That was where J.P. Morgan came in. By mid-July, IKB was frantically calling other banks, seeking a loan to plug the gap. “Will you help?” the IKB officials asked Winters. Winters discussed the loan with his colleagues in London, as well as with Black in New York. He wanted to take the request seriously as IKB had traditionally been a good client. Winters had always been suspicious of SIVs, though, and the saga at IKB confirmed his doubts. As tactfully as he could, Winters said no.
For a few days, officials at IKB flailed around, trying to find new sources of funds. Eventually, the German government stepped in and forced a group of domestic banks to extend a 3.5-billion-euro lifeline to IKB. That enabled it to prop up its two SIVs. Once again, traders in the mortgage-backed bond markets heaved a sigh of relief. If the IKB funds had collapsed, they would have been forced to engage in a fire sale of assets, which would have pushed down CDO prices. The German rescue—once again—had averted that disaster.
Yet, as with the Bear bailout, the move seemed little more than a temporary reprieve. Across the financial system as a whole, tension was rising. Very few investors or bankers who worked outside the commercial paper market really understood what had gone wrong at IKB. Precisely because the commercial paper sector had been so slow-moving and dull in the past, it had been comprehensively ignored by journalists and regulators in the previous years. The fact that a buyers’ strike was under way in the ABCP sector was all but invisible to anybody outside that market. Yet the headlines about IKB showed that something was amiss, even if it was barely understood by anyone outside IKB.
Equity investors did not appear excessively alarmed. On July 20, the S&P 500 and FTSE, the main UK stock market index, both hit an all-time high. In the debt world, though, fear was spreading. By the end of July, the ABX was implying that the price of BBB mortgage bonds had tumbled to just 45 percent of their face value, while even AAA had fallen towards 95 percent. The models had assured that the triple-A tranches had an absolutely minuscule chance of ever losing value; but the ABX was now suggesting otherwise, and that was alarming. The market for corporate credit derivatives was also signaling alarm: by early August, the cost of insuring risky American and European corporate bonds against default had doubled in price, compared to its level in early July.
In early August, bankers linked to IKB called Winters again. They asked him for advice about what they should do with the mortgage securities on their books. “Sell your assets now,” Winters told them. “As much as you can!” It was a typical trader’s reaction: his years of working in markets had taught him that when crisis strikes, the people who sell first get the best price, if they can move ahead of a wave of forced sales. But the IKB officials rejected that idea. To them, the prices being signaled by the ABX just did not make sense. They could not believe that highly rated mortgage assets could be valued at significantly less than face value, at least not for long. They told Winters that they were going to wait it out until the markets returned to “normal.”
[ TWELVE ]
PANIC TAKES HOLD
Half a world away in Tokyo, watching the IKB drama unfold, Hiroshi Nakaso, a senior official at the Bank of Japan was struck by déjà vu. Nakaso had never visited IKB and knew little about how SIVs worked. However, from his vantage point in Tokyo, he saw uncanny echoes with what he had observed almost a decade earlier. Back then, in the 1990s, the Japanese banking system had become overloaded with bad loans after a property bubble collapse, sparking a crisis. At the time, most American officials blamed the peculiarities of Japanese finance and criticized the Japanese government for its failure to tackle the woes at an early stage.
When Nakaso saw what was happening at IKB, it suddenly seemed as if Japan had not been so unique after all. The bailout deal that the German government had cobbled together to prop up IKB looked uncannily similar to measures the Japanese government had used to stave off a collapse of Japan’s banks. The investor psychology seemed dangerously similar, too. From a distance, Nakaso could sense that disorientation and panic were spreading, creating strange price swings. Investors were starting to lose faith. The shift was subtle, something almost none of the central bankers and regulators who worked in America and Europe had personally ever seen before. But to Nakaso it was profound. “I see striking similarities today with the early stages of our own financial crisis more than a decade ago,” he told some of his international contacts on August 2, 2007. “Probably we will have to be prepared for more events to come…the crisis management skills of central banks and financial authorities will be truly tested [in the months ahead].”
Nakaso’s reaction was shared by other Japanese onlookers. When Nakaso’s counterparts in America or Europe heard such comments, though, most discounted them. They considered it fanciful, if not alarmist, to draw parallels between Japan’s woes and the troubles brewing in Western finance. By 2007, American and European financiers took it for granted that their financial system was vastly more sophisticated and efficient than that in Japan. There was also an overwhelming assumption in Washington—and in London—that any losses in the subprime world were unlikely to cause wider financial shock. In the spring of 2007, Henry Paulson, the US Treasury secretary, had told Congress that the subprime problem “appears to be contained.” Bernanke, the Federal Reserve governor, repeatedly echoed that line. “Given the fundamental factors in place that should support the demand for housing, we believe the effect of the troubles in the subprime sector on the broader housing market will likely be limited,” Bernanke observed in a speech before the Federal Reserve of Chicago in May. “Importantly, we see no serious broader spillover to banks or thrift institutions from the problems in the subprime market; troubled lenders, for the most part, have not been institutions with federally insured deposits.”
In early July, after the collapse of the Bear Stearns funds, Bernanke changed his tune slightly. “Rising delinquencies and foreclosures are creating personal, economic, and social distress for many home owners and communities—problems that likely will get worse before they get better,” he testified to Congress on July 18, suggesting that subprime losses would be “in the order of around $50 billion to $100 billion.” He stressed, though, that the problem still seemed negligible given the size of the wider banking system. “It seems very far-fetched to make any parallels with Japan’s crisis. The key thing to remember is that these losses are not just held by American banks, as the bad loans were in Japan, but they are dispersed,” one senior American official observed shortly before Bernanke’s testimony. Or as Bill Dudley, a senior figure at the New York Federal Reserve, told bankers in early summer, “This is a correction, but it is not dramatic in light of history…it could be over in a matter of weeks.”
As the summer of 2007 wore on, though, the panic in the commercial paper market steadily intensified. Before the summer, ABCP notes typically paid investors between 5 and 10 basis points more than the US overnight dollar borrowing rate. By the start of August, that was moving towards 100 basis points, making it absurdly expensive for SIVs to raise funds. Many could not sell notes, even at that exorbitant rate. An entire network of shadow banks was suddenly discovering that their lifeblood had been cut off. Meanwhile, the housing market took a decided turn for the worse.
On August 6, American Home Mortgage Investment Corporation filed for bankruptcy, having suffered substantial losses on its mortgage assets and finding it impossible to sell ABCP notes. “This is getting serious,” Winters thought. The SIVs alone were estimated to hold almost $400 billion of securities. In truth, only a third of those securities were thought to be directly linked to mortgages. But if the SIVs collapsed, that could spark fire sales of assets that would make the drama of the Bear Stearns funds seem trivial.
On the other side of London, at Cairn Capital, one of Winters’s former colleagues at J.P. Morgan, Tim Frost, was also alarmed—albeit for more personal reasons. By 2007, Frost had been working with Cairn for three years. In that period, it had expanded into a formidable operation, w
hich employed more than one hundred staff and ran some $22 billion of assets spread between two dozen CDO-like structures and a hedge fund. It had moved from its initial, cramped office into swanky new headquarters in the posh neighborhood of Knightsbridge, with a fabulous view of London’s Hyde Park. The office was open plan and airy, and the walls showcased a revolving collection of quirky, cutting-edge art, including arresting portraits of shabby unemployed British miners. “It’s a warning of what happens if the returns are bad!” the Cairn staff joked to clients. Not that they were: during 2005, 2006, and early 2007, Cairn produced steady profits in almost every corner of its sprawling empire. It enjoyed a high reputation among investors.
But by early August, ugly storm clouds were building. The problem was an SIV that Cairn had created back in January 2006, called Cairn High Grade Funding. Cairn had tried to run it in a relatively conservative fashion. Unlike some other SIV managers, Frost and his colleagues had been fussy in selecting their mortgage-backed bonds, trying to choose safe assets even when that meant earning lower returns. As a result, the fund had a higher proportion of triple-A assets than any other SIV, and Frost assumed that made the fund almost bulletproof.
Yet Cairn had an Achilles’ heel. Its SIV—like the IKB vehicle—funded itself in the commercial paper market, and it did not have a committed bank backup credit line. Many investors presumed that Barclays Capital would be obliged to help the SIV if it ran into crisis, since the British bank had played a central role in creating the fund back at the start of 2006. There was no legal commitment, though, for Barclays to help. Like so much else in the shadow banking world, that support was a matter of trust.
Until the summer of 2007, the Cairn managers saw little reason to worry about that state of affairs. The commercial paper market was so utterly calm that Cairn found it easy to raise funding. The execution was done by another company, known as QSR. “Quite honestly, [the] funding ordinarily never kept us awake at night,” David Littlewood, one of Frost’s partners, later explained. “[It] required very little maintenance apart from agreeing on a daily funding strategy with QSR.” In mid-July, however, QSR told Cairn that the commercial paper sector was freezing up. By late July, Cairn could sell notes only at the ruinously high cost of 100 basis points over the risk-free rate of borrowing.
Frantically, Frost and Littlewood tried to discuss with investors about what action Cairn could take. They were convinced that their fund was far better than those of rivals. But investors did not wish to hear about all the data that Cairn had to back that up. They were losing any ability to discriminate. Just like consumers who panic during a food poisoning scare and stop buying all sausages or burgers overnight, ABCP investors had heard that some dodgy assets had got into the securitization chain—and since they could not tell exactly where the rot had ended up, they were boycotting all SIV notes.
Shocked, the Cairn partners debated what to do. Some investors wanted to sit tight and ride out what they believed would be a short-lived storm. That was what many other shadow banks, not to mention the IKB officials, appeared to be doing. But Frost—like his former boss Winters—had a trader’s instinct, honed from years trading risk at J.P. Morgan. He was convinced Cairn needed to act fast, to salvage whatever it could, rather than just pray that the markets would recover. His partners agreed.
At the beginning of August, the senior management of Cairn hunkered down in their Knightsbridge office, turning the largest conference room into a “war room.” Outside, tourists strolled through Hyde Park, licking ice cream cones and enjoying the summer sun. Inside, the Cairn managers frenetically worked the phones, desperately trying to work out what they could do with their crumbling SIV. It was far from clear. In the corporate world, there were well-established precedents for how to deal with bankruptcy. There were also clear rules about how to handle a failed bank. After all, over previous decades, regulators and bankers alike had seen plenty of banks collapse.
However, the problem with the SIVs was that nobody had worked out before what to do if they collapsed. They sat in a regulatory limbo since they were not covered by any regulatory rules, and there were no precedents for bankers, investors, or regulators to follow, either in relation to Cairn itself or to the system as a whole. “We are literally reading through our rule book, trying to work out what to do,” confessed one of Frost’s former J.P. Morgan colleagues who ran a rival SIV. In London, Düsseldorf, Frankfurt, and New York, the system was heading into uncharted territory.
On the morning of Thursday, August 9, 2007, the European Central Bank in Frankfurt posted a brief and dryly worded statement on its website. The gist was that the ECB would provide as much funding as banks might wish to borrow at a rate of 4 percent, in response to “tensions in the euro money markets…notwithstanding the normal supply of aggregate euro liquidity.”
Journalists and investors who read the bulletin were bewildered. Central banks normally pump money into financial markets almost by stealth, using long-standing devices such as auctions in which banks each bid for a preassigned pot of funds. The ECB, however, was offering the equivalent of an emergency blood transfusion. It seemed to perceive a crisis.
Two hours later, the ECB revealed that forty-nine banks in Europe had demanded—and received—a staggering 94 billion euros of cash, three times the normal level of demand. The last time the ECB had injected that much money into the markets was after the attack on the World Trade Center in 2001. But there was no such obvious disaster rocking the financial world now. The only specific new development that morning was that an asset management unit linked to BNP Paribas, a large French bank, had announced it was suspending three investment funds that held mortgage-linked bonds because a “complete evaporation of liquidity” made it impossible to value the mortgage assets. Yet that appeared small scale compared to what the ECB had done.
Frantically, journalists besieged the ECB’s press team with questions: “What has prompted the ECB to act?” The ECB staff struggled to cope. It was common practice at the ECB—in line with most financial institutions in continental Europe—to let its officials go on vacation for several weeks each summer. On August 9, Jean-Claude Trichet, the wily ECB president, was on a beach in northern France, and most senior officials were on vacation, too, including those who would normally run the press team.
“This is just a fine-tuning exercise,” a hapless junior press official was instructed to say, over and over again. More specifically, he added, the ECB had noticed in the days leading up to August 9 that the cost of borrowing money in the interbank market had jumped to a level of 4.7 percent, well above the rate officially set at 4 percent by the ECB. However, what neither the press officials—nor the senior ECB staff themselves—appeared able to explain was why the borrowing rate was rising.
If the ECB’s move was supposed to calm markets, it disastrously backfired. Before August 9, most investors had not even realized that the cost of borrowing euros for banks was rising. The ECB’s actions, though, blazoned that news onto trading terminals and television screens around the world. Many of the traders and investors who saw the news had no idea what to think. The senior officials at many European banks and investment groups were also on vacation. Uneasily, their desk-bound colleagues dispatched emails to holiday destinations around the world. The gist of those messages was usually: “Something is really spooking the markets; but we don’t know what!”
On the other side of the Atlantic, officials at the New York Fed were spooked, too. Ever since the Bear Stearns funds had imploded in mid-June, central bankers from the largest Western nations had been holding regular telephone calls to discuss the strains building in the credit world and to swap information. In the preceding weeks, Fed officials had noted that conditions in the credit markets were becoming strained. The Fed had repeatedly discussed these tensions with the ECB, as well as with officials from the Bank of England, Bank of Japan, Central Bank of Canada, and the Swiss National Bank. However, the official mantra at the Fed, as at the Treasury, w
as that the mortgage problems were “contained.” US policy makers did not want to make any emergency move, since they feared that would do more harm than good. They were seriously irritated by what the ECB had done, particularly since the ECB had not notified the Fed about its intervention.
Fed officials debated how to respond. By the afternoon of August 9, New York time, some ten hours after the ECB posted its statement, almost every indicator tracked on the computer screens of the Fed signaled panic. The price of gold was rising, together with the price of US Treasury bonds, while the price of risky corporate bonds and mortgage-backed assets was tumbling. Investors were dumping anything that might contain default risk and heading for the safest assets around. Most ominously of all, the cost of borrowing dollars in the interbank market was also rising. That implied that banks and other key financial institutions were reluctant to lend money to each other, either because they needed that cash or they did not trust each other—or both.
Fed officials did not wish to do anything that would sow further panic, nor did they want to admit how irritated they felt with the ECB. So they aimed for the middle ground. A few hours after the ECB move, the New York Fed provided $24 billion worth of daily funds, higher than usual but not unprecedented. The next day, it offered $36 billion more funds, as the ECB injected another 61 billion euros. But Fed officials repeatedly stressed to reporters that they did not consider the situation to be an emergency. The mantra—as ever—was that the market turmoil should be a short-lived storm.
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 21