There were a few sages who cautioned the bankers and politicians that they were courting catastrophe. Warren Buffett, the great American investor who had seen markets rise and fall since the 1929 Crash, warned that they were trading in ‘weapons of mass financial destruction’. Vince Cable, a former Chief Economist for Shell and the lead Treasury spokesman for the Liberal Democrats, was a lonely British voice forecasting disaster. Buffett was ignored; Cable was derided as ‘Dr Doom’. Only a select minority in politics, the media, academia and the markets pointed to the risks being run. Most were captured by the ‘Mutually Assured Delusion’ that fuelled the bubble built on leverage of debt.31 In so much as the Conservatives raised any objection, they argued that there should be ‘even less need for regulation’.32 As George Osborne subsequently admitted: ‘The British political classes were somewhat bedazzled by the enormous success of Britain’s financial services internationally.’33
Bankers, regulators, central banks, finance ministers, economists and leaders were all guilty of failing to see that the entire edifice was structurally unsound. Who killed the economy? It was like Agatha Christie’s Murder on the Orient Express. They all did it.34 The central culpability of the politicians was to allow the environment in which it could occur. The financiers were the reckless and intoxicated drivers who smashed the economy; the politicians failed to set speed limits or administer the breathalyser.
The political elite treated the City of London as if it were a City of Gold. There was a disinclination to ask searching questions about ballooning debt, financial instruments so opaque that they were often incomprehensible even to those trading them, and gargantuan bonuses that incentivised madness. Bonus payments nearly tripled between 2001 and 2008 to reach £16 billion. The Governor of the Bank of England later characterised the bonus culture in the City as ‘a reward for gamblers’.35 Yet there was no attempt to restrain the casino when the tables were busy. The City was cosseted and its excesses encouraged. ‘The hedge fund guys had a lot of fun under Labour,’ says one observer who monitored them closely. ‘They had more fun than they had under the Tories.’36
During the 1997 election campaign, Labour ran a funny party political broadcast in which Stephen Fry and Hugh Laurie played tycoons revelling because the Conservatives allowed them to use offshore havens to avoid paying tax. Yet Labour went on to be so indulgent of rich foreign residents that it effectively turned Britain into the world’s most popular tax haven among millionaires and billionaires. The treatment of private equity firms and some hedge funds allowed them to enjoy much lower tax rates than poorer citizens. Even those enjoying the prodigious rewards occasionally wondered why. Nicholas Ferguson, the Chairman of SVG Capital, asked how it could be right that some in his industry were allowed to get away with paying ‘less tax than a cleaning lady’.37
Brown was personally austere. When a colleague once suggested that he should buy a national lottery ticket, he recoiled with horror: ‘What would people say if I won?’38 He wore his ‘moral compass’ on his sleeve and liked to advertise the ‘Presbyterian conscience’ that he claimed to have inherited from his minister father. Yet it was the preacher’s son who presided over a brittle age of avarice, vulgarity and rapacity. The era was epitomised by the diamond-encrusted skull manufactured by Damien Hirst. This grotesque was a classic sign of a bubble about to burst. The jewelled death’s head sold for $100 million to a consortium of investors, who included Hirst himself, at the end of August 2007. It was the symbolic artefact of an age which had lost both its aesthetic and its moral bearings. Homeowners measured their self-worth by the value of their houses, boasting of how much they had made as if this was a personal achievement rather than the simple good luck of surfing a property boom. Brown himself talked about a ‘bubble’ as early as 2005, but he did not act to control it. He chose to ignore the explosive growth of the balance sheets of British banks. Moderately sized when New Labour came to power, a decade later Britain’s banks dwarfed the rest of the economy. Their accumulated liabilities grew larger than the entire economic output of Britain. No other major country had such disproportionately enormous banks. This made it even more imperative that Britain had a robust system of regulation.
One of Brown’s first significant acts as Chancellor in 1997 was to take regulation of the financial sector away from the Bank of England and transfer responsibility to a new Financial Services Authority. In his habitually pre-emptory way, Brown sprang this as a rude surprise on the Bank’s Governor, Eddie George. He was so stunned and angry that he almost resigned.39 ‘Eddie felt terrible because he thought he’d walked into a trap set by Brown,’ says a very senior Treasury official who was close to the Governor. ‘Eddie felt he’d let down everyone at the Bank. He thought he was looking at the dismemberment of the Bank.’40 Tony Blair helped to draw back the Governor from resignation by taking up some of his concerns, but he did so in a half-hearted way. As Derek Scott, Blair’s economic adviser, puts it: ‘Ultimately, Gordon Brown had his way.’41 Blair fought Brown over other turf, but ‘he accepted that the Chancellor was king on economic policy and he was very happy to let him lead on that,’ says Sir John Gieve, a senior Treasury official.42 Blair was content to let Brown have that crown because there seemed to be no need to question the stewardship of the economy when growth was good and the money rolled in.
The new architecture of regulation created by Brown was called ‘the tripartite system’ because it split responsibility between the Treasury, the Bank of England and the FSA. Once this triangular arrangement was established, Blair paid it no further attention. More remarkably, neither did Brown. ‘As dysfunctional as he is, Gordon has a very keen sense of what he can deal with and those things he isn’t comfortable with,’ observes a Treasury mandarin.43 Brown displayed a lack of interest in his own creation from early on. He left Alistair Darling, then the Chief Treasury Secretary, and Sir Steve Robson, a senior civil servant, to take through Parliament the legislation creating the FSA.44 From long and close observation of Brown, Robson says: ‘I don’t think he was terribly interested in the regulation of financial services really.’45
There were ‘long and tortuous negotiations over the Financial Services Authority’ which resulted in a Memorandum of Understanding. This was supposed to delineate who was responsible for what in the tripartite arrangement known to Whitehall as ‘T3’. This left a fatal flaw which was concealed during the bubble and exposed only once it burst. The Bank of England Act 1998 left the Governor with ‘no formal powers’ to intervene to save banks.46 A senior official at the heart of those negotiations later concluded: ‘What was never really resolved was who would be the lender of last resort, what was the Bank of England’s role in a crisis, and who had the final say.’47
Brown’s priorities inevitably shaped the behaviour of the civil servants at the Treasury. Officials focused on child poverty, international development, welfare reform – ‘Gordon’s pet causes’. They took little interest in financial regulation because their political master did not.48 After a decade of prosperity, there was barely any institutional memory within the Treasury about how to deal with an unbenign economic environment. Few of the officials had experience of coping with a crash or responding to a recession. Rachel Lomax, who was the Permanent Secretary at the Department of Trade and Industry before she became a member of the Monetary Policy Committee, went to the Treasury to give a talk in 2007. She asked the senior civil servants present: ‘Put up your hands if you were here before 1997.’ Not a single hand was raised.49
Brown had no desire and felt little necessity to pay attention to financial regulation. One of his City ministers, Ruth Kelly, did not have a one-to-one conversation with Brown for two years after her arrival at the Treasury.50 Kitty Ussher, another City minister, had a brief interview with Brown when she took up her post. The one-sided conversation consisted of him instructing her to keep the City sweet.51 Ed Balls, Brown’s ‘second brain’ and City minister from May 2006 to June 2007, bragged that Britain had develo
ped a system of ‘increasingly light touch and risk-based regulation’ so superior to its international competitors that it had ‘made London a magnet for international business’.52
Self-congratulation at the Treasury was accompanied by wilting interest in financial regulation at the Bank of England once its authority over banks was deliberately diluted by Brown. Threadneedle Street was the traditional sentinel of the soundness of banks. After losing powers to the FSA, the Bank focused on monetary policy. This was especially the case after Mervyn King became Governor in 2003 because that was his speciality. The Bank’s lodestar of economic stability was the control of inflation, at which King excelled, to the neglect of other potential threats. ‘The leadership of the Bank of England was really much more interested in monetary policy issues and interest rate issues than it was in financial-stability issues,’ observes Sir Steve Robson. ‘The stability wing of the Bank did wither … the resources did drain away from that area.’53 Sir John Gieve, who became the Deputy Governor with responsibility for financial-stability in January 2006, agrees that his remit ‘did take second place to monetary policy’.54
Complacency at the Treasury and indifference at the Bank were compounded by the flaws in the third pillar of the house built by Brown. The Financial Services Authority concentrated on consumer issues rather than invigilating systemic risks. In the words of the FSA’s Chief Executive from July 2007, Hector Sants: ‘The prevailing climate was that the market does know best … that was the mood of society and politicians. The FSA just wasn’t a forward-looking organisation in respect of business model risk.’55 The FSA took a box-ticking approach. There had already been some warning that it was ticking the wrong boxes. The regulator was heavily criticised over the collapse in 2000 of Equitable Life, Britain’s oldest insurer. Yet in so much as the Government took an interest in the FSA, it was to push for weaker rather than stronger scrutiny of financial institutions. Adair Turner, who became chairman of the regulator in 2008, observed that ‘All the pressure on the FSA was not to say: “Why aren’t you looking more closely at these business models?”, but to say: “Why are you being so heavy and intrusive? Can’t you make your regulation a bit more light touch?” ’56 Mervyn King later noted that any regulator who told bankers to stop being reckless during the bubble years ‘would have been seen to be arguing against success’.57
A design fault of the tripartite system was that it operated ‘on auto-pilot in the good years’.58 The principals – the Chancellor, the Governor of the Bank of England and the head of the Financial Services Authority – ‘never met’ according to one senior Treasury official.59 Another mandarin agrees: ‘Gordon just wasn’t interested. He didn’t want to do it.’60 The monthly meeting of the standing committee was attended by the deputies. Sir Andrew Large, the Deputy Governor of the Bank from 2002 to early 2006, came the closest to foreseeing how the asset price bubble could one day explode. ‘Andrew was the Jeremiah of these meetings,’ recalls one participant. ‘No-one wanted to believe it. They’d bought into the Greenspan consensus that somehow the good times would keep rolling.’61
Officials at the Treasury and the Bank met each other much less frequently than they had before 1997.62 There was little communication between the Treasury and the FSA. The regulator did flag as many as thirty warnings about individual banks and yet on Brown’s own account they were never discussed with the Treasury.63 The three corners of the triangle would come together only in a crisis. This meant that it would take a crisis to expose the flaws in the design. By that time it would be too late.
To make things even more dangerous, nearly everyone in charge was looking in the wrong direction. The Bank of England ‘placed all its emphasis’ on threats from terrorism after 9/11 and even more so after 7/7.64 ‘War games’ were conducted to test the robustness of the financial system in the event of massive terrorist attacks. The avian flu scare prompted further war gaming about the consequences of a pandemic. This missed the much more potent threat to the economy lurking in reckless gambling by the banks themselves. The authorities were doing horizon planning, but their binoculars were not scanning the right horizon. According to one official at the top of the Treasury’s finance directorate, there was ‘an unwillingness to stress-test extreme scenarios’ involving banks.65 Only one war game of a financial crisis took place within the Bank of England in 2004–5.66 One participant says that ‘no-one acted on any of the suggestions that came out of it.’67
Another war game at the Treasury raised serious questions about the structure created by Brown. It revealed that ‘thinking was relatively undeveloped as to how the resolution of an insolvent firm with systemic repercussions would be handled and by whom.’ The deficiencies were regarded as so troubling that a plan was drawn up with target dates for remedial action. This plan was submitted to ministers, but never acted upon. Rather than fix the flaws, ‘work on improving the existing arrangement was not judged by the Treasury to be a priority in a benign economic environment.’68 A war game conducted at the FSA’s headquarters in late 2006 concluded that the deposit guarantee scheme was not adequate to prevent bank runs, a gaping deficiency which would be a critical element of the crisis that broke nine months later. Yet nothing was done to remedy a flaw even when it had been identified.
Gordon Brown subsequently claimed that he supervised a ‘huge simulation exercise’ in 2006 to test what would happen in the event of a major institution ‘running into problems’ in either America or Britain.69 It was true that there was a video conference that year involving Brown and Hank Paulson, the US Treasury Secretary, along with officials and regulators from both sides of the Atlantic. But one participant recalls ‘we spent an awful lot of time introducing people to each other’ and others involved agree.70 Sir John Gieve lobbied for more war gaming. So did some Treasury officials. Brown got Paulson to agree to another exercise, but ‘it never happened because it was very complicated to arrange and the Americans did not want it.’71 Paulson, the former Chief Executive of Goldman Sachs, reluctantly became US Treasury Secretary in 2006 for an unpopular, lame-duck President. His comprehension of financial regulation was far from complete – he later admitted: ‘I knew a lot about regulation, but not nearly as much as I needed to know, and I knew very little about regulatory powers and authorities.’72 It was a rather sensible idea to stress-test what might happen in the event of a global banking crisis, but it was quietly forgotten.
Westminster goes on a long holiday in August, as do many journalists, with the result that the month has long been known as ‘the silly season’ in the belief that nothing of significance ever happens. This is a myth. The First World War broke out in August, Saddam Hussein invaded Kuwait and the Second World War began three days after the end of the wicked month. The initial tremors of the financial quake were felt in early August 2007. The first bubble to burst was the American market in sub-prime mortgages. In the greedy pursuit of higher returns, US banks had lent far too much to poor borrowers who would never have the means to repay them. These ‘liar loans’ were sliced and diced, churned with other loans to disguise them as better assets than they were and turned into tradable packages which were exported all over the world. ‘Securitisation’ was the jargon, but there was nothing secure about it. It fuelled the creation of a vast $6.5 trillion market in mortgage securities which was played by banks around the globe.73 Though the instruments were complex, the root cause of the credit crunch was simple. Banks had lent money they didn’t really have to people who could never pay it back. By the summer of 2007, interest rates were rising, American property prices were slumping and the bottom had fallen out of the sub-prime bonanza. To magnify the crisis, the conversion of dodgy mortgages into exotic instruments meant that no-one could be certain who was holding the bad stuff and how much of it. Banks, pension funds and investment houses were waking up to their exposure to liabilities that they could only guess at and holding toxic contracts they didn’t understand. HSBC, the British-based global bank, caused a shock early in t
he year when it announced a staggering write down on its sub-prime loan book of more than $10 billion. Share prices of major banks tumbled over the summer. By early August, three German banks were close to collapse because of subprime. The boulder that caused an avalanche began to roll on Thursday, 9 August, the day that changed the world. BNP Paribas, the largest bank in France, revealed that it was exposed to huge losses. What really spooked the markets was that no-one, including the bank itself, could say precisely how huge. John Eatwell – a Labour peer and President of Queens’ College, Cambridge – was one of the select minority of economists who had foreseen the potential for disaster. He observes that ‘nobody expected the collapse of the sub-prime market in the United States to have the knock-on effect into the rest of the securitised market with a total collapse of confidence in all those markets.’74 Almost overnight, banks lost trust in each other. They became hugely reluctant to lend between themselves and would only do so at punishingly high levels of interest. Credit markets seized up.
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