just beginning in the real economy. The United States entered the worst recession since the Great Depression. Unemployment peaked at over 10 percent. The Dow Jones Industrial Average crashed from 10,831.07 on October 1, 2008, to 6,547.05 on March 9, 2009—a stunning 40 percent plunge on top of the losses that had already occurred since the October 2007 peak.
As was the case in 1998, policymakers ignored crisis lessons and did the opposite of what was needed to prevent a future collapse. Policy blunders began immediately with the use of the newly approved TARP funds. Paulson and Bernanke sold this to the Congress as a fund to buy bad assets from banks and then sell them gradually to recoup costs for taxpayers’ benefit. This tactic made sense; a version of this was used effectively to clean up the 1980s savings and loan crisis. Another benefit was that bad assets were removed from the banks. With clean balance sheets banks could resume lending to small-and-medium-size enterprises that are the most dynamic and create the most jobs.
Instead of implementing his promises to Congress, Paulson gave the money to the banks and allowed them to keep the bad assets in the hope that they recouped their losses. Recoveries did not go to the taxpayers. Paulson made sure future gains went to the bankers, including his former partners at Goldman Sachs.
The Paulson bait and switch was extended by the Obama administration in March 2009 when mark-to-market accounting was suspended. This meant banks’ pretended assets we
re worth more than they were. With inflated values in place, banks waited patiently as the Fed pumped up asset prices with easy money until market values were closer to the phony accounting values. The last step was for banks to unload the assets slowly and lock in gains, which were diverted to the bankers and stockholders as executive bonuses and dividends. Taxpayers were treated like forced lenders who got their money back, but had no share in the upside. The fact that this fraud was perpetrated by both the Bush and Obama administrations shows that bank power transcends politics, and is a permanent condition in Washington.
Aftermath II
The White House and Congress spent a year from 2009 to 2010 drafting and enacting the Dodd-Frank Wall Street Reform and Consumer Protection Act. It was signed into law by President Obama on July 21, 2010. Dodd-Frank was more than one thousand pages long in its final form, and was scarcely read by members of Congress who voted on it. Dodd-Frank was an odd mix of genuine reform, pseudo-reform, dereliction, and nonessential matter from lobbyist wish lists.
Some Dodd-Frank provisions, including increased capital requirements for banks, and the Volcker Rule, which limited certain forms of proprietary trading, were useful if limited steps in the direction of a safer financial system. The most overhyped provision was “orderly liquidation” authority. In theory, this was a roadmap to wind down failing too-big-to-fail banks without the chaos of the 2008 Lehman collapse and ad hoc bank bailouts. In practice, orderly liquidation is another Washington confection that will break the minute it is tested under real panic conditions. Regulators will resort to cronyism and improvisation as they always do.
Dereliction of congressional duty is evident in the two-hundred-plus rule-writing projects required by Dodd-Frank. Congress identified important matters not covered by the statute, then delegated rule-making authority to agencies. From 2011 onward, this rule making became a feeding frenzy for bank lobbyists out to gut the intent of Congress. In the end, there was no more left of legislative intent than there was flesh on the marlin in The Old Man and the Sea. Nonessential matter in Dodd-Frank included creation of an overbearing new agency called the Consumer Financial Protection Bureau. To date, “The Bureau” has forced more than $11 billion of settlements from financial institutions and has made consumer credit less available, which hurts the recovery. How Bureau enforcement prevents a new banking panic remains a mystery.
Dodd-Frank did address the systemic risk issue directly by creating two other agencies: the Financial Stability Oversight Council (FSOC) and the Office of Financial Research (OFR).
FSOC is a new embodiment of the old President’s Working Group, which squashed Brooksley Born’s derivatives warnings in 1998. The FSOC includes the treasury secretary, Fed chairman, and heads of the SEC, CFTC, FDIC, and several other financial regulators. Dodd-Frank formalizes FSOC’s power and centralizes that power in the Treasury. FSOC is intended to coordinate an emergency response to a future systemic crisis.
The Office of Financial Research is a new think tank set up inside Treasury to enable financial regulators to keep up with Wall Street whiz kids in derivatives risk measurement. The OFR is the analytic arm of the FSOC. In principle, FSOC decisions on systemic risk and policy responses to panic will be informed by OFR analysis. The two agencies are intended to work closely together.
In early 2013, I was invited to give a private briefing to FSOC and OFR officials at the Treasury in Washington. The briefing took place on Friday, April 12. The Treasury official who organized the briefing was interested in learning more about complexity theory and its use in identifying systemic risk in capital markets. I was encouraged by the invitation. Perhaps glasnost had arrived in Washington a quarter century after it hit the old Soviet Union.
I prepared a white paper on my main risk management models and sent it to Treasury in advance. In Washington, I met with nine officials from the FSOC and OFR and launched into my presentation. The meeting lasted about two hours, a generous allotment of time by the Treasury officials. I was grateful for the opportunity.
Still, as the presentation continued, I gained the impression that despite their attentiveness, Treasury was not interested in next steps. The officials seemed to be “checking the box” with regard to hearing new ideas, yet not internalizing the implications.
At one point, I interrupted my presentation flow, turned to the senior Treasury Department official present, and said, “I don’t envy your job. New ideas don’t seem to matter. There’s not much you can do because the banks own this town.”
I expected an indignant response to my sympathetic, yet provocative remark. Instead, the official looked at me and said, “You’re right,” a candid admission that risk management took second place to bank profits.
Later in the presentation, I asked the senior OFR official what models they used to assess systemic risk. I knew they were not using complexity theory, and still used value at risk. I wanted to know whether refinements or advances to VaR had been adopted. The official said, “Well, we’re really just doing implementation of the Dodd-Frank regulations. We leave systemic risk management to the Fed.”
This admission was more disconcerting than the prior remark about bank power. I knew how flawed the Fed models were from conversations with senior Fed officials and research staff. I hoped for better from OFR. Yet Washington was serving up more of the same—bigger banks, more derivatives, more interconnectedness. OFR was taking its risk management cues from the Fed. It was the blind leading the blind.
In the past thirty years, global capital markets reached critical mass and headed toward complete collapse four times. The first was October 19, 1987, Black Monday, when U.S. stock markets fell over 20 percent in one day. The second was December 20, 1994, the Tequila Crisis, when Mexico devalued the peso 15 percent in one day. The third was August 17, 1998, when Russia devalued the ruble and defaulted on its debt, leading to the LTCM collapse. The fourth was June 20, 2007, when two Bear Stearns hedge funds collapsed after a failed rescue attempt leading to the Lehman crisis the following year. Capital markets are in what physicists call a supercritical state, which means one critical event can trigger a chain reaction and catastrophic end result. A simple extrapolation from this thirty-year time line reveals the next critical event is overdue.
There were other major market events over this period, including the popping of the Japanese asset bubble in 1990, and the dot-com bubble in 2000. Those bubble events resulted in huge losses for investors, yet did not have global systemic implications. The reaction to the Brexit vote by the United Kingdom to leave the European Union on June 23, 2016, had the potential to go critical, and may yet. For the time being, Brexit was contained by central bank promises the same way a nuclear reactor operator prevents a meltdown by inserting control rods into a radioactive core.
The 1987, 1994, 1998, and 2007 catalysts all went supercritical. The crisis chain reactions were truncated only with massive central bank and other policy interventions.
I lived through all four crises in different capacities as a banker, hedge fund executive, and analyst. I did not see the first three crises coming. They just happened, or so it seemed at the time, and I did my best to manage through them. Based on those experiences, especially 1998, I did the research and developed the models needed to properly understand the statistical properties of risk. Looking back at 1987, 1994, and 1998, I can see those crises didn’t “just happen,” but were a foreseeable result of critical state dynamics. Using the proper models, the 2007 crisis was foreseeable by 2005, as I warned at the time.
Using these same models and looking ahead, the contour is troubling. Once again the system is blinking red.
CHAPTER 6
EARTHQUAKE: 2018
No single incident can really be imagined to have brought about the end of the Bronze Age; rather, the end must have come as the consequence of a complex series of events that reverberated throughout the interconnected kingdoms and empires of the Aegean
and Eastern Mediterranean and eventually led to a collapse of the entire system. . . .
Eric H. Cline 1177 B.C.: The Year Civilization Collapsed
If the crowded, interconnected, urbanized and nuclear-armed world we have created does stagger into a new dark age, it will surely be the most terrible of all.
Ian Morris “The Dawn of a New Dark Age,” July 2016
Man Without a Face
“Not yet” was Jon Faust’s reply when I asked if the Federal Reserve saw a bubble like the ones that burst catastrophically in 1998 and 2008. His answer was distressing. It showed that the Fed had learned little from prior episodes. If the Fed cannot see the new bubble about to burst, then it will not stop it from bursting.
Faust is a Fed insider handpicked by Chairman Ben Bernanke in 2012 to serve as special adviser to the board of governors. The term “insider” is often used loosely to describe those who might only be tangentially involved, and not in the inner circle of the institution they are purportedly inside. This loose usage does not apply to Jon Faust. As for his role at the Federal Reserve, “insider’s insider” is a more apt description.
Faust’s Fed tenure from January 2012 to August 2014 included the transition from Bernanke to Janet Yellen as Fed chair. His role was broad-based, but focused on communications. This did not mean public relations or press liaison. The communications role meant Faust was consigliere and chief wordsmith with respect to forward guidance.
Forward guidance is a central bank’s main monetary tool in a world of zero or low rates. The Fed uses forward guidance to manipulate market expectations. Manipulation allows the Fed to tighten or ease policy without changing rates. Instead the Fed changes expectations about rates. This is done with words in speeches, statements, minutes, and press leaks. Those words are forward guidance, and Faust wrote the words.
The Road to Ruin Page 19
