Off Balance

by Paul Blustein

  Citing “a remarkable transformation” since the last meeting of the CGFS, Checki said, “We’ve moved from an environment in which there seemed to be little perceived risk and lots of appetite for it, to one in which there is a lot of risk and no appetite.” He continued, “I couldn’t help but be struck by a number of anomalies that, in retrospect, maybe deserved more of our attention along the way.” These included the fact that the credit process had been “outsourced” to credit-rating agencies, and a system that was supposed to generate loans on a prudent basis had become a “machine” to satisfy the demand by investors for assets.

  Figuratively hanging their heads, CGFS members reflected on what they had missed. “We expected hedge funds to get hurt, but in the end we have the banks getting hurt,” said José Viñals, deputy governor of the Bank of Spain. Echoing similar sentiments was Jean-Pierre Landau, deputy governor at the Bank of France, who said, “When we talked about redistributing risks, we never thought they would go to people who have no capital...We didn’t expect the size and speed of the hit for the banks — perhaps no one did.” Among the most rueful was Hermann Remsperger of the Deutsche Bundesbank. “Why weren’t ‘conduits’ discussed much earlier at the CGFS?” Remsperger demanded. “Everyone else knew, but not us.”

  The IMF

  The titles on IMF staff reports and working papers tend toward the turgid, with liberal use of words such as “stochastic,” “heterogeneity” and “asymmetry.” One notable exception was “Money for Nothing and Checks for Free,” a paper by John Kiff and Paul Mills, economists in the Fund’s Monetary and Capital Markets Department.3 Alas, the insightfulness of the paper’s analysis did not match the whimsicality of its title.

  3 See John Kiff and Paul S. Mills (2007), “Money for Nothing and Checks for Free: Recent Developments in US Subprime Mortgage Markets,” Working Paper No. 07/188, July 1, available at: www.imf.org/external/pubs/ft/wp/2007/wp07188.pdf.

  Published in July 2007 — just as the first severe outbreak of financial turbulence was intensifying — the report examined the historical growth and inner workings of the US subprime mortgage market.

  “[N]ew origination and funding technology appear to have made the financial system more stable,” the authors concluded, although this came “at the expense of undermining the effectiveness of consumer protection regulation.” They acknowledged concerns about many of the industry’s practices, noting that its model was “driven by fee generation [which] brings with it potential incentive conflicts.” And they noted that the weakening US housing market would lead to losses on the US$350 billion of outstanding mortgage-backed CDOs — US$18 billion to US$25 billion in losses assuming home prices flattened, they predicted, and approximately US$60 billion in losses assuming a five percent price decline. But their report derided fears of a more widespread impact:

  The dispersion of credit risk to a broader and more diverse group of investors has...helped to make the US financial system more resilient. The magnitude and scale of losses being currently experienced in subprime mortgage markets would have materially impacted some systemically-important US financial institutions in the traditional originate-and-retain business model. But thus far, most subprime losses have been borne by, and contained in, the origination network’s periphery of thinly-capitalized specialty finance companies, lower-rated ABS [asset-backed securities] and CDO tranches, and some hedge funds. A proportion of the loss is no doubt accruing to foreign investors.

  The paper is one of many examples of how the IMF underestimated the forces that were propelling the global financial system in a catastrophic direction. In case after case, those at the Fund who believed, however vaguely, that some sort of disaster was looming (and I can recall discussions with such people at the time) lost out to colleagues who saw the system as much more resilient than it proved to be. To the IMF’s credit, its Independent Evaluation Office published a blistering report4 in 2011 about the Fund’s performance in the period prior to the crisis, noting that “as late as April 2007, the IMF’s banner message was one of continued optimism within a prevailing benign global environment.” The report cited “a high degree of groupthink, intellectual capture, a general mindset that a major financial crisis in large advanced economies was unlikely, and incomplete analytical approaches” as the chief reasons for the Fund’s failings. Importantly, it also noted: “Many area department economists felt that there were strong disincentives to ‘speak truth to power,’ particularly in large countries, as there was a perception that staff might not be supported by management if they disagreed with these authorities.”

  4 Independent Evaluation Office (2011), “IMF Performance in the Run-Up to the Financial and Economic Crisis: IMF Surveillance in 2004–2007,” January 10.

  Where the IMF’s surveillance is truly a source of mortification is its rosy evaluations of the United States. The Fund was in thrall to the view, prevalent at the Fed and Treasury, that the US financial system was a marvel of efficiency at capital intermediation and risk minimization.

  As noted in chapter 5, one notable exception to such complacency among IMF officials was Raghuram Rajan, who, during his tenure as chief economist, issued a now-famous alarm at an August 2005 conference in Jackson Hole, Wyoming, sponsored by the Federal Reserve Bank of Kansas City. In a remarkably perceptive address5 at that conference, Rajan cited “two particularly worrisome behaviours” that he perceived as taking hold in the world’s financial capitals. The first behaviour was the concealment of risk by money managers — because “typically, the kinds of risks that can most easily be concealed...are ‘tail’ risks — that is, risks that have a small probability of generating severe adverse consequences and, in exchange, offer generous compensation the rest of the time.” The second behaviour was the tendency by market players to act as a “herd” in making investment choices, which offered “comfort that they will not underperform significantly [by comparison to others] if boom turns to bust.” Although the banking industry, given its historical conservatism, might be assumed to offer a source of stability that would limit the damage from such behaviour, Rajan warned that if anything, banks “may well be riskier” than in the past because they “now require more liquid markets to hedge some of the risks associated with the complicated products they have created or guarantees they have offered.” He concluded:

  5 Raghuram Rajan (2005), “The Greenspan Era: Lessons for the Future,” remarks at a symposium sponsored by the Federal Reserve Bank of Kansas City, August 27.

  While it is hard to be categorical about anything as complex as the modern financial system, it’s possible that these developments are creating...a greater (albeit still small) probability of a catastrophic meltdown.

  But Rajan’s views, as the post-mortem by the Independent Evaluation Office observed, “did not influence the IMF’s work program or even the flagship documents issued after the Jackson Hole speech.”6 Indeed, “the IMF praised the United States for its light-touch regulation and supervision” and even “recommended to other advanced countries to follow the US/UK approaches to the financial sector as a means to help them foster greater financial innovation.”

  6 Independent Evaluation Office (2011), “IMF Performance.”

  The following are examples of the most egregiously erroneous statements that the IMF made about the US economy in surveillance reports, as cited by the Independent Evaluation Office:

  An IMF analysis of various US economic issues published in 2006, while noting that a fall in house prices could inflict some losses in the financial sector, highlighted the comforting fact that “better data and more refined financial tools have become available to lenders,” with innovations enabling “the tailoring of attendant risks to dedicated investor classes.” In response to the question whether a bubble in the US housing market had developed, the report’s answer was “probably not.”

  Even later, in its 2007 Article IV report on the US economy, the Fund declared: Core commercial and investment banks are in a sound financi
al position, and systemic risks appear low. Profitability and capital adequacy of the banking system are high by international standards…despite a recent uptick following subprime difficulties, market measures of default risk have remained benign.

  [T]he income of institutions at the core of the financial system, the commercial and investment banks, increasingly derives from bundling and servicing securitized assets for investors — asset-backed securities and collateralized debt/loan obligations — rather than from holding loans. The system has thus evolved to yield: (i) a profitable and well-capitalized core relatively protected from credit risks; (ii) an innovative and lightly-regulated periphery, including specialized institutions that originate loans and a multitude of hedge funds that support market liquidity and price discovery; and (iii) the transfer and diversification of credit risk via a wider range of securitized assets and credit derivatives. Against this rapidly changing financial landscape, US markets have remained globally pre-eminent and robust to a range of shocks.

  The Fund’s special checkups of countries’ financial systems — the inelegantly named FSAP reports — were no more useful in detecting the prospects for a crisis. One of the most spectacularly mistaken FSAP reports was the one conducted in February 2006 on the United Kingdom, which stated: “The UK banking system is one of the strongest among advanced economies...banks’ mortgage books do not appear to be a significant direct source of vulnerability...overall, the financial sector is well regulated.”

  The BIS

  Not all international economic institutions deserve as much opprobrium as the FSF, the CGFS and the IMF for failing to comprehend the direction in which the financial system was heading. The oldest institution of them all — the BIS — can take credit for having issued warnings that, in retrospect, would have been well worth heeding. As noted earlier, the gloominess of the views espoused by the BIS’s chief economist, Bill White, earned him the sobriquet “Merry Sunshine” from Roger Ferguson, the Federal Reserve Board vice chairman. White, who is a former deputy governor of the Bank of Canada, takes justifiable pride today in recalling the scorn he endured for his pessimism.

  Together with his Italian deputy, Claudio Borio, White advanced the argument that the triumphant conquest of inflation by central banks in the 1980s and 1990s, and the associated moderation of economic fluctuations, was lulling policy makers into complacency. As early as 2003, White and Borio presented a paper to the Fed’s annual conference in Wyoming in which they contended that the combination of low inflation and financial deregulation “may unwittingly allow the build-up of imbalances...making [the economy] more vulnerable to boom and bust cycles.”7 The financial system, in their view, “is inherently procylical,” with the uptrend likely to be amplified as investors respond to incentives to take on greater risk; the problem is that eventually, “the procylical forces go into reverse...in extreme cases, broader financial crises can arise.”

  7 Claudio Borio and William White (2003), “Whither Monetary and Financial Stability? The Implications of Evolving Policy Regimes,” paper presented at the Jackson Hole Symposium on Monetary Policy and Uncertainty: Adapting to a Changing Economy.

  The best way to guard against such an outcome, according to White and Borio, was to revamp the prevailing “micro-prudential” approach to regulation, which viewed crises as stemming from the failure of large individual institutions whose problems would spread to others. Although it was obviously desirable to ensure the safety of big banks, they argued, it was even more important to embrace a “macro-prudential” orientation, which would focus on the vulnerability of the entire system to a catastrophic breakdown. A macro-prudential approach “would be less concerned with the failure of individual institutions per se...it would fully recognize how financial distress of this type tends to arise from common exposures and the mutual interaction between the financial and real economy.” Monetary and regulatory policy would work closely together to dampen the excess generation of credit during the boom phase, actively leaning against markets’ natural tendencies even in the absence of the ordinary symptoms of overheating — that is, inflation.

  Ironically, one of the first consequential uses of the term “macro-prudential” had come in the report written in 1999 by Hans Tietmeyer, president of Bundesbank, proposing the creation of the FSF. His report had envisioned that one of the principal aims of the new group would be “overcoming the separate treatment of micro-prudential and macro-prudential issues.” And during his term as the FSF’s first chairman, Andrew Crockett delivered speeches urging the adoption of a more macro-prudential focus. But central bankers, especially those at the Fed, viewed as anathema the idea that they ought to consider raising interest rates in any situations other than those in which inflationary pressures were mounting. With backing from others on the Fed board, including his successor Ben Bernanke, Alan Greenspan insisted that such a policy would have far too many damaging ramifications for the real economy — the equivalent of using heavy doses of chemotherapy to cure a patient of a fever. In any event, there is little evidence that the FSF took Tietmeyer’s charge seriously for very long.

  The reluctance of the policy-making establishment to embrace their views was a source of frustration to White and Borio. The BIS, of course, has even less power than most other international economic institutions. Numerous economic officials with whom I have spoken recall repeated expressions of concern by White and Borio within the confines of private discussions, but because of their BIS positions the pair felt constrained in what they could say publicly. Annual reports published by the BIS conveyed the essence of their downbeat outlook, albeit in carefully couched language, as the following selections attest.

  In 2005: [T]he single most remarkable feature in the financial area has been the recurrence of credit, asset price and investment booms and busts…[I]t seems increasingly evident that we are today well into the boom phase of a third such cycle, dating from the economic upturn of the mid-1990s…[I]t remains to be seen how the [credit default swap] and CDO markets would handle a string of credit blow-ups or a sharp turn in the credit cycle…One concern is the impact of highly leveraged positions on the balance sheets of financial institutions when markets turn.8

  In 2007: Assuming that the big banks have managed to distribute more widely the risks inherent in the loans they have made, who now holds these risks, and can they manage them adequately? The honest answer is that we do not know. Much of the risk is embodied in various forms of asset-backed securities of growing complexity and opacity. They have been purchased by a wide range of smaller banks, pension funds, insurance companies, hedge funds, other funds and even individuals, who have been encouraged to invest by the generally high ratings given to these instruments. Unfortunately, the ratings reflect only expected credit losses, and not the unusually high probability of tail events that could have large effects on market values.9

  8 BIS (2005), 75th Annual Report, Basel: BIS.

  9 BIS (2007), 77th Annual Report, Basel: BIS.

  Was that a straightforward prediction that the world was headed into crisis unless a drastic change of course was undertaken? Of course it wasn’t. But it was better than the assessments prepared by others, in particular the institutions — including the FSF — that had more direct responsibility for discerning what was happening in global financial markets.

  8

  The Worsening of the Worst Case

  A Super-Elite Club

  In late September 2007, a few weeks after the first signs of serious trouble in financial markets, FSF members convened in New York for a regularly scheduled meeting amid a transformed environment. The seize up of markets in Europe and New York in August, which required emergency injections of cash into the banking system by the Fed and European Central Bank, had been followed by even more shocking developments in the United Kingdom. In scenes redolent of the 1930s, British depositors had rushed in mid-September to withdraw their savings from Northern Rock, the once-high-flying mortgage lender — an old-fashioned
bank run that the authorities had been able to halt only by promising that they would guarantee every penny of depositors’ money.

  The mood at the FSF meeting was thus similar to that of the earlier gathering of the CGFS (see chapter 7) — that is, the members were flogging themselves for having been too lax. Callum McCarthy of the United Kingdom’s FSA set the tone by noting that “the major issue for banks was facing up to off balance sheet liabilities that they (and their supervisors) had collectively ignored,” according to the minutes. BIS General Manager Malcolm Knight summed up worries raised at recent meetings about weaknesses in financial markets that were becoming apparent: “The structured finance market had not held up well when market conditions became adverse...the scenarios adopted in stress testing had not taken sufficient account of the dynamic interaction of risks underlying structured finance products.”

  This does not mean that the FSF was finally getting ahead of the curve. On the contrary, there is considerable evidence suggesting that, at this point, the body was still underestimating the severity of the turmoil that lay ahead. The summarization of vulnerabilities in the financial system prepared by the FSF Secretariat, for example, contained an elaborate analysis of the turbulence that had occurred during the summer, but, in retrospect, its assessment of the future was sadly deficient. “It may be useful to review a number of ongoing risks, how they might evolve, and what a worst-case scenario might be,” the document said, and then, after that sensible suggestion, it continued, “The most likely scenario going forward is for losses to continue, but without threatening core financial institutions. However, a downside risk is that a core financial institution encounters severe financial distress.” As we shall see, the “worst-case scenario” envisioned by the Secretariat would be a good bit worse at the FSF’s next meeting six months later, shortly after the collapse of Bear Stearns.