The Silo Effect

by Gillian Tett

  FOUR MONTHS LATER, IN April 2007, Tucker gave another public speech. This time the venue was a conference for hedge funds at a smart London hotel organized by Merrill Lynch, the Wall Street bank, for hedge funds. The mood was exuberant. “World growth has been robust . . . headline inflation across the industrialised world has remained contained. . . . In short, the world has enjoyed a further period of monetary and financial stability,” Tucker told the crowd in the conference room. “Banks and dealers have posted fairly remarkable profits. Returns of the fund sector—and so probably for most of you here today—have been healthy.”20 Translated out of central bank jargon, that meant that times were good. Those men (and a few women) attending the Merrill conference were getting richer.

  But, once again, Tucker felt unease. To his eyes, the dials on the economic instrument board did not seem to be moving in the normal way. The numbers on inflation and growth still looked healthy. But broad money kept rising. So did the price of assets such as houses and shares. In an effort to curb these increases, central banks such as the Bank of England and the Fed had repeatedly raised interest rates to make it more expensive to borrow money. But this monetary policy tightening had not stopped the party. Money kept swirling around the economy at a pace that did not entirely make sense. Or not if you looked at the normal economic models.

  Tucker suspected that the reason for this discrepancy lay in the entities outside the banks. Somehow all those CDOs, SIVs, and conduits were pushing money around the financial system in a manner that policymakers and economists did not understand. But it was one thing to have a hunch. It was much harder to actually prove that something was going wrong when there was so little data. In any case, King had made it very clear to his colleagues that he did not want Bank staff ringing too many alarm bells; that was the FSA responsibility.

  So Tucker decided that the best thing to do was simply to point out that this strange new hinterland of hard-to-define entities existed—and let investors draw their own conclusions. He hoped that more public debate and scrutiny might keep these innovations under control. “The key intermediaries [in finance] are no longer just banks, securities dealers, insurance companies, mutual funds and pension funds,” he told the Merrill Lynch audience. “They include hedge funds of course, but also Collateralised Debt Obligations, specialist Monoline Financial Guarantors, Credit Derivative Product Companies, Structured Investment Vehicles, Commercial Paper conduits, Leverage Buyout Funds—and on and on. . . . SIVs may hold monoline-wrapped AAA-tranches of CDOs, which may hold tranches of other CDOs . . . and hold LBO debt of all types as well as asset-backed securities bundling together household loans.”21

  Tucker knew that this sounded like gobbledygook to most listeners. Indeed, one reason it was easy to ignore this shadowy world was precisely because this language sounded so alien. In a world where technology keeps becoming more complex, we all tend to turn our eyes away from specialist jargon we do not understand. Professional experts wield power precisely because they wrap their craft in language that is labeled as the preserve of “geeks.” It is hard to start a public policy debate if there are no widely accessible words to explain the ideas being conveyed, and when it came to nonbank finance, it seemed that there were no good phrases available at all.

  So, as he stood in the hall at the Merrill conference, Tucker tried to offer his audience some mental labels to cut through the jargon. Instead of calling these new financial innovations by strange acronyms such as SIVs or CDOs—or OFIs of OFCs—why not use a catchier label? Might, he suggested, “vehicular finance” work? After all, money was being moved via financial “vehicles.” Or could a phrase like “Russian doll finance” express what was going on? These new entities were so tightly entwined, they nestled together like Russian dolls.22 Then Tucker presented a chart to the audience of how he thought these financial entities worked. He hoped that a picture could communicate what words did not capture. “This may or may not help,” he joked.

  It did not work. The phrase “vehicular finance” was difficult to say and evoked images of cars, not high finance. “Russian doll finance” sounded as if it was linked to shadowy oligarchs. When journalists later wrote reports about Tucker’s speech to the Merrill conference, almost all of them ignored the part of his speech talking about modern finance. Instead, they just focused on some bland comments in the other parts of his speech that touched on issues that journalists (and economists) did recognize: the state of the British housing market, inflation trends, interest rates. These, after all, were the issues that were at the center of economists’ and journalists’ mental map. A newspaper headline about “OFIs of OFCs” did not make sense; it sat too far off the mainstream mental map. OFIs were an area of social silence.23

  FOUR MONTHS LATER, THE cognitive and linguistic breakthrough that Tucker had sought occurred. However, this step did not take place inside the Bank, but 4,000 miles to the west. Each August since 1978, the Federal Reserve Bank of Kansas City has organized a high-profile gathering of academic economists, central bankers, journalists, and government officials in Jackson Hole, the Rocky Mountain ski resort.24 These high-altitude debates are often dull and academic. However, in August 2007, the annual gathering took place against an alarming backdrop: around the world, financial markets were freezing up.

  The first signs of this crisis had emerged at the start of the summer, when the price of bonds linked to mortgages in America had tumbled. Initially, most observers thought that this development was simply a temporary wobble. After all, they reasoned, by the summer of 2007 the global economy had just enjoyed a long boom, which had pushed house prices higher. It seemed natural—if not inevitable—that some correction would take place. Over at the Federal Reserve, Ben Bernanke, another economics professor, who had replaced Alan Greenspan as the new chairman, declared the turmoil would soon be over, and create no more than $25 billion in losses on mortgage bonds, a tiny fraction of the overall U.S. economy.25 The Bank of England’s Mervyn King expressed similar thoughts. There did not seem reason to panic.

  But as the summer wore on, the sense of anxiety steadily worsened. Around the world, a host of different investment groups were refusing to trade with each other. Market confidence in the banks was crumbling. The price of assets such as mortgage bonds was collapsing. This scale of panic was baffling to the economists gathered in Jackson Hole in August. After all, the data suggested that the underlying—“real”—economies in Europe and the United States were healthy. Statistics about the state of the banking sector seemed reassuring too.

  But on the second day of the Jackson Hole conference, an asset manager from California called Paul McCulley made an electrifying comment.26 He was something of a maverick in the economics world. Though he worked for PIMCO, the giant bond fund, he sported a long gray ponytail.27 He was trained as an economist, and familiar with abstract models. But he also loved talking with traders, to see what was happening in the darkest weeds of the global financial system, and the seemingly dull “plumbing” mechanisms that moved money around the world. That perspective meant McCulley knew all about the financial vehicles that had caught the eye of Tucker. He did not like them: he feared that the design of these new innovations was fundamentally unstable, and had repeatedly told his colleagues in PIMCO’s office in Orange County in California (and anyone else who might listen) to avoid cutting deals with SIVs, conduits, and so on. Somehow, as he debated the issues with his colleagues in the PIMCO office, McCulley started using the term “shadow bank” to describe these strange beasts. “I don’t know where the word ‘shadow bank’ came from, I might have heard it from an academic or something,” he later recalled. “But we just started using it because it seemed convenient.”

  As he stood on the conference podium in Jackson Hole with central bankers and economists, McCulley reached—almost unthinkingly—for his favorite phrase to tell the central bankers and other economists what was happening in the global markets. “The real issue going on right now is a run on [the] shadow
banking system,” he announced, likening the pattern to an old-fashioned run on banks. And if this run continued, the impact could be very dangerous, he added, precisely because almost nobody had paid any attention to this sector before.28 “It is the shadow banking system which is about $1.3 trillion in assets which is [the issue] at hand.”29 The comment had an electrifying effect. Until then, most economists and policymakers had never pondered what lay outside the “known” world of the banks or hedge funds. But McCulley had suddenly given a name to this world. Central bankers now had a phrase they could use in speeches. Journalists had catchy words to insert their headlines. Economists had a title to put into their charts or use in their columns and blogs.30 Better still, McCulley had also offered a framework to understand why the markets were freezing up. The technical details of this run were complex. But the fundamental point was that investors who had been funding these shadow banks were panicking, since they had realized that these entities had quietly acquired a large volume of mortgage-backed securities.31 Without funding, these vehicles were starting to collapse.

  If the shadow banks had been tiny in size, this panic might have had no wider impact. But the problem, McCulley explained, was that the shadow banks were entwined with numerous parts of the financial system, in ways that policymakers had not spotted. They were like the tree roots in a forest, concealed from the gaze of a casual observer, but vast in scale, a network that tied the entire ecosystem together. More importantly, they were pumping credit into the economy in a way that had affected numerous different asset prices, causing parts of the economy and financial system to overheat. These entities alone had not created the credit that was inflating the bubble; that emanated from the savings glut in places such as China and other elements of imbalance in the world. But these entities had recycled money around the economy with such a speed and scale that few observers had understood that the system was overloaded with debt (or “leverage,” to use the term that economists prefer) in a dangerous way. It was a classic cycle of boom and bust, of the sort that economists like Hyman Minsky had often warned about during the middle of the twentieth century. But in the case of this twenty-first-century bubble and bust, few observers had realized the scale and dangers of the excess leverage until it was too late, largely because they were ignoring the shadow banks. Now, with a name, they finally had a way to reframe the scourge that was creating such turmoil

  IN THE MONTHS AFTER the Jackson Hole meeting, the credit crisis deepened, and policymakers recast their vision of the world. At the New York Federal Reserve, a team of researchers set about trying to create a map of the new shadow banking world to better understand it. This task was long and arduous, since data on the sector was patchy. But the team painstakingly tried to work out how the financial flows interacted with each other at the new frontiers of finance. “We got all the information we could, from lots of different sources, hunting for clues and more clues—and tried to put everything together,” explained Zoltan Pozsar, a young Hungarian-born researcher who headed the Fed project.

  After many months, this exploration produced a map of sorts. By then, Zoltan’s team at the New York Fed had realized that the world they had uncovered was so vast and complex that the only way to plot it all out in a diagram was to create a poster that measured several feet wide. The diagram was far too big for most people to hang on their walls, even in the cavernous, high-ceilinged offices of a central bank. But in a sense, that illustrated the crucial point: the shadow bank sector was so big that nobody could afford to ignore it. Anybody who glimpsed that vast “shadow bank poster” had to change their mental image of finance. Instead of assuming that the banks were the center of the financial system and shadow banks a mere footnote, it was clear that the shadow banks were at the center of the system too. Entities such as money market funds, say, were key pillars of this shadowy financial world. Looking at that map created a cognitive shift a little similar to the one that had occurred back in the sixteenth century, when the mathematician Nicolaus Copernicus showed in his diagrams that the earth revolved around the sun, not the other way around.

  Zoltan’s team gave a copy of the shadow banking poster to Tucker. It was too large to hang on any of his office walls; in any case, it would have looked odd against the backdrop of marble floors, subtle pastel paint, ornate ceiling moldings, and heavy oil paintings that decorated the historic corridors of Britain’s central bank. But he put a rolled-up copy of the map in the corner of his office, and sometimes pointed it out to visitors. “It’s there for spiritual comfort!” he joked, by way of explanation, tinged with a sense of regret. “If we had understood the shadow banking sector better before 2007, the bubble might never have become so bad.”

  In subsequent months Tucker and other regulators pushed for more and more analysis of this shadowy world. So the Financial Stability Board in Basel, a joint committee of central bankers and supervisors, set about trying to measure the size of the shadow banking world. Initially, when Paul McCulley had popularized the phrase, he had suggested the shadow banking world might be $1.3 trillion in size, using a narrow definition of the term. However, the FSB decided to take a much broader definition, which captured not just conduits and SIVs, but hedge funds, mutual funds, and a host of other vehicles. On that basis, the sector was sixty times larger than McCulley’s initial estimate, running at about $67 trillion in 2011, the FSB declared. That was half the size of the official banking sector in the world—and four times larger than the size of the American economy. Some financiers disputed this, and complained that the FSB’s definition of shadow banking was too broad. The FSB subsequently recalculated the figures, using a narrower definition, and concluded that the real size of the sector was nearer to $27 trillion, not $67 trillion. But what nobody disputed was that regulators and economists needed to pay attention to this world, and rethink their mental image of finance. “For far too long, the global regulatory community has ignored the shadow banking world,” declared Mark Carney, the man who had headed the Bank of Canada during the crisis and later chaired the Financial Stability Board (but then moved to the Bank of England).32 “That needs to change.”

  IN THE SUMMER OF 2009, almost a year after the queen had visited the London School of Economics, the Royal Academy—one of the most prestigious academic clubs in Britain—organized a conference of economists. The attendees included a host of senior figures from the economic priesthood, such as Jim O’Neill, chief economist at Goldman Sachs, Tim Besley, a member of the Bank of England’s monetary policy committee, and Nick Macpherson, a top official at the U.K. Treasury. Tucker indirectly contributed to the discussion too. For several hours, the group debated the question that the queen had posed in 2008: why had nobody seen the “awful” crisis coming? Then the economists decided to write a formal letter of explanation to the Palace. This ran to three pages and set out in exhaustive detail all the reasons why the economists thought that they had missed seeing the problems. But the fundamental message was simple. The single biggest reason why policymakers had become blind was that the entire system was fragmented. Macro economists had looked at economic statistics, but ignored the finer details of finance. Banking regulators had watched individual banks, but had not looked at the nonbanks. Some financiers working in the private sector banks had been experts on how the shadow banks worked, but they did not speak to the senior economists at central banks. Meanwhile, the people who were actually borrowing money in the “real” economy, such as homeowners, or companies, had no idea how the bigger financial ecosystem operated. Just as the institution of UBS had been fragmented, with the traders in London having little understanding of what New York was doing, so too the different policymakers had failed to swap crucial information, or look outside the narrow sectors that they were trained to explore. Economists had stayed inside their narrow field, and had felt no need to venture out of that box, since the economy seemed fine. As a result, they had missed spotting the most crucial point of all, namely that the system was overloaded with lever
age, or debt.

  “There was a psychology of denial,” the letter declared, arguing that because “low interest rates made borrowing cheap, the ‘feelgood factor’ masked how out of kilter the world economy had become beneath the surface. . . . Everyone seemed to be doing their own job properly on its own merit. And according to standard measures of success, they were often doing it well. The failure was to see how collectively this added up to a series of interconnected imbalances over which no single authority had jurisdiction.” Or as the letter concluded: “Your Majesty, the failure to foresee the timing, extent and severity of the crisis and to head it off, while it had many causes, was principally a failure of the collective imagination of many bright people, both in this country and internationally, to understand the risks to the system as a whole.”33

  What the queen thought about the letter is not known. She never wrote a reply. But in the months that followed, the policymaking community on both sides of the Atlantic scurried to show that they had learned at least some of the lessons. A host of initiatives were launched to train economists to take a much wider view of their discipline. George Soros, the billionaire philanthropist and hedge fund manager, backed a New York–based group called the Institute for New Economic Thinking to promote a more holistic approach toward the study of economics. Adair Turner, the former head of the main British regulatory agency, was named as its second chairman. “We know there needs to be a complete rethink of how we talk about economics and train economists,” Turner explained. Universities launched programs to connect the study of finance to macroeconomics. There was an upsurge of interest among economics students in courses on behavioral finance, a discipline that seeks to blend economics with psychology. Even some of the most renowned and senior members of the economist community declared that it was time to rethink the way that economics was done, and stop relying on models and a narrow vision of numbers. “The whole period [of the credit crisis] upset my view of how the world worked,” admitted Alan Greenspan.