Mouthing the Words of Greenspan
Bubbly US housing prices, reckless purchases of risky mortgage securities, conflict-of-interest-riddled credit-rating agencies, pro-cyclical regulations, too-big-to-fail banks, complex investment models with hidden pitfalls — all these phenomena and more came up for discussion at FSF meetings. Indeed, close scrutiny of meeting notes and minutes reveals numerous instances in which members piped up with observations and worries that are almost eerily prescient in retrospect.
As far back as the September 1999 FSF meeting, for example, Nout Wellink, the Dutch central bank chief who chaired the Basel Committee on Banking Supervision, ruminated on the risks engendered by the increasingly prevalent view among his country’s banks that they must expand or succumb to takeovers. “Are we creating banks that are too big to run, too big to supervise, too big to fail?” Wellink asked.
In a discussion about the US economy, Jürgen Stark of the Bundesbank wondered aloud, “Is there a housing bubble underway?” — and while that question might seem unremarkable, it was uttered at an FSF meeting in March 2002. About a year later, Alastair Clark of the Bank of England fretted about how banks were offloading mortgages to investors who might not understand what they were getting into. “Where has the credit risk gone?” Clark demanded, adding that although one group of international regulators had prepared a report on the issue, “the market is changing very fast. The real problem is that we really need full information on credit risk — who has it?...And another problem is that those who buy the risk may know less than those who offered the credit.” Likewise, at a March 2007 meeting, Michel Prada, France’s chief securities regulator, informed his fellow FSF members about a study of credit-rating agencies that showed that they were growing increasingly dependent on fees from rating structured products such as CDOs. Prada noted that IOSCO, whose technical committee he chaired, had previously studied the potential for conflict of interest at credit-rating agencies by focussing on their ratings of individual borrowers; perhaps further examination was merited in light of the rating agencies’ newer and more lucrative line of revenue, he said — a sentiment others agreed with. (By the next FSF meeting, Prada was able to report that IOSCO had responded by duly establishing a task force.)
To help organize and focus the discussion about such matters at FSF meetings, the FSF Secretariat established a “High-level Vulnerabilities Working Group,” consisting mainly of senior staffers from central banks and regulatory agencies (the top aides, in other words, to the principals who attended the body’s plenary sessions). It included a number of public servants esteemed for their expertise, among them were Vincent Reinhart from the Federal Reserve, Paul Tucker from the Bank of England, Claudio Borio from the BIS, John Sloan (who, although Canadian, was then working for the United Kingdom’s FSA), Garry Schinasi from the IMF and the FSF’s own Svein Andresen. The vulnerabilities working group met before each FSF meeting to scan the financial horizon for threats and consider scenarios that would help the forum’s members identify the system’s biggest potential weaknesses. Based partly on the working group’s discussion, the Secretariat prepared a document for distribution to all FSF members prior to each meeting — documents which, like the meeting discussions themselves, contain nuggets of insight into where dangers and problems would eventually materialize. One example was the note distributed to FSF members prior to the September 2005 meeting, which foresaw one of the most disastrous results of VaR models and other complex methods used by large financial institutions. “To the extent that the signals from...models...lead [large banks] to implement similar strategies to contain risks, this could result in a ‘rush for the exit’ and amplify credit movements,” the note observed.
As these snippets from FSF meetings and documents suggest, the group was aware of, and discussed, a number of the problems that today are recognized as major causes and accelerants of the crisis. Yet the concerns expressed about these problems were far from Cassandra-like, or even close to matching the seriousness of the situation, as later became evident. Several reasons appear to account for the FSF’s shortcomings in this regard.
First, alarmist sentiment would generally run afoul of the FSF’s most powerful member country, the United States. Although by no means alone in playing down risks to the financial system, American representatives on the FSF tended to be the most steeped in the pro-market ethos — that is, the view that the innovations and new financial instruments devised by market participants were making the system not only more efficient at allocating capital, but also less prone to cataclysms. Crockett recalled one particularly striking conversation he had on the sidelines of an FSF meeting with the then undersecretary of the US for international affairs:
John Taylor, who’s also a good friend, said to me, “Look, the Forum is writing all these things about problems [in the global financial system, such as hedge funds and offshore financial centres]. Can’t we write about things that are going well?” Of course, many things were going quite well. But the purpose of the Forum was to spot the rocks ahead instead of saying, “it’s all smooth blue sea.”15
15 In an email exchange, Taylor corroborated Crockett’s account, though with this caveat: “I recommended to Andrew that ‘the FSF should write both about the problems and about what is going well.’ [The words ‘both’ and ‘and’ are key parts of my point.] The point was that you learn from policy successes as well as policy failures.”
As has been amply documented elsewhere, the most influential bastion of the pro-market perspective during the lead-up to the crisis was the Greenspan Fed. Rather than fretting about the tendency of financial markets to generate unsustainable booms followed by devastating busts, Fed officials believed that the self-interest of market participants would lead them to avoid taking the kinds of risky positions that could bring down their institutions. In a remarkably candid interview, former Fed Governor Laurence Meyer acknowledged that during his time on the FSF he was much too cavalier in dismissing the concerns of European members, especially the French, about the unknown risks of financial instruments such as derivatives and how they might exacerbate market turbulence during periods of stress:
To my utter regret, I responded by simply mouthing the words of Greenspan — that banks are different, they’re subject to the safety net, and as a result they have to be supervised, but other parts of the financial system that are not subject to the safety net operate with a lot of market discipline. So we should just let those markets evolve on their own.
The Fed’s Vice Chairman, Roger Ferguson, succeeded Crockett as FSF chairman in 2003. Although Ferguson was well-liked for both the good humour and conscientiousness with which he ran FSF meetings, some members have said it was a bad idea, especially in light of what happened later, to give the chair to an official from such a large stakeholder in the system. I found no evidence that Ferguson showed any overt favouritism toward one party or another. But nor did I find evidence that he used the powers of the chair to intensify the examination of problems in the US system. A revealing anecdote about his general attitude may be the sardonic name — “Merry Sunshine” — that he gave Bill White, the chief economist of the BIS. White’s repeated warnings about the dangers of a crash would later turn him into one of the few policy makers to emerge from the crisis with a vastly enhanced reputation.
It would be unfair, however, to pin all of the blame for the FSF’s failings on the complacency of its American participants. More fundamental weaknesses kept the forum from galvanizing itself to what, in retrospect, would have been an appropriate level of concern. Many of the attendees considered FSF meetings to be a chore; some of the phrases they used in interviews include “boring...pointless...unmemorable...lot of hot air...everyone checking their watches.” Such perceptions were widely shared, despite efforts that Crockett made at the outset to liven up the meetings; he decreed that members must refrain from reading prepared statements and should address each other by first names. He also opened each segment of the me
etings by posing provocative questions about the next topic on the agenda.
A paradox underlay the FSF’s lack of urgency: each meeting considered a wide variety of potential dangers, many of which appeared worrisome at the time, but eventually proved financially inconsequential or at least not systemically damaging. These included avian flu, Argentina’s debt default and Brazil’s close brush with default in 2002, the woes afflicting the Doha Round, geopolitical events such as the September 11 attacks and the invasion of Iraq, the potential for the US fiscal deficit and current account imbalance to generate a collapse in the US dollar, and banking problems in Japan and China. Searching widely for possible triggers of global financial panic was a big part of the FSF’s mandate, so it should not be faulted for doing so. But after attending several meetings where such issues were aired, especially during periods when financial markets were continuing to manifest signs of ebullience, officials understandably came to regard the gatherings as repetitive and lacking in clear direction for policy. Votes were never taken on matters of substance; the group operated by consensus. A related phenomenon was the mantra-like similarity of the conclusions that were reached from one meeting to the next. “Members noted that conditions were generally benign, but...continuing developments...could over time lead to strains in financial markets,” the FSF stated after its September 2005 meeting in London — wording very close to that which it issued on other occasions.16
16 FSB (2005), “Fourteenth Meeting, London,” September 8, available at: www.financialstability board.org/meetings/pm_050908.htm.
To get a better sense of what FSF meetings were like during the pre-crisis period, it is worth examining in detail one meeting, an account of which follows in the next section. This account is based both on the confidential minutes prepared by the FSF Secretariat as well as sketchy notes taken by a person who attended. The meeting offers an illustrative case study because it took place about a year before the crisis began to erupt. In the note circulated by the FSF Secretariat prior to this meeting, one sentence stands out as heralding — albeit in understated terms — what was to come: “There are indications that the benign conditions of recent years may be approaching a turning point.”
An Illustrative Meeting
The FSF meeting in Paris on September 6, 2006 marked the start of a new era: Mario Draghi was taking over as the forum’s chairman from Roger Ferguson, who had left the Fed. Much has been written over the past couple of years about the rise of “Super Mario,” now that he has become president of the European Central Bank — how the orphaned teenager from Rome won a scholarship to the Massachusetts Institute of Technology, advised successive Italian governments as an economics professor, held the position of Director-General at the Italian Treasury for a decade and spent three years at Goldman Sachs before becoming governor of the Bank of Italy in 2005. In his introductory remarks to the group he now chaired, Draghi showcased his skills at agenda setting. He “acknowledg[ed] the achievements of his predecessors in establishing the reputation of the FSF,” the confidential meeting summary states; he then spelled out how his stewardship might differ. He said he wanted “to focus [the FSF’s] work on specific operational issues and practical ways in which risks could be mitigated, while avoiding spending time on macroeconomic issues in which the forum had no comparative advantage over other groupings.”
For all the energy and clarity of purpose Draghi might have brought to the table, though, this meeting, like previous ones, did not achieve any conceptual breakthroughs about the problems that were mounting beneath the financial system’s seemingly placid surface. Comments from members ranged in tone from moderately deep concern to ones that, with the benefit of hindsight, manifest relative nonchalance about a wide variety of issues. Perhaps most interesting, as we shall see, was a trenchant criticism by one member about the futility of the whole exercise.
As usual, members received a note from the Secretariat prior to arriving, and also as usual, the note started with a review and analysis of the previous six months’ developments, including illustrative charts. To set the agenda and stimulate discussion among FSF members when they got together on September 6, the note’s second and main section, titled “Potential areas of vulnerability,” enumerated several sources of concern, with the following equivocal overview: “The list of prominent vulnerabilities is broadly unchanged since the FSF’s previous meeting. However, the changing macroeconomic environment may have increased both the probability that one or more of these vulnerabilities would be worsened, and the impact that they might have on financial stability should they crystallize.”
Turning first to housing markets and household indebtedness, the Secretariat’s note cited “clear signs of a significant cooling” in US home prices and evidence that a substantial number of American homeowners faced higher mortgage payments as the rates on their adjustable-rate mortgages rose. “Although...increases in mortgage payments...will be spread out over a number of years, so that the impact on the household sector as a whole is likely to be gradual, these issues warrant continued close attention,” the note said. “Stress tests conducted by supervisory authorities and central banks...suggest that financial institutions are resilient to shocks to their mortgage portfolio. However, structural changes...make it difficult to apply past patterns to present portfolios.”
Next on the note’s list of potential vulnerabilities, each of which it elaborated on, were private equity and leveraged buyouts, followed by global imbalances and overheating of the Chinese economy. Then, in a section titled “Possible areas for consideration by FSF members,” the Secretariat cautioned: “A scenario in which troubles at one or more large institutions spread to others in the system, although unlikely, continues to be a possibility.” Among the “possible triggers” that might lead to such an eventuality were macroeconomic events (that is, a significant slowdown in growth or acceleration in inflation), geopolitical events and “other shocks” such as “the failure of international trade talks or a worsening of global current account imbalances [that] could lead to an increase in protectionist pressures.” The upshot: “Any of these shocks would be likely to have an impact on several of the vulnerabilities identified above. A worsening of one or more vulnerabilities could in turn raise the materiality of others.”
That meaty array of issues formed the basis for the discussion that followed Draghi’s opening comments. As at previous meetings, the bullish attitude that prevailed among investors worldwide evoked some anxiety. Xavier Musca, director-general of the French Treasury, was outspoken on this point, fretting that “risks are underpriced.” A weakening of the US economy could coincide with a disorderly unwinding of global imbalances; moreover, “financial markets are changing rapidly, with huge interconnections” that were poorly understood, in Musca’s view. “Better interaction among regulators” and “crisis management war games” were needed, he concluded.
The subject turned to housing. Fed Governor Susan Bies acknowledged that in some parts of the United States “market prices are not sustainable,” but she pointed out that in general, “price rises are slowing — not falling.” Although delinquency rates on mortgage payments were increasing, the interest rates on many adjustable- rate mortgages would not rise for another couple of years, “so we have some leeway.” Overall, she said, “the strength of the labor market should offset any setbacks in the housing market.”
Members from other countries followed with observations about their own regional and national housing markets. Lucas Papademos, vice president of the European Central Bank, worried (sensibly, as events would later show) about the “currency mismatches” in central European countries, where many borrowers had taken out mortgages in euros and Swiss francs that they would be unable to repay if foreign exchange rates shifted significantly. “The subsidiaries of key [European] banks could be hit,” he noted. Callum McCarthy, chairman of Britain’s FSA, opined that most of the United Kingdom’s big banks were in sound shape; “the broader question is how hous
eholds will react” should home prices falter. Echoing that sentiment was the Netherlands’ Nout Wellink, who said, “Excessive mortgage lending will affect households, but not the banking system except through reputational risk.”
A discussion ensued about the increased use in the United States of “exotic” mortgages and the securitization of the mortgage market. According to the meeting summary, FSF members generally felt that “to the extent [mortgage-backed] securities have been sold to other investors, banks’ exposure should be limited. However, risk managers are still developing techniques to price and model these exotic instruments.” Moreover, “these products are not always well understood by consumers and expose them to ‘payment shock.’”
So far, this account of the meeting underscores that FSF members were well aware of problems that would fuel the crisis — but (with the arguable exception of Musca) not very concerned about them. The remainder of the meeting was devoted mainly to other worries raised in the Secretariat’s note that didn’t end up contributing much to the crisis. These included private equity and leveraged buyouts (“members expressed concern that banks involved in private equity activity may be taking on sizable risks,” according to the summary), and the potential for a “hard landing” in China. Regarding global imbalances, “some members assigned a low probability to a disorderly adjustment...others expressed greater concern.” Items on the agenda for the last portion of the meeting included reports and stock-takings on various matters including avian flu, offshore financial centres and international accounting and auditing issues.
One intervention appears, in retrospect, to have been more on point than most — an exhortation by Geithner, then president of the New York Federal Reserve Bank, that “the principal task for authorities is to strengthen the cushions that will make the financial system more resilient in times of stress. According to notes of the meeting, Geithner pointed out that “large financial institutions have off balance sheet risk equal to about 50% of what they have on-balance sheet,” and although “core institutions are much larger and better managed” than others, regulators “must look at [the likelihood of] ‘tail events.’” He argued that “stress testing has improved but it not good enough.” No longer was he focussed on “upgrading” emerging market countries, as he had been six years earlier.
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