by Iain Martin
A legal fight rumbled on with unsuccessful attempts to block the sale of LaSalle to Bank of America. This might have been the moment for Goodwin to withdraw. That was certainly what some on the management team presumed would happen after LaSalle disappeared. Iain Allan was worried but he hoped that it would be off now. Dickinson remarked to Cameron that the deal must be dead, surely. His boss shook his head and said no, Goodwin was even more keen to do it. Cameron was asked to produce projections showing what marrying GBM with ABN Amro’s investment banking activities might mean. Armed with the numbers from Cameron, Goodwin explained to the board that actually, the likely loss of LaSalle was no impediment. The calculations still showed that it was worth doing, because the merger of the ABN Amro investment bank with GBM would give RBS global scale. The board was minded to push on and agreed to proceed when it was discussed at the annual strategy session, held at Gogarburn, on 20 June. Each and every one of them went along with it: Tom McKillop, Fred Goodwin, Gordon Pell, Johnny Cameron, Guy Whittaker, Mark Fisher, Larry Fish, Peter Sutherland, Bob Scott, Colin Buchan, Jim Currie, Joe MacHale, Archie Hunter, Charles Koch, Janis Kong, Bill Friedrich and Steve Robson. The chairman’s committee then voted unanimously in favour of proceeding when it met on 15 July. On 20 July the consortium published its offer of 71.1bn euros. The decision was taken to pay mainly in cash, rather than offering ABN Amro shareholders RBS shares. That would mean depleting capital and running it low for a while – as they had when they took over NatWest, Goodwin reminded his colleagues. Thereafter the plan was to quickly rebuild capital. There was no shortage of liquidity, the money flowing around the world that banks could access overnight to keep business going. It was going to be easy to borrow any amount that was needed.
While Goodwin was focused on the biggest deal of his career, something had been going wrong inside RBS’s investment bank since the turn of the year. Again they were just small tremors, just a flicker of the needle on the dial in one corner of an enormous business that otherwise seemed to be heading for record profits. The downturn in American housing was starting to have an impact. The market in collateralised debt obligations (CDOs) that Levine’s team in Greenwich had plunged into so enthusiastically from the middle of 2006, to deliver the growth that Goodwin and the RBS board sought, had started to turn bad.
In early 2007, Levine told Cameron that he was worried by the outlook and was looking to ‘de-risk’ in certain areas. That meant cutting back on dealings with companies that were up to their necks in lending to millions of Americans buying houses they could not really afford. But there was also the question of the CDOs, which Rick Caplan had been hired to help scale up from the summer of 2006. Caplan and Fred Matera’s team, overseen by Bob McGinnis, had been assembling these CDOs and billions of dollars of ‘super-senior’ exposure (supposedly better than AAA) was piling up on the RBS balance sheet. Levine was convinced that it would provide a flow of new revenue that would boost profits, and bonuses, as head office in London wanted. Matera and McGinnis had been concerned, but decided to get on with doing it if that is what was required. ‘If they wanted super-seniors, then you know, fuck it, whatever, they’re going to get super-seniors,’ says a member of the CDO team.
As far as Goodwin was concerned, the first minor manifestation of problems appeared in January 2007. Right from the start of the new year Cameron’s revenue numbers on one of the ‘structured credit’ initiatives, which had been agreed the previous summer, were off target, as the CDO business stuttered. Goodwin focused on the shortfall. The primary responsibility of executives was to deliver on the numbers that they had signed up to, which all went towards fulfilling his annual plan in any given year. Yet the misfiring in the engine room of GBM seemed to be related to income of only £15m a month, almost nothing in the context of a bank heading for £10bn profits. GBM’s monthly budget was in the region of $1bn a month. It was a niggling worry to Cameron and Brian Crowe, which was discussed most mornings in GBM, although the only pressure Cameron was put under at this stage in Goodwin’s management meetings was about hitting budget. The RBS chief executive said to the chair of GBM: ‘You got your income projections wrong. Why aren’t you getting the growth you promised me?’ He didn’t then go to Cameron or Crowe and ask what the underlying problem might be with the markets or whether there was a serious issue. It seemed to Cameron, in the light of everything else that was going on in RBS right then, that it was a problem no bigger than a small cloud in a wide open sky.
In February 2007, HSBC suddenly announced it was making provisions for losses of more than $10bn related to the American mortgage market.8 Demand for housing in the United States was collapsing, defaults were rising as sub-prime borrowers struggled to pay and foreclosures were up more than 30 per cent and rising on the previous year. Companies with optimistic names such as New Century Financial Corporation, which had done so much of the basic sub-prime lending in the boom, were starting to go bust. Greenspan had been increasing interest rates gradually since 2004, in an effort to dampen the explosion in lending.
Goodwin was still unfamiliar with the products involved in any detail, say colleagues. Since 2006 he had relied on the line that RBS ‘does not do sub-prime’, a position he amended subtly until by early 2007 he claimed they did not deal ‘directly’ in sub-prime, meaning they did not create sub-prime mortgages. Cameron also did not have as clear an understanding as he gained a few months later. ‘We make the sausages but we don’t keep any of the sausages,’ is how he would explain it when asked in early 2007 by Goodwin and others about the CDOs the bank had churned out. As it turned out, Jay Levine’s team had kept rather a lot of ‘the sausages’. RBS moved to assure investors that it was not heavily exposed. All major banks were being asked these questions as analysts began to ponder how much they would have to write down if the situation deteriorated. On 1 March Cameron told analysts: ‘We have around $4bn [£2.5bn] of collateralised lending and $2bn of warehouse. The amount of sub-prime, sub-investment grade exposure we have across both the warehouses and collateralised lending and residual interests, whichever way you look at it, is really very, very, very small. A minuscule amount of that. A minimal amount of those totals.’ That was true, in the sense that the super-senior RBS CDOs were highly rated. But were the ratings reliable? What would happen if investors, unable to get coherent answers from any bank on what this complex stuff was really worth, fled from banks that were exposed?
Shortly after Cameron gave his assurances, Goodwin did express some concerns about what was going on at Greenwich, following an intervention from a surprising source. He had finally moved against Larry Fish, bumping him upstairs in March 2007 into a non-role as chairman of RBS Americas. A new CEO of Citizens, Ellen Alemany, joined from Citigroup. Fish acted appalled, although the suspicion was that his theatrical display on being told the news obscured the fact that he realised he had been given an elegant and well-paid route to retirement. ‘Is this how I am to be treated after fifteen years and after everything I have done for this bank?’ The answer was yes.
Fish used his new RBS Americas chairman position to straight away start pointing out problems. He said to Goodwin that he was worried about Greenwich: ‘Fred, there’s a lot of guys making a lot of money there. Jay’s making a lot of money. They are making a lot of money for Johnny, Brian and Leith too.’ Fish had made serious money himself, but compared with Jay Levine and the astronomical standards of the hedge funders of Connecticut he was an underpaid American retail banker. That spring Goodwin flew to see Jay Levine in Greenwich. A very awkward meeting ensued, in which the bonhomie of previous visits was replaced by clinical cross-examination. He was there, it was clear, to ‘kick the tyres’ and it was apparent that Goodwin was annoyed at the way Greenwich seemed to have too much freedom. He did not, however, probe deeply on the specifics of CDOs or the markets; his concerns seemed more procedural. Cameron was not present, and if Fish hoped that Goodwin would confront Cameron back in London then he was wrong. It seemed again to Fish and the A
mericans that Fred had a problem bossing Johnny, or directly telling him what to do.
The underlying picture across large parts of the banking system was even worse than it appeared on the surface. The vast financial machine that had been constructed by banks, piling layer upon layer of innovation and complexity, was malfunctioning. All manner of strange creations had come into being at the behest of US and European investment banks. There were synthetic CDOs, and CDOs squared, and CDOs stuffed full of unsellable bits of other CDOs, and CDO computerised ‘robots’ that filled up virtual warehouses with mortgages and bonds stamped by the ratings agencies.9 The ratings agencies – Moody’s, Standard & Poor’s and Fitch – had been happy, for a chunky fee, to endorse many of these innovative CDO products with AAA ratings. The theory had been that because of the cleverness of the mathematical theories underpinning the process, the power of the computers used, the sophistication of the risk models employed and the assurances of bankers and policymakers, it would all dilute risk and help to create stability. The accountants could point to the endorsement of the ratings agencies when they signed off on banks holding so much of this stuff on their books. It had been deemed close to impossible imagining it blowing up in any serious way. Indeed the models used tended not to allow for this possibility.
As well as CDOs there was the multi-trillion-dollar market for credit default swaps (CDSs), traded to try to offload risk. The American investor Warren Buffet famously called the CDS a ‘weapon of financial destruction’. Buffet was not wrong. Some investment banks had created sets of CDOs to sell to other banks and investors, and then taken out credit default swaps, effectively gambling against their own clients who had been daft enough to buy their products. In the name of innovation, a sinister alternative financial universe had been created, in which customer care and ethics had been swapped for pure greed and downright treachery.
The root of the problem was that those sub-prime mortgages now going wrong were the raw meat that had been fed into the CDO mincer. If the underlying mortgages were falling in value, how long would it be before the CDOs themselves lost value? Not long. The major US banks started looking at marking them down. At Greenwich, in an atmosphere of rising concern, there was considerable discussion about this from the early spring onwards. What should the ‘super-senior’ slices of CDOs that RBS had kept on its books be valued at? In theory they were the safest slices of the CDO, but who knew what was safe now? Bruce Jin, the head of Risk Management at Greenwich, approached Bob McGinnis and said he was very concerned about the amount of super-seniors on the bank’s balance sheet. But this was exactly what had been envisaged when Levine hired Caplan and made him joint head of the CDO team, McGinnis explained. Fred Matera, Caplan’s co-head of the CDO unit, had been examining the data and concluded that they would have to be ‘marked down’. They were now valued at par – 100 cents in the dollar – and any reduction would mean taking a hit. Even marking down the value from 100 to 98 would mean a write-down, a real loss, of $100m on $5bn of CDOs. Caplan was reluctant, and called some contacts in other banks such as Citigroup, who said that there was no need to do it. McGinnis’s argument was that there was a good reason why some other banks were reluctant to advocate mark-downs. Their CDO teams were holding even bigger amounts of similar material and wanted to avoid giant losses, particularly when it would hit bonuses for that year. Anyway, some other banks had been marking down already, heavily. McGinnis broke the news to Levine in April, which caused the colour to drain from the Greenwich boss’s face. He would have to call London and explain what had happened. It was the first of several such calls.
In London, Cameron was getting to grips with understanding more about what the problem might be. On 14 May he sent an email to Crowe asking why the daily profit and loss numbers were deteriorating: ‘How much leakage of sub-prime into CDO business?’ Crowe responded: ‘CDO is all sub-prime.’ That month Cameron went to see Goodwin in his office, asked him how much he understood about CDOs and then did the chief executive a drawing on a sheet of A4. It demonstrated how a CDO was structured, with all of the different descending tranches with their various ratings, and super-senior at the top that was still stuffed with sub-prime. That was super-seniors of the kind RBS now had on its balance sheet. Goodwin simply didn’t react. It was another example of what even his friends acknowledge. In areas where he is not comfortable he does not want to admit ignorance. Goodwin also knew that Iain Allan, sidelined on ABN Amro, was intuitively concerned about CDOs. He had tried to explain the potential seriousness of the situation to the chief executive and others, and had mentioned the possible risks in GBM.
Cameron, Crowe and Levine now considered ‘hedging’ their exposure, by using the ABX sub-prime index that had been established the previous year. It enabled all banks and hedge funds to place bets that would pay out if the decline continued. Those who calculated that the US housing market was about to implode had been staking billions on such bets for months. Yet every time it was looked at in RBS, it became steadily more expensive to do. Some $250m of protection was taken out in July, although it was concluded that the market would recover so it was not worth going further. The discussions continued over what exactly the CDOs on the books of RBS were worth. That summer, Riccardo Rebonato, one of Cameron and Crowe’s risk experts in London, arrived in Greenwich for a look. He told McGinnis that he wanted to make sure that everyone was comfortable with the ‘marks’. At that point the super-seniors had been marked down to 88–90. Wouldn’t a number like 65 perhaps be more appropriate? Fine, if that’s what you want, said McGinnis, who had concluded the CDO game was up and that the argument about what they were worth was increasingly ridiculous and theoretical. Crowe was so concerned about developments in Greenwich that he suddenly dropped in and stayed for almost four weeks in July and August. While he was there, Caplan and McGinnis warned him it would be insane to buy ABN Amro in the circumstances. Crowe set up in the meeting room that had once been Ben Carpenter’s office; Carpenter had stood down as joint CEO leaving Levine in sole charge. He interviewed many senior staff in an effort to establish what had been going on. By the time he went back to London he had concluded that Levine would have to go.
The disaster in the upper echelons of Greenwich was approaching its denouement. Having hired Caplan, colleagues noticed that Levine could now hardly stand to look at him or be in the same room. Another of the initiatives – the ‘total return swap business’ – that Caplan had advocated when he was hired was in trouble. Essentially it was a fancy name for lending money to hedge funds, which used it to gamble. Why has it become so big? Levine asked colleagues who thought that had been what he wanted. But it was Caplan’s CDO problem that exercised him most. ‘That guy, I can’t believe it,’ he told colleagues. ‘Those fucking super-seniors.’ McGinnis and Matera started work on laying off two thirds of the CDO team, while Caplan left in the middle of August, convinced that RBS was a shambolic operation out of control.
As the CDO machine at Greenwich was disintegrating, Goodwin was fixated on getting ABN Amro. At the regulator, where John Tiner had departed as CEO, they seemed very relaxed. If anything, the team from RBS felt that the FSA was going out of its way to be obliging: ‘The priority seemed to be that they wanted a level playing field so that we would get a fair crack at it in competition with Barclays,’ says an adviser to Goodwin. The regulator could have blocked a deal if it judged there was a risk to consumers, if RBS was running its capital too low in order to afford the takeover. Yet no consideration was given to intervening between the regulator being notified on 17 April that RBS was preparing a bid and the consortium publishing its offer on 20 July. More generally, Hector Sants, the new CEO, was clear that the FSA’s monitoring of British banks had been deficient. He was beginning an overhaul in an attempt to break down the wall between the teams monitoring retail banks and investment banks, and to refocus the FSA. In chaotic circumstances it was about to be revealed just how unprepared they were for a market meltdown.
On
9 August 2007, as RBS raced to buy ABN Amro and the CDO business melted down, the ‘credit crunch’ began properly. That day Robert Peston, on his BBC blog, diagnosed the decision of the French bank BNP Paribas to suspend three of its investment funds as a pivotal moment.10 The funds contained sub-prime material that it was impossible to value, meaning it was impossible to sell. It was junk. A freeze began in the funding markets, with lenders uncertain whom to trust. Who held this rubbish and in what quantities? It was suddenly, frighteningly, unclear. In such circumstances those banks such as RBS needing to fund themselves with a lot of borrowing were going to find the cost going up. By mid-September the credit crunch spread to the British high street and there were queues outside branches of Northern Rock, as an old-fashioned bank run got under way. The Northern Rock business model had been built on lending large multiples of salary to Britons who wanted to buy a house, on the expectation that it could borrow this on the international ‘wholesale’ money markets, markets that were now freezing. An ill-prepared FSA, Bank of England and Treasury were desperately trying to work out how to keep Northern Rock going, before moving later to full nationalisation at huge cost to the taxpayer.
In August and September there was considerable concern inside RBS over market turbulence, although it didn’t yet turn into panic. At the end of August McKillop convened a meeting at Gogarburn, with Cameron dialling in from holiday. What was the exposure from this CDO-related activity, McKillop asked. It amounted, it was decided, to about £200m to £400m. The conclusion was that this was containable in the context of such huge revenues and profits. Perhaps in such fluid circumstances it was time to stop and rethink on ABN Amro. McKillop said to Goodwin that he was getting nervous and they discussed attempting to lower the price, or even finding an excuse to call a halt. The City lawyers Linklaters was commissioned to give an opinion, and concluded that there was no legal justification for withdrawing. ‘It would have meant massive litigation so at the time, on the facts available, it just wasn’t a serious option,’ says one of Goodwin’s team. That was to prove an extremely expensive miscalculation. The FSA did briefly consider having a rethink, with Hector Sants and Callum McCarthy concluding that they did not have sufficient grounds to intervene. RBS was a big bank, and surely it knew what it was doing? Incredibly, Sants then overlooked the rules on capital. He allowed Goodwin and RBS to dip below 4 per cent, below the minimum regulatory requirement on capital, to do the ABN Amro deal. The last line of defence had crumbled.
