by Conor McCabe
OTC derivatives may appear to limit risk for the individual client, but the risk does not go away. It does not leave the system. It is merely passed on to somewhere (and someone) else. ‘You as an individual can diversify your risk,’ said Lawrence B. Lindsey, former Governor of the Federal Reserve. ‘The system as a whole, though, cannot reduce the risk. And that’s where the confusion lies.’42 And in the case of financial markets, risk is not a by-product of the process of buying and selling, it is risk which makes the act of buying and selling financial products possible. Without risk, financial markets as constituted today would cease to exist. Nobody has an edge. There is nothing of which to take advantage.
OTC derivatives increased the amount of leverage that a bank could utilise on its assets. They allowed ‘financial services firms and corporations to take more complex risks that they might otherwise avoid – for example, issuing more mortgages or corporate debt’.43 However, OTC derivatives did not diversify risk; instead, they had the effect of concentrating systemic risk within the handful of financial firms that dealt in the issuing of these contracts. If one of those firms was to collapse, the effect on the rest of the financial markets would be devastating. In the words of Alan Greenspan, ‘The very efficiency that is involved here means that if a crisis were to occur, that that crisis is transmitted at a far faster pace and with some greater virulence’.44 Despite this, there was no oversight, no regulation, no checking of whether the insurers had the capital to cover any potential losses. When questioned on this lack of oversight, Greenspan responded that the chances of such an event occurring were extremely remote. And anyway, ‘risk’ he said, ‘was part of life’.45
The power of OTC derivatives to destabilise markets showed itself, seemingly, as an anomaly, but became more frequent as the twentieth century drew to a close. The multinational firm Proctor & Gamble reported a pre-tax loss of $157 million in 1994. It stemmed from OTC derivatives sold to it by Bankers Trust. The same year, Orange County, California, filed for bankruptcy. It lost $1.5 billion speculating on derivatives. Its dealer was Merrill Lynch. The county treasurer, Robert Criton, later pleaded guilty to six felony counts. In 1996, the Japanese Sumitomo business group lost $2.6 billion on copper derivatives. The Commodity Futures Trading Commission (CFTC) later fined Merrill Lynch $15 million ‘for knowingly and intentionally aiding, abetting and assisting the manipulation of copper prices’.46 In 1995, the UK-based Barings Bank was declared insolvent after it lost $1.3 billion due to the activities of one of its derivatives dealers, Nick Leeson. In September 1998, the New York Federal Reserve organised a bailout of the hedge fund management firm Long-Term Capital Management (LTCM), which had lost €4.6 billion during the 1997 and 1998 Asian and Russian financial crises. It ‘held more than 50,000 derivatives contracts with a notional sum involved in excess of $1 trillion’.47
The instability, lack of oversight, and toxic concentration of risk that was generated by OTC derivatives led Warren Buffet to declare, in 2003, that ‘derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal’. By 2007, the five largest investment banks in the US – J.P. Morgan Chase, Citigroup, Bank of America, Wachovia and HSBE – were among the world’s largest derivatives dealers. Goldman Sachs estimated that from 2006 to 2009, somewhere between 25 per cent and 35 per cent of its revenues were generated by derivatives. The American insurance corporation AIG had sold credit default swaps totalling $79 billion ‘to investors in these newfangled mortgage securities, helping to launch and expand the market and, in turn, to further fuel the housing bubble’.48 In 2006 and 2007, the top underwriter of mortgage bonds in the US was Lehman Brothers. ‘When housing prices fell and mortgage borrowers defaulted’, said the Financial Crisis Inquiry Report, ‘The lights began to dim on Wall Street’.49
‘THE FUNDAMENTALS REMAIN VERY, VERY STRONG’50
Alan Doherty, head of AIB Corporate Finance, September 2007.
In February 2007, US stocks fell, ‘as concern about the extent of the housing market’s slowdown unleashed a sell-off in shares of mortgage lenders and hurt shares of big banks like Citigroup’.51 One month later, shares in the European-based Deutsche Bank and Credit Suisse slipped by over 4 per cent, ‘amid mounting concerns about their exposure to the US subprime mortgage market’.52 By the end of the year, the crisis was such that the Federal Reserve was ‘scrambling to head off a recession’.53
One of the first victims of the escalating situation was the global investment bank Bear Sterns, which was a key player ‘in the credit default swaps market, a prime broker to many hedge funds, a primary dealer in the bond market and a counterparty to many leading Wall Street firms’.54 The bank had issued huge amounts of asset-backed securities and derivative financial instruments, and by the end of 2007 found itself facing a multitude of court actions, with a loan book valued at $395 billion which was supported by a net equity position of €11.1 billion. On 14 March 2008, the Federal Reserve authorised the provision of emergency funding for Bear Sterns, stating that the bank was ‘too interconnected to be allowed to fail at a time when financial markets are extremely fragile’.55 The bank was sold two days later to its one-time rival, J.P. Morgan Chase, as part of the federal funding deal. Six months later, on 7 September 2008, both Freddie Mae and Fannie Mac were placed under the conservatorship of the Federal Housing Finance Agency. The following week, Merrill Lynch, on the verge of bankruptcy, was sold to Bank of America for $50 billion, while Lehman Brothers filed for chapter 11 bankruptcy protection. The US government’s decision to allow Lehman Brothers to go to the wall sent shockwaves around the world. The Irish Central Bank said that it was ‘carefully monitoring the emerging developments on the global financial markets’, while the Taoiseach, Brian Cowen told reporters that whatever response the government took, it was informed by the principle that it ‘must do its duty in the long-term interests of the Irish people’.56
The next day, Michael Casey, former chief economist at the Central Bank and a former member of the IMF board, put the collapse of Lehman Brother in context. He told the readers of The Irish Times that although Irish banks had lent a lot of money for housing and property development, the difference between Ireland and the US was that in the US, ‘several … banks were greedy, incompetently run, and that the US system of regulation failed almost completely’.57 Furthermore, ‘Irish banks have not had to raise more capital from existing shareholders; if and when they have liquidity problems, they can access funds from the European Central Bank. They can also pledge their existing mortgage assets in exchange for these funds.’ In addition, Casey repeated the Central Bank’s statement that ‘Irish banks are virtually free of the subprime mortgages which have caused all the problems in the US’ – as if Ireland was somehow firewalled from the international markets, MBSs, and OTC derivatives. Casey ended his piece with a fatherly reassurance:
The Financial Regulator examines the books of all the banks regularly with a fine-tooth comb and is fully engaged in the stress-testing exercises – which hypothesise very difficult scenarios – and then assess the banks’ abilities to deal with them. No one else in the country would have anything like the detailed knowledge of the financial sector. The Central Bank’s and Financial Regulator’s assurances are the best indicators Irish shareholders are going to get.
No mention of derivatives and leverage, no mention of the shadow banking system, no acknowledgement of the fundamental changes in financial trading in the past thirty years – the financial system that ‘bears little resemblance to that of our parents’ generation’.58
Just two weeks later, the US Congress rejected a €700 billion bailout of the country’s financial system, which had been proposed by the Bush administration. The resulting panic saw markets in freefall around the world. In Ireland, ‘shares in Allied Irish Banks tumbled 16.7 per cent, Bank of Ireland slid 20.2 per cent, Irish Life and Permanent sank 39.9 per cent and Anglo Irish Bank plummeted 46.2 per cent’.59 Charlie Weston of the Ir
ish Independent said that ‘as a peripheral country in the middle of a property bubble burst, Ireland has been singled out unfairly as the next country likely to see a bank go bust’.60 It was a curious comment to make, as if a country on the periphery, with a heavily leveraged banking system, in the middle of a property bubble burst, should be considered a safe, steady bet.
That same day, three European banks were rescued in State bailouts – Bradford & Bingley in the UK, Hypo Real Estate in Germany, and the Dutch-Belgian financial giant Fortis – while Irish stocks shed almost €6.5 billion in value. The Taoiseach told the press that while Ireland was officially in recession, he wished to reassure the country that these events were simply part of the economic cycle. ‘We must not at any time underestimate the capacity of our own people to confront these challenges,’ he said, ‘to face up to them and to do whatever is necessary to protect the achievements to the greatest extent we possibly can.’61
The Irish Central Bank had planned for such a crisis. In April 2008, its staff members role-played a crisis simulation exercise. ‘We pretend that there is a bank experiencing difficulties such as large loan defaults, a withdrawal of liquidity or false rumours’ said Pat Neary, Chief Executive of the Irish Financial Services Regulatory Authority, in a conversation with The Irish Times.62 ‘People pretend that they are representatives of the media,’ said Neary, ‘or some people act as creditors who attempt to appoint an administrator … It is quite intense.’ The authority’s prudential director said that the Central Bank ‘first held crisis simulation exercises four years ago’ and so ‘there is nothing especially ominous about the fact that they have held them recently’. The Irish Times finished the article with the comment that ‘unfortunately, the only way to judge if simulation exercises work is to see how calm the regulators are when a real crisis hits’.
On 30 September 2008, the Irish people woke up to find that the Fianna Fáil/Green coalition had put up the entire Irish State as collateral for the crushing liabilities of six private banks. The country was now liable for approximately €400 billion in leveraged loans, in a recession, while sitting on top of a slowly deflating property bubble. The Irish people were about to find out just how calm and organised the government, the Central Bank, and the Department of Finance were when it came to a real-life crisis.
‘AN ELEGANT SOLUTION TO THE CRISIS OF LIQUIDITY AND CONFIDENCE FACING THE BANKING SYSTEM’63
Deutsche Bank in London on the Irish bank guarantee, 30 September 2008.
On 29 September 2008, a meeting to discuss the government’s approach to the bank crisis took place between representatives of Bank of Ireland and AIB, the Irish Central Bank, and the Department of Finance. It was held at Government Buildings. The details of the meeting – even who exactly was in attendance – are still subject to controversy. One thing is certain. In order to combat the problems faced by Ireland’s banking system, the government moved to ‘guarantee all the liabilities – the customer and interbank deposits, and also the vast majority of bonds – of the six Irish banks’.64 Several of the major players of the Irish financial system had argued for this solution, as had the economist and journalist David McWilliams.65 At 6.45 a.m. on Tuesday 30 September, the government released the following press statement:
The Government has decided to put in place with immediate effect a guarantee arrangement to safeguard all deposits (retail, commercial, institutional and interbank), covered bonds, senior debt and dated subordinated debt (lower tier II), with the following banks: Allied Irish Bank, Bank of Ireland, Anglo Irish Bank, Irish Life and Permanent, Irish Nationwide Building Society and the Educational Building Society and such specific subsidiaries as may be approved by Government following consultation with the Central Bank and the Financial Regulator … This very important initiative by the Government is designed to safeguard the Irish financial system and to remedy a serious disturbance in the economy caused by the recent turmoil in the international financial markets.66
Later that day, Brian Lenihan outlined in the Dáil the bare bones of the Credit Institution (Banking Support) Bill. The government would guarantee ‘deposits and debts totalling €400 billion at six Irish-owned lenders in a move to protect the country’s financial system … the liabilities amounted to almost 10 times the value of the national debt of about €45 billion’.67 The government’s apparent rationale was that the Bill would allow Irish banks access to the ‘short-term funding that enables Irish financial institutions to fund their day-to-day operations [and which] had become scarce in the global banking system since the collapse of US investment bank Lehman Brothers’.68 The Bill was passed by the Dáil at 2 a.m. on the morning of Tuesday 2 October, by 124 votes to 18. The Labour Party voted against the Bill, while Sinn Féin abstained. The Seanad sat all night and passed the Bill at 7.40 a.m. It was signed into law at 3.30 p.m. by President Mary McAleese – just shy of thirty-three hours after the release of Brian Lenihan’s press statement. The Minister for Defence, Willie O’Dea, told the readers of the Sunday Independent that weekend that, ‘in the case of a problem [under the guarantee], the first call will be on the bank’s funds, on its shareholders, on their assets, capital and funds. This is a very significant buffer as the estimated total assets of the six financial institutions exceed their liabilities by about €80bn.’69
The guarantee was commented on by a flurry of economists, columnists, agencies and experts, all clamouring to support the government’s decision. The credit rating agency Fitch continued with Ireland’s top triple-A ranking, saying that ‘this proactive measure should help buttress confidence in the Irish financial system and limit the risks of a deeper and more prolonged than necessary recession at a time of unusual stress in global banking markets’.70 The source of its confidence was the announcement that the government intended to charge the six institutions a fee for the cover provided by the guarantee. ‘While the amount of liabilities covered by the guarantee is more than double Irish gross domestic product,’ said Fitch, ‘The government will receive fee income to help protect taxpayers against any potential costs relating to possible calls on the guarantee.’71
Dermot O’Leary, chief economist with Goodbody Stockbrokers, said that ‘The innovative and timely intervention by the Department of Finance in relation to the Budget, the deposit guarantee ceiling and now wider deposit safeguards, must be applauded.’72 Simon Carswell of The Irish Times said that although the size of the liabilities covered by the legislation was something the government could hardly afford, ‘The guarantee would only be triggered if one of the six institutions defaulted on some of their debt, and this is regarded as unlikely’.73 In fact, the Bill would act as a boon for the economy, as it ‘will also attract foreign deposits to the Irish banks at a time of turmoil when cash is king’.
Brendan Keenan of the Irish Independent gave a cautious welcome to the government’s plan. ‘The purpose of the guarantee is to make conditions more normal for Irish banks,’ he wrote, adding jokingly that now ‘they can get on with the time-honoured process of bankrupting over-stretched customers, selling off their assets, writing off the resulting losses, and moving on’.74 Keenan’s banking world, however, had little in common with the twenty-first-century reality of electronic transfers and credit default swaps. His ‘time-honoured’ allusion was more akin to a Frank Capra movie, where the clock on the bank manager’s wall still ticked and tocked, as the local children played hopscotch on chalk-scratched pavements outside. Deregulation and financial innovation; these were the brush strokes of the modern banking system. In the days after the bank guarantee, the leader of the opposition, Enda Kenny, called for ‘fair play’, and for the banks to stick to the rules. He did not seem to understand that in the world of derivatives and deregulation, there are no rules. That is what deregulation is all about.
The Credit Institution (Banking Support) Bill received the approval of Kenny in the Dáil, who said that ‘The Fine Gael party will continue to act responsibly in opposition and our primary concern here is for t
he protection of the Irish economy and Irish taxpayers’ interests’.75 Yet the party by-passed the €400 billion in potential liabilities with a call for ‘a freeze on bonuses and super-payments to bankers for the duration of the government guarantee’, adding that ‘The importance of this guarantee is that it is guaranteeing depositors’.76 It is not known if the leader of the opposition had actually read the Bill, but, if he had, he clearly did not understand it. While the Labour Party did oppose the Bill – calling it a blank cheque for the banks – its amendments imply that the explicit danger of guaranteeing all creditors equally passed them by. The party’s spokeswoman, Joan Burton, called for a cap on bank manager pay levels, saying that none should earn more than the Taoiseach or Minister for Finance. She added that with the guarantee in place, ‘The banks should supply liquidity for the real economic activity of the nation: the jobs, the businesses and the firms, not the speculators and fat cats who had been making a killing in the past 10 years’.77
The economist and journalist David McWilliams told his readers in the Irish Independent that ‘Finance Minister Brian Lenihan has made a wise choice. By coming up with a unique, Irish plan – guaranteeing all deposits – instead of importing a failed solution from abroad, he has installed confidence in the Irish financial system.’ ‘Most importantly,’ he added, ‘Irish banks are now safe. This is the single most crucial upshot of yesterday.’78 McWilliams, in this instance, had got it wrong. The government had not guaranteed deposits: it had guaranteed deposits and loans – the banks’ debts to investors, bondholders and other financial institutions were also covered. In the same article, McWilliams said that with the guarantee ‘The chastened banks will now have to accelerate the process of writing down loans, sort out bad debts, bring developers to book, and repay the government’s trust, not in their own interest, but in the national interest’.
