The most tangible sign of unease was that Geithner clamped down on the trading infrastructure of the credit derivatives world. Back in 1993, the J.P. Morgan bankers who wrote the G30 report had considered and dismissed the idea of instituting a mandatory clearinghouse for tracking and settling derivatives trades. One huge benefit of a clearinghouse would have been protecting against undue “counterparty risk,” or the danger that if two institutions traded and one suddenly collapsed mid-trade, the deal could not be completed. The clearinghouse idea was rejected because the bankers who wrote the G30 report argued that investors had sufficiently strong incentives to monitor that counterparty risk themselves. Their strong bias was for keeping the derivatives markets private, subject only to voluntary oversight.
By late 2004, though, it was clear to Geithner that self-policing had not removed counterparty risk. What particularly alarmed him at the time was the situation in banks’ back offices. Though credit derivatives were supposed to be the epitome of efficient “virtual” banking, many banks were still using faxes to confirm deals. In the early days of the market, that wasn’t a problem, but as the markets exploded, the volume of trades overwhelmed the banks’ back offices, creating long backlogs in the processing of the paperwork. By 2004, the delays were so bad that it took almost eighteen working days on average for banks to confirm their deals. Worse, a new fashion had started for “novating” deals, or assigning them to someone else. If Bank A cut a CDS deal with Bank B, for example, it might later decide to sell that deal to Bank C—without actually telling Bank B. That left vast quantities of deals in a legal limbo land.
In the rational market conceived of by free-market economists, the banks would have responded to this problem by voluntarily investing to create better trading systems. However, the banks weren’t doing so. At most banks, the derivatives traders had not only no control over the back office but no desire to sacrifice their profits to pay for infrastructure investment. With the notable exception of Jamie Dimon at JPMorgan Chase, most bank CEOs also knew very little about trading infrastructure. And no individual bank wanted to stop doing trades until a new system was in place, as that would let its competitors leap ahead. To Geithner, it was a classic case of a “collective action problem.”
In late 2004, he acted, encouraging Corrigan to head a study of a group of leading Wall Street financiers to examine the state of the complex financial world. By then Corrigan was working as a managing director at Goldman Sachs and had already conducted one such exercise, back in 1999, which set out the lessons to be learned after the Long-Term Capital Management hedge fund collapsed. This second study would have a much wider agenda, analyzing the state of complex finance more generally. When the three-hundred-page report was finally released in the summer of 2005, it duly demanded that banks overhaul their back office procedures for credit derivatives. “Dear Hank,” Corrigan wrote in a letter to Henry Paulson, then CEO at Goldman Sachs, that accompanied the report. “I want to call your particular attention to [our recommendations] which call for urgent industry-wide efforts to cope with serious back-office and potential settlement problems in the credit default swap market and to stop the practice whereby some market participants assign their side of a trade to another institution without the consent of the original counterparty to the trade…this practice has the potential to distort the ability of individual institutions to effectively monitor and control their counterparty credit exposures.”
In September 2005, Geithner summoned representatives from the fourteen largest Wall Street banks to attend a meeting at the New York Fed. It was the first time the banks had gathered for a collective meeting in the Fed since the implosion of the LTCM hedge fund. Determined to make his point, Geithner solemnly lectured the banks that they had to overhaul their systems or face a regulatory clampdown. It worked. By the end of 2005, the average time for confirming trades fell to eleven days, and in 2006 it fell sharply again. Geithner and Corrigan were thrilled. They appeared to have nipped this problem in the bud with deft, proactive action involving regulators and banks. “Often it takes a crisis to generate the will and energy needed to solve a problem,” Geithner observed in an article in late 2006, coauthored with Callum McCarthy, head of Britain’s FSA. “Here, the industry deserves credit for acting in advance of a crisis.” British officials fervently backed what Geithner was doing, as they had also been worried about the backlogs, but since regulatory responsibility was split between the Bank and FSA, it was unclear who should clean up the mess.
Yet when Geithner and Corrigan reflected on the backlog issue in early 2007, they felt little sense of triumph. Cutting backlogs was a relatively easy issue to address. There was consensus about what needed to be done, and there was also tangible data that proved why everyone needed to act. But what if the problem in the banks’ back offices epitomized a much bigger problem in the system as a whole? What if “collective action problems” were distorting the credit markets in a myriad of other, less transparent ways? Was there anything regulators do about those intangible “collective action” issues? Neither Geithner nor Corrigan was sure.
On April 17, 2007, Corrigan traveled down to Washington for a meeting organized by the German Finance Ministry. That year the Germans held the revolving chair of the G8 grouping, the body that brings together leaders from eight of the world’s leading industrialized nations for debate. They wanted to use the gathering to focus on the thorny matter of financial stability. Like others, German financial officials feared the credit bubble might be spinning out of control. However, they had an unusually clear idea who might be the culprit—the hedge funds. Almost exactly a decade earlier, in the autumn of 1998, the financial system had been rocked to its core when LTCM imploded. LTCM had been leveraged no less than 100 times and had used that money to place massive bets in the interest-rate derivatives world, which later turned sour. After that event, banks and regulators had scrutinized the funds, spurred on by the lessons outlined in Corrigan’s report. Nonetheless, the Germans remained alarmed by the lack of formal regulation over these funds.
Even if they did not know exactly why credit conditions seemed so extreme, they were convinced that the high-rolling, risk-loving hedge funds must somehow be to blame—and they hoped to persuade the rest of the G8 to regulate them. If nothing else, that would show that global leaders were willing to act to prevent another bubble burst. “There needs to be a proper debate about what hedge funds are doing,” Peer Steinbrück, the German finance minister, declared.
On a Sunday afternoon, the G8 delegates met at the World Bank’s headquarters to discuss the German proposals. Among them were senior US officials, including Robert Steel, US Treasury undersecretary, and Tim Geithner. Senior central bankers and treasury officials from Europe also attended, ranging from Mario Draghi, governor of the Bank of Italy, and Nigel Jenkinson, a senior official at the Bank of England. Some private-sector financiers had been invited too. Corrigan was one. Another was Jim Chanos, the founder of the hedge fund group Kynikos, famous for taking the type of aggressive “short” positions that the Germans hated.
The delegates trooped into a large conference room in the World Bank. Security at the meeting was tight. Corrigan was one of the first to speak. With his usual gruff manner, he outlined the key issues that were dogging the world of complex credit in relation to hedge funds and other investors. The good news, he observed, was that trading backlogs were falling. The bad news was that innovation was occurring so fast that it was posing a host of new risk management challenges—so many, in fact, that Corrigan admitted he was far from sure that the regulators—or even bankers—really knew what risks were building up.
One of the Italian officials jumped in. A few months earlier, he observed, the Bank of Italy had asked twenty-eight financial institutions with operations in Rome to complete an anonymous survey on their level of exposure to credit derivatives and other areas of structured finance. “But as of now, not one has replied,” he observed. The room erupted in nervous, embarra
ssed laughter.
Then Chanos was summoned. Steel, of the US Treasury, had asked him to come to make sure that the hedge fund community got a chance to defend itself. The Treasury didn’t agree with the Germans that hedge funds were the key problem, and it wasn’t keen on regulating them. Doing so would fly in the face of Alan Greenspan’s argument that it was good to have some freewheeling risk takers in the system to disperse risk across a wider group of players.
“So what are your views about hedge funds and financial stability?” a senior German official asked Chanos. As succinctly as he could, Chanos tried to defend himself. The hedge funds, he argued, were in the business of taking calculated risks, and precisely because they were in the risk-taking business, they tended to monitor those exposures. Other parts of the financial system, though, were far more dangerous because they were taking risks that nobody could see. “It’s not us you should be worrying about—it’s the banks!” he declared.
He explained why he was worried: leverage at investment banks was surging; banks were holding huge piles of opaque credit assets on their books that no one understood; strange CDO and SIV vehicles were springing up with all manner of tentacles into the banks. Worrying about what hedge funds were doing amid all that litany of dangers was like fiddling with the deck chairs while the Titanic was heading for icebergs. “It is the regulated bits of the system you should worry about!” he said, explaining that he was so concerned that his own fund had taken out numerous “short” positions on the share price of most large investment banks and many monoline insurers. The Germans looked utterly unimpressed. “Thank you, but do you have anything to say about the risks that hedge funds pose?” one official asked. “No,” Chanos said and sat down.
He had the impression that most of the officials around the room had barely heard what he had said, far less agreed with him. In part, the problem was one of data. The main way that the regulators and central banks judged whether banks were healthy was whether they were meeting the terms of the Basel Accord. All banks needed to set aside capital worth 8 percent of their assets, and by that measure the banks all looked extremely healthy. In early 2007, British banks had a capital ratio of 12 percent, while the American ratio was just slightly lower—way above the minimum that regulators required. Given that, it was very hard for regulators to make a case for getting too worried about the banks. What they didn’t know, and Chanos had tried to alert them to, was that those capital reserves were set against only a relatively small portion of the banks’ true risk exposure, because so much of that risk was tucked away in shadow banks or measured using only very narrow and flattering tools.
In reality, some of those around the table suspected that the Basel measurements were far from perfect. By 2007, many international banks were using a reformed version of the original Basel Accord called Basel II that let banks use their internal systems when deciding how risky assets might be and thus how much capital was required. If the bank’s own models for judging the risk of, say, a CDO were wrong, then the Basel II system would not work and the dangers in the market might be considerable. Corrigan had spent enough time looking at various banks’ models to know that they were far from foolproof. Geithner’s repeated warning that banks needed to pay more attention to the “tail risk” of fat tails indicated that he too was uneasy about the modeling. However, vague notions about invisible risk were not enough to force the G8 to act.
When Geithner had launched his campaign to clean up trading backlogs, he had been armed with alarming data. Similarly, when the Germans had launched their appeals for hedge fund regulation, they at least had a concrete disaster story to point to in LTCM. But in the case of the large banks, it was hard to point to any numbers that showed why anyone should be worried.
The meeting closed inconclusively. It was clear that the rest of the G8 did not support the German idea of clamping down on hedge funds, but it was also clear that nobody else around the table could articulate any better, proactive ideas about what they should do. As CEO of JPMorgan Chase, Jamie Dimon could impose policy shifts based on a gut feeling that the credit cycle was turning. Central bankers and regulators, by contrast, were trapped in vast bureaucratic machines. They were equipped only to fight the last war. Faced with a financial system that few people seemed to understand anymore, the G8 did nothing—other than hope that the losses appearing in the US subprime mortgage world would be absorbed quickly, just as the innovation evangelists presumed.
PART 3
DISASTER
[ ELEVEN ]
FIRST FAILURES
The sun slipped slowly down the cerulean Spanish sky. Next to the elegant Barcelona waterfront, hordes of vacationers strolled along the beach, enjoying the balmy summer air. A few stragglers could be heard screeching with laughter as they jumped into the sea. Above them, several hundred bankers stood on the elegant terrace of a futuristic, gleaming white hotel, staging a so-called champagne salute in celebration of the fact that investment banks had just enjoyed their most lucrative year in history. The date was June 11, 2007, and the occasion was the annual meeting of the European Securitisation Forum (ESF), the body devoted to promoting the art of securitization in Europe.
Champagne corks popped. Raucous laughter rang out. And as the light faded, a rock band struck up, playing cheesy covers. The band called itself “D’Leverage” and was composed of bankers from Barclays Capital, Credit Suisse, and others. The name was a joke. (“It’s meant to be funny—it’s da leverage, not de-leverage,” one of those watching explained.) They were slightly out of tune.
“It’s been an extraordinary year!” beamed Rick Watson, the man who ran the ESF, as the band struck up. Watson had every reason to be pleased. Back in the 1990s, Europe had no trade body like the ESF to champion securitization, and for years after the ESF sprang to life, its meetings attracted only a thousand bankers or so.
By the time of this gala, however, securitization had spread like wildfire in Europe, and more than five thousand attendees had turned up. The meeting carried a lofty title: “Global Asset Backed Securitization; Towards a New Dawn!” An exuberant crowd included smooth-talking, white-toothed salesmen from large American banks, eagerly selling repackaged mortgage debt; self-deprecating British traders; and earnest, chain-smoking representatives from German insurance companies and banks. Their prey included asset managers from Italy, Spain, Germany, and Greece, often decked in elegant pastel colors. A silent gaggle of Chinese and Singaporeans circulated. It was rumored that they were furtively buying CDOs to find a home for foreign exchange reserves. A few regulators could also be spotted, conspicuous in looking generally dowdier than the bankers. Some of the biggest delegations, though, came from the three credit ratings agencies that were drawing fat profits from the CDO boom. Barcelona was the perfect opportunity to market their skills.
Long queues formed outside the bathrooms and around the coffee stations and computer terminals. Bankers jostled in the corridors on their way to sessions so full that they were forced to stand in the aisles or squat on the floor. Lively debate ensued about the American mortgage-backed bond market, the CDO sector, the SIVs, the state of the Spanish mortgage market, and the outlook for Russian ABS. There was even a high-profile debate on Islamic finance, in which investing must comply with the sharia ban on usury. Some hoped Islamic finance would be a hot new growth area for securitization. “What we are seeing right now in the securitization sector is an extraordinary burst of innovation,” Watson boasted.
But could the party last? Not everyone was convinced. In late May, just before the Barcelona conference, the prices of bonds and loans had suffered some drops, implying the credit market had reached a peak. “What has happened [in recent days] in the bond market suggests we could be at a turning point,” suggested Ganesh Rajendra, head of securitization research at Deutsche Bank. “There are some signs that the weather is changing,” echoed Alexander Batchvarov, a highly respected senior securitization analyst who worked at Merrill Lynch. “The market has been
growing very fast—it doubled last year—we have to ask whether there will be such a fast pace of growth this year.”
Nobody doubted that some growth would occur. Most of the bankers in Barcelona had never worked in the field when it wasn’t booming. The ESF organizers were so supremely confident about the future that they announced during the conference that the 2008 gathering would take place in Cannes, a bigger venue and considerably swankier, too. “We need more space. Next year’s conference will be even bigger,” Watson effused, as the champagne kept flowing and D’Leverage played on.
The very next day, on June 12, the news broke in New York that a crisis was erupting at a hedge fund with close links to Bear Stearns. “Hard hit by turmoil in the market for risky mortgages, a big hedge fund has fallen 23 percent from the start of the year through late April,” the Wall Street Journal reported. “The fund, called the High-Grade Structured Credit Strategies Enhanced Leverage Fund, is widely exposed to subprime mortgages, or home loans to borrowers with weak credit histories.” The New York–based fund was run by two former Bear bankers, Ralph Cioffi and Matthew Tannin.
Initially, few details were reported about what exactly had gone wrong. What was clear, though, was that the fund had been hit by a toxic combination of bad mortgage bets and massive levels of leverage. Cioffi and Tannin had first set up shop back in October 2003, raising $925 million of investor money to create a fund called Bear Stearns High-Grade Structured Credit Strategies. They then borrowed heavily from banks to buy securities that were described in their marketing literature as “high-quality, floating rate, structured finance securities.” That included asset-backed bonds, CDOs, and bank loans, many of which had been created by Bear and most of which carried high credit ratings. In 2004, 2005, and 2006, as the credit markets boomed, the strategy produced fat profits, allowing the fund to produce annualized returns of between 13 percent and 40 percent. That success was so impressive that in the summer of 2006 the group created a second fund, called the High-Grade Structured Credit Strategies Enhanced Leverage Fund. This version employed similar tactics but was more leveraged, sometimes as much as $20 for every dollar of investor equity.
Fool's Gold: How the Bold Dream of a Small Tribe at J.P. Morgan Was Corrupted by Wall Street Greed and Unleashed a Catastrophe Page 19
