British central bankers, though, broke ranks with the ECB in a more pointed manner. The ECB had not warned the Bank of England either that it was planning to unleash so much liquidity, and by the afternoon of that first day, wild rumors were swirling around the London markets that some large European banks were about to collapse. British regulators tried to work out what was going on, but they found it hard because so many bureaucrats in continental Europe were away on vacation. Briefly, they wondered if they should copy the ECB and inject large quantities of funds into the sterling system too. However, Mervyn King, the Bank of England governor, demurred. Back in the days of the credit boom, in the spring of 2007, he had repeatedly warned investors and financiers that they needed to prepare for a future turn in the credit cycle. Now that it was turning sour, he had no sympathy for those who had refused to heed his advice. It served them right, he reckoned, if their overhyped innovations were starting to collapse. “We are certainly not going to protect people from unwise lending decisions,” he sternly told British politicians the day before the ECB move, in the style of a headmaster lecturing foolish pupils. He saw little reason to rescue bankers or investors; in any case, he did not see much chance that problems in the CDO world would ever have too great an impact on the financial system as a whole.
On August 15, another tremor hit. Countrywide, America’s largest independent mortgage lender, announced that the rate of foreclosures and defaults on its portfolio of subprime loans had risen to the highest levels since 2002, due to “unprecedented disruptions” in the home loan market. It also admitted that unsold mortgages were starting to pile up on its books, because it could not persuade investors to purchase mortgage-backed bonds anymore. Countrywide’s share price crashed 13 percent in a matter of hours, dragging a host of banking stocks lower.
The next day, investors were handed a small respite. Countrywide announced that it had raised an $11 billion loan from a group of banks, including Bank of America and J.P. Morgan, to plug its funding gap. The largest American groups, like their German counterparts, had realized they could ill afford to see one player collapse, since that risked setting off a domino effect. Then, on August 17, the Federal Reserve took another step to calm the markets. It cut the so-called discount rate (a special rate applied to emergency loans that banks might need to raise) by 50 basis points to 5.75 percent. This was an effort to signal that the Fed stood ready to help the banks—if they actually needed support. The equity market signaled a modicum of relief. But, in the ABCP sector, investors remained stubbornly on strike.
In mid-July, there had been around $1.2 trillion worth of ABCP notes outstanding in the market; by mid-August, the sector had shrunk to below $1 trillion because notes were maturing—and investors were refusing to purchase new, replacement notes. Activity in the mortgage-backed market was drying up, too: whereas around $80 billion of notes a month had been sold at the start of the year, in August almost no notes were sold. Liquidity was being sucked out of the system at a startling rate.
As tensions spread, the senior managers in many banks ordered each department to stop lending money to any counterparties that looked at all risky. Just like households that might stockpile baked beans and bottled water when a hurricane approaches, banks were hoarding whatever cash they had. Yet the more that banks hoarded cash, the higher borrowing costs in the interbank market rose, creating more fear. And the more that investors refused to purchase ABCP notes, the more investments with firms that relied on ABCP funding were also shunned, for fear they might collapse. “The main fear [now is] fear itself,” Matt King, an analyst at Citi, noted in a research report issued on August 16. “Of course, there is no fundamental reason why the ABCP buyers should take fright—the assets themselves are generally sound and most of the banks are very well capitalized. But the greater the fear in the system, the greater the potential for problems.”
At the end of the month, economists and central bankers from Europe and America gathered for an annual symposium in Jackson Hole, Wyoming. By then, the fear in the commercial paper market had leaked out into the news. However, economists and policy makers appeared deeply split about what—if anything—could be done. Though the Fed had already cut the discount rate, officials were not eager to start cutting the main federal funds rates, because they were concerned about inflation. Many economists were also opposed to bailing out investors from their foolish mistakes. “There are a lot of investors who invested on a leveraged basis in high-risk assets,” Michael Mussa, the former chief economist of the IMF, tartly observed. “They are going to have to eat substantial losses, and their creditors are going to have to eat substantial losses. And as far as I am concerned, the proper policy response is bon appétit!” Many economists and policy makers also appeared convinced that any turmoil in the mortgage market would sort itself out relatively soon. “What we are seeing right now is a total overreaction in terms of expected losses,” insisted Axel Weber, head of the German Bundesbank. He suggested that the most sensible strategy for many institutions might be to wait “and simply ride it out.”
Yet officials at PIMCO, the giant American bond fund, were uneasy. They did not run any SIVs themselves, but they were keenly aware of the interlinkages that were starting to unravel. “The real issue right now is a run on the shadow banking system, which is about $1.3 trillion in size, funded by commercial paper,” Paul McCulley, a senior PIMCO official, told the Jackson Hole conference. “The key issue [that] is going to come to a head in the next couple of months is that the shadow banking system is going to have to be put on the balance sheet of the real banking system.” The “real” banks were going to have to bail out their shadowy offspring—or face a terrible chain reaction of collapses. The pattern seen at IKB could be repeated many times. It was a terrifying thought. In theory, the big banks were supposed to have fat capital cushions. But when regulators had stipulated how fat those cushions needed to be, they had never given any thought to the $1.3 trillion shadow banking world. “It is stunning how little many policy makers know about the workings of asset-backed commercial paper (ABCP) and collateralized debt obligations (CDOs),” lamented Carl Tannenbaum, chief economist at LaSalle Bank, the day after the conference ended.
By late August, Tim Frost and the Cairn Capital management team were haggard. The summer heat had turned Hyde Park from verdant green to a parched, dusty brown. Inside the Cairn offices, stress was taking its own toll. For several weeks, Frost and the other managers had lobbied Barclays and other banks for a loan to plug their funding gap, but Barclays had refused. It was starting to worry about the impact of the mortgage market turmoil on its own portfolio of CDOs and was engaged in a massive—and ill-timed—bidding war with Royal Bank of Scotland to purchase ABN AMRO, a Dutch group. It did not wish to expose itself to any new credit risk.
Cairn refused to take no for an answer. What would happen, they asked Barclays, if a way could be found to remove any credit risk from a loan, using Frost’s beloved credit derivatives? Barclays indicated that it might extend a loan under those circumstances. So Frost and his colleagues worked the phones, trying to find someone willing to write protection on the assets held by the Cairn SIV, using credit derivatives. Many banks were wary of the idea, since they—like Barclays—were battening down the hatches. However, the bankers who traded credit derivatives at the Lehman Brothers’ office in London were feeling more bullish than most and agreed to organize a consortium to write the necessary CDS contracts on Cairn’s SIV assets, protecting it from the risk of default.
Then Frost got back on the phone and tried to persuade the investors in the Cairn SIV to back the idea—and to pay for the cost of raising that insurance. It was not easy. The investor roster included not just European banks and American asset managers but a clutch of Asian banks, too, and some were reluctant to pay for insurance. “Can’t we just wait this out?” some asked. Like the IKB bankers, they were still assuming that the woes in the mortgage market were temporary. Frost was adamant: Cairn simply had
to restructure its SIV. The charter that governed the SIV stipulated that if the vehicle’s funding levels fell below a certain threshold, it would need to start selling off its assets, and that moment was ticking closer.
Finally, on August 31, a deal was struck: Barclays announced that it would “provide senior financing” in the form of a loan to the fund, in exchange for getting the loan “fully hedged.” Frost was elated. Once again, it seemed that the magic of derivatives had solved the problem, linking people who wanted to shed risk with those who wanted to roll the dice. He considered the Cairn deal to be as creative and groundbreaking as anything he had ever concluded during his days at J.P. Morgan; to him, this was a prime example of true financial innovation at work. The crisis seemed to have been averted, at least at Cairn, but ominous portents would soon signal that this was merely the end of the beginning.
[ THIRTEEN ]
BANK RUN
On the morning of August 31 in Washington—or a few hours after Tim Frost completed the rescue plan for the Cairn fund—President George W. Bush stepped out into the Rose Garden of the White House to meet with reporters. He was flanked by the imposing figure of US Treasury Secretary Henry Paulson. All through the long summer, Bush had pointedly avoided getting dragged into the escalating debate about America’s troubled subprime market. But by the end of August, it was becoming ever harder to maintain the official line that the problems were contained. At one end of the financial system, the funding crisis that had engulfed Cairn was spreading out to hit a host of institutions holding assets linked to subprime debt. At the other end, in the “real” world, the mortgage picture was steadily deteriorating. The National Association of Realtors finally dropped its bullish stance and admitted that US house prices looked set to post the first annual decline since the Great Depression of the 1930s.
In the subprime world, the mood was particularly grim. At the start of 2007, the rate of default on subprime mortgages had been running at around 13 percent; by September it was 16 percent and rising. What was especially vexing was that it was so difficult to predict how much higher the rate might go. Cycles of default had been seen in the mortgage world before, usually as a result of a recession or a sharp rise in interest rates. However, this cycle was not behaving quite as economists had expected.
The economy was not in a recession overall, and unemployment was low, but interest rates had risen sharply on many loans, with the average rate on an adjustable mortgage rising from 3.5 percent in late 2005 to 5 percent by the autumn of 2007. As a result, households were defaulting in surprisingly large numbers. When economists peered into the data, most blamed the fact that so many households had been so overstretched when they took out their loans. Now that house prices were falling, they had no incentive to hang on to their homes. It was clear that house prices were the key to the default pattern, but nobody was sure just how far house prices might fall—or how many more defaults that might trigger. “There’s no model for what’s happening now in the housing and mortgage industries,” said Josh Rosner, managing director at the New York investment research firm, Graham Fisher & Company.
That left Bush and Paulson in a bind. They certainly didn’t want to see millions of voters thrown out of their homes. Nor did they wish to see the financial crisis spread. Yet Bush hailed from a Republican Party that espoused free-market ideals, and using federal intervention to prevent so-called creative destruction flew in the face of those principles. So, as Bush stood in the Rose Garden in the August sunlight, he tried to steer a middle line. “Owning a home has always been at the center of the American Dream,” he declared in his folksy style. “[But] the markets are in a period of transition, as participants reassess and reprice risk, [and] one area that has shown particular strain is the mortgage market, especially what’s known as the subprime sector of the mortgage market.” Bush continued, “This market has seen tremendous innovation in recent years, as new lending products make credit available to more people. For the most part, this has been a positive development…[but] there’s also been some excesses in the lending industry. One of the most troubling developments has been the increase in adjustable-rate mortgages that start out with a very low interest rate and then reset to a higher rate after a few years. This has led some home owners to take out loans larger than they could afford based on overly optimistic assumptions about the future performance of the housing market. Others may have been confused by the terms of their loan or misled by irresponsible lenders.”
Bush went on to unveil some modest measures of aid. These included a pledge that the Federal Housing Association would provide some guarantees for mortgages if the lending industry agreed to modify the terms for households in default. The idea was to keep troubled families in their homes, if possible, but without bailing them out. It was little more than a token show of help. Economists calculated that the measures—at best—would apply to only around 600,000 of some 2 million households that were close to default. Nonetheless, Bush clearly felt loath to do more. “We’ve got a role, the government has got a role to play—but it is limited,” he declared. “It’s not the government’s job to bail out speculators or those who made the decision to buy a home they knew they could never afford…. America’s overall economy will remain strong enough to weather any turbulence.” With that, Bush paused for breath. Then a reporter yelled out: “Sir, what about the hedge funds and banks that are overexposed on the subprime market? That’s a bigger problem! Have you got a plan?”
Bush blinked vaguely. “Thank you!” he said, and then he and Paulson turned to leave.
For a few days after Bush’s speech in the Rose Garden, the mood in the financial world perked up. The equity markets rallied, and the tone of the credit markets improved as well, with declines in the cost of buying protection against the default of corporate and mortgage bonds. Inside Cairn, some managers started to fret that they might have overpaid Lehman Brothers for the CDS protection they had bought in the deal to restructure their SIV. The managers of some rival SIVs quietly dropped plans to conduct similar restructuring deals. Across the industry, bankers began to clutch at straws, hoping that the commercial paper markets would reopen soon and that the August turmoil would prove a short-lived squall.
The respite, though, barely lasted two weeks. At 8:30 p.m. on September 13, Robert Peston, the gangly business editor of the BBC, appeared on the news channel of the British media group. Until that point, the BBC had given only cursory coverage to business dealings. On that Thursday night in September, however, Peston had electrifying news to report. In breathy, nervous tones, he declared that Northern Rock, the fifth largest British lender, had gone to the Bank of England and asked for emergency support. “Although the firm remains profitable,” Peston declared, “the fact that it has had to go cap in hand to the Bank is the most tangible sign that the crisis in financial markets is spilling over into businesses that touch most of our lives.”
It was a damning, shocking statement, and within seconds, it had flashed up on trading terminals all over the world. During the summer, most investors had assumed that the problems in the subprime mortgage market would hurt only the shadow banking world and some specialist mortgage lenders, such as Countrywide. Northern Rock took the crisis into a whole new dimension. It was a large regulated bank, located in the gritty northern town of Newcastle, hundreds of miles from the high-stakes financial machinations practiced in the City of London or the housing markets of Florida and California. The “Rock,” as it was known locally, extended loans to families all over the UK. It held the savings of millions of British consumers and was deemed eminently safe. Or it had been until Peston’s report.
Within minutes of the BBC bulletin, consumers began logging on to Northern Rock’s website and withdrawing their cash. The website then crashed, fueling panic. The next morning, Northern Rock savers flocked to the bank’s branch offices, and pictures of terrified savers in a long line in front of the bank beamed onto computers, television screens, BlackBerries, and mobile
phones around the world. By midmorning, a full-scale bank run was under way. Never before had so many terrified consumers and investors seen a bank run in action, in real time. Technology was helping to spread the panic.
What brought Northern Rock down was another variant of the woes that had beset IKB and Cairn. At the turn of the century, the bank had embraced securitization with a vengeance, raising funds by selling masses of mortgage-backed bonds to investors all over the world. By 2007, less than a quarter of Northern Rock’s funding came from retail deposits, with the rest raised by securitization.
Because the bank was securitizing its mortgages with off-balance-sheet vehicles, it did not need to hold a large volume of capital reserves against those loans, and it could extend about three times more mortgages, per unit of capital, than in its presecuritization days. By 2007, Northern Rock had trebled its share of the UK mortgage market, accounting for 18.9 percent of all mortgages, and was still hungry for more. At the start of that year, its website cheerfully told consumers that “if your wallet has taken a beating over the festive season, a new loan from Northern Rock could be the perfect way to sort things out.” When the money markets seized up in August 2007, though, Northern Rock discovered that its main funding source had frozen.
For a few days, officials cast around to see whether any large UK banks would be willing to buy Northern Rock or club together to offer a loan. Lloyds TSB, one large lender, seemed interested in a deal. However, it refused to commit itself unless the Bank of England offered a loan to the group, and Mervyn King, the Bank governor, was unwilling to do that. King worried that offering aid of that sort might contravene the laws that set out what the Bank could—or could not—do in a crisis.
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 22