Off Balance

by Paul Blustein

  One aspect of that weekend’s events has drawn scant attention — a revelation that, in retrospect, seems almost incomprehensible: In their desperate effort to obtain British approval for the Barclays purchase of Lehman, US officials never told their British counterparts why they preferred Barclays to Bank of America. That is, the Americans never disclosed that Bank of America had withdrawn from the bidding so that it could buy Merrill Lynch. British officials were well aware that Bank of America was, at least initially, the top prospect (that information had been widely disseminated in the news media). They thus found Paulson’s eagerness for a Barclays takeover both odd and discomfiting. Describing his reaction at the time in his memoir, Darling wrote:

  The Americans would not pull out of a good deal and allow the Brits to get it instead. If Bank of America was walking away, something was wrong. What we did not know at the time, but learned shortly afterwards, was that Bank of America had decided to buy Merrill Lynch instead...We were deeply suspicious.7

  7 Alistair Darling (2011), Back from the Brink: 1,000 Days at Number 11, chapter 5, London: Atlantic Books.

  This is not to say that the course of history would have changed — that Lehman would have been saved and the attendant chaos averted — if the British had been informed about the Bank of America-Merrill Lynch deal. The British officials who were involved in the discussions unanimously agree that they would have refused to give their blessing for Barclays to make the purchase in any event, simply because it was too risky for their banking system to absorb an entity as troubled as Lehman.

  Still, the episode epitomizes the lack of candour among national authorities that prevailed during this period — a lack of candour symptomatic of broader coordination problems, which in turn led to dreadful consequences in the days following the Lehman bankruptcy.

  The US authorities did a reasonable job, considering the rushed time frame, of readying the domestic operations of Lehman for bankruptcy, by keeping the firm’s New York-based broker-dealer unit open and operational for a few days so that trades could unwind in fairly orderly fashion. But havoc reigned abroad. The firm’s overseas units suddenly found themselves bereft of cash because their now-bankrupt parent, which had always managed liquid resources centrally, had swept cash back to New York, including US$8 billion transferred from London hours before the bankruptcy filing. Hardest hit of all were Lehman’s UK subsidiaries, which could not even pay their janitors or cafeteria workers; bankruptcy administrators had to negotiate 43,000 separate trades with counterparties. Dozens of hedge funds based in London and Tokyo that had traded through Lehman discovered that their assets were frozen, because local laws required the local Lehman affiliates to go into bankruptcy proceedings immediately. In a sort of poetic justice, all this legal chaos in Europe and Asia redounded on US markets as hedge funds all over the world became so desperate to raise cash to meet margin calls that they dumped massive amounts of securities, creating a vicious cycle of ever-cascading prices. None of this had been contemplated, much less planned for, until the devastating consequences materialized.

  “It was an absolute demonstration that we should have been doing these joint war exercises, around real banks with real case studies,” Gieve said, looking back at this period. “If there was any chance of managing a cross-border issue of that sort, it would only have been possible in a world in which the national regulators had, beforehand, shared a lot of information, shared a lot of understanding about the structure of the groups in question and the nature of their balance sheets. You can’t enter a Friday or Saturday [when an institution is on the verge of failing] without any of that mutual understanding.”

  An even more sobering lesson could be drawn — that no matter how much talking and planning officials do in advance, chances are high that the failure of a major international bank or financial institution will take place in an uncoordinated fashion. This is because decisions about a rescue ultimately rest with the institution’s home country national authorities, and in the absence of international rules or agreements, home country authorities will understandably put top priority on their own country’s interests rather than global considerations. Or, to cite an oft-quoted aphorism: banks are global in life, but national in death.

  In Lehman’s aftermath, the fraying of international coordination would soon worsen further.

  Amsterdam, and Other Fiascos

  Given the large number of people who attended the FSF’s semi-annual meetings, the importance of the jobs they held and the distance they had to travel, meetings were scheduled well in advance. The risk, of course, was that unforeseen events would render the chosen date seriously inconvenient for many members. Never was that truer than the meeting held in Amsterdam on Monday, September 29, 2008, which proved to be the FSF’s greatest fiasco.

  In the days prior to the meeting, frantic efforts to contain the global reverberations of the Lehman bankruptcy consumed the time and energy of officials in nearly all of the world’s major capitals. British authorities — haunted by memories of the run on Northern Rock — scrambled over the weekend of September 27-28 to prevent the collapse of Bradford & Bingley, a Yorkshire-based mortgage lender. Similar situations were unfolding that weekend in Germany, where the government was negotiating a bailout for property lender Hypo Real Estate, and in the Benelux countries (Belgium, the Netherlands and Luxembourg), where Fortis, a financial conglomerate, was on the brink. In the United States, administration and Fed officials were furiously lobbying members of Congress in the hopes of securing quick passage of the bill to launch the Troubled Asset Relief Program (TARP), which at that point envisioned restoration of the financial system’s health via a complex scheme involving government purchases of “toxic” assets from banks, with plans to eventually sell those assets to private investors. US officials were also working intently to line up aid for stricken giants such as Morgan Stanley.

  Recognizing that these exigencies would take priority over the FSF, Svein Andresen, the FSF secretary general, sent an email late on Saturday, September 27 to all members, saying: “Owing to conditions, a number of members have indicated they will not be able to join this FSF meeting.” The email explained that although the FSF members who did come would meet as planned on Monday morning with private sector representatives, Draghi would adjourn the gathering earlier than scheduled, after a “vulnerabilities discussion” on Monday afternoon, with plans to resume it in the second week of October during the IMF-World Bank meetings in Washington, which many members would presumably be attending. A conference call was also scheduled for October 1.

  By the time the email landed, some members were already on their way to Amsterdam. Among them was Kathleen Casey, a commissioner of the US Securities and Exchange Commission, who, upon landing at Schiphol airport on Sunday morning, turned on her BlackBerry to find Andresen’s email in her inbox. Realizing that the meeting would probably be a waste of time, and that staying would divert her from urgent tasks back home, Casey did not even leave the airport; she booked a return flight and flew immediately back to Washington.

  The officials who skipped the Amsterdam meeting had compelling reasons for doing so, of course, and could not be expected to put the FSF ahead of their domestic responsibilities. But the episode was a low point in a period marked by many failures in international cooperation. By coincidence, it came on the same day as one of the most notorious examples of such a failure — Ireland’s unilateral decision to guarantee all the liabilities of its banks. Dublin’s announcement stunned policy makers in other countries, who feared they might be obliged to follow suit lest their countries’ banks suffer panicky withdrawals by depositors eager for the sorts of ironclad guarantees the Irish were offering.

  Draghi, for one, grasped the imperative. During a period of such severe financial strain, some international body ought to be trying to foster closer coordination among countries — and what better body for the task than the one Draghi chaired? Although top officials in major capitals, such as deputy fin
ance ministers and deputy central bank governors, were in telephone and email contact on an almost daily basis during this period, Draghi told the Amsterdam meeting he supported “creating a communication network among national financial authorities to enhance information exchange,” in response to a suggestion by one member who complained that some governments had been launching important initiatives without informing their colleagues abroad. He “tasked the [FSF] Secretariat to make the needed arrangements,” according to an email sent by Andresen to FSF members a couple of days later. And during the morning session with private sector representatives, Draghi “emphasized that, as this crisis worsens, there is a growing danger that countries will push ahead with reforms in different directions, which will be disruptive to globally integrated markets,” according to a summary of the meeting that was also sent to members, which also stated, “market participants concurred and noted the importance of globally coordinated responses to the crisis, and that the mission of the FSF, which can support the needed coordination of actions, was key.”

  This was inspired thinking. Without global coordination, the chances of countries going into devil-take-the-hindmost mode would surely rise, increasing the likelihood of a profoundly suboptimal outcome for most nations, and quite possibly a depression engulfing the entire world economy. In fact, a look back at some of the major events of this turbulent period, pieced together from various accounts including memoirs written by some of the key participants,8 shows a scenario of that nature came appallingly close to reality. The summary of those events that follows does not do justice to the complexities, nor the drama, of what happened during those late September and early October days of 2008. But it helps to provide a backdrop for understanding how truly global the crisis became, and how tenuous the circumstances confronting policy makers were in the absence of a well-functioning coordination mechanism. As a body, the FSF could do little more than stand by helplessly.

  8 These include Paulson (2010), On the Brink, and Darling (2011), Back from the Brink, as well as David Wessel (2009), In Fed We Trust: How the Federal Reserve Became the Fourth Branch of Government, New York: Crown Business; Andrew Ross Sorkin (2009), Too Big to Fail: The Inside Story of How Wall Street and Washington Fought to Save the Financial System — and Themselves, New York: Viking; Anthony Seldon and Guy Lodge (2010), Brown at 10, London: Biteback Publishing; and Andrew Rawnsley (2010), The End of the Party: The Rise and Fall of New Labour, London: Viking.

  Shell Shock

  In the weeks following Lehman’s collapse, the government of one country, the United Kingdom, was ahead of the curve compared to other major economies. Having bailed out one individual bank after another, British leaders were increasingly reaching the conclusion that a comprehensive approach — injecting tens of billions of pounds worth of taxpayer money into all their major banks, with the government taking partial ownership — would be necessary to keep the large agglomeration of financial institutions in London afloat. Prime Minister Gordon Brown was terrified that such a move would destroy him politically — “How do we explain this to people?” he kept asking his aides9 — but as one of the world’s most economically astute national leaders, he recognized the lack of tenable alternatives. The rationale for this conclusion became ever clearer as the chief executives of some of the country’s mega-banks, notably the Royal Bank of Scotland, reported in confidence that their cash reserves were nearly drained and their ability to tap overnight loan markets was virtually non-existent.

  9 Rawnsley (2010), The End of the Party, chapter 34.

  On October 5, 2008, Brown held a meeting with Chancellor Alastair Darling and Bank of England Governor Mervyn King. The men agreed on the urgent need for a capital injection; they also concluded that it was essential to act in concert with other countries, because hugely destabilizing flows across national borders would probably result if major financial centres were taking disparate measures to save their financial systems.10 But at that point, they were unable to persuade US officials, who preferred their initial TARP plan, of the merits of a direct capital injection; nor could they sway other European governments, who saw no need for such a radical step and feared the political consequences of taking it.

  10 Although it might seem as if British policy makers could have regarded such destabilizing flows as a matter primarily of concern to other governments, they believed that their own country’s banks were unlikely to survive the financial shockwaves that would result.

  Mistrust among governments was growing by the day, despite countless phone conversations and emails between capitals aimed at assuaging concerns and sharing information. Paulson’s book recounts how he and his team were “warily” watching the Europeans because “we thought they might turn to a wave of defensive actions, including guarantees, not only for depositors but for unsecured bank borrowing...[that] would put our banks at a disadvantage.” The Irish blanket guarantee of bank deposits on September 29 had thrown a fright into policy makers everywhere by raising the prospect that all governments would have to match Dublin’s policy. Even more nerve-jarring were comments issued by German Chancellor Angela Merkel a few days later suggesting that her government was going to offer a similar inducement for German banks: “We tell the savers that their deposits are safe. This is what the Federal government vouches for,” Merkel said.11 British officials who frantically sought to get a clarification of Merkel’s statement couldn’t even find anyone in Berlin or Frankfurt to take their calls at first; only later did their German counterparts provide assurances that the chancellor did not intend to go as far as her remarks had implied.

  11 I am grateful to Hermann Remsperger, formerly of the Deutsche Bundesbank, for his translation of Merkel’s words.

  All the while, large banks and financial institutions were continuing to blow up — and, as in the Lehman case, there was a striking lack of collaboration among the countries where these institutions operated. Fortis was a noteworthy example — its main operations were in the Benelux countries, where economic and political ties were ostensibly close, yet the rescue went awry because of acrimony between the Belgian and Dutch governments over how to manage the holding company and how to return an Amsterdam-based affiliate to Dutch control.

  Even more fraught with hostility among governments was the implosion in early October of three super-aggressive Icelandic banks, whose total loans exceeded Iceland’s GDP by ninefold. Following a partial nationalization of the smallest of these banks, Glitnir, in September, a run ensued on the other two, in particular Landsbanki, which had raised a substantial amount of funding from depositors at its branches in Britain and the Netherlands. The British government demanded that Iceland make good on the losses suffered by British depositors; when Iceland balked — protesting that its taxpayers couldn’t possibly shoulder the burden of supporting all the depositors of a banking system so much bigger than the country’s own economy — London resorted to an extraordinary asset grab. The UK authorities invoked anti-terrorist laws to freeze Landsbanki’s assets, a move that sealed the doom of the third Icelandic bank, Kaupthing.

  This spectacle threw into doubt some of the international rules and principles — especially the system of home country regulation of banks — that had governed the global financial system for decades. It will be recalled from chapter 2 that top regulators from major countries had agreed in 1975 on the home country regulation principle, by which the lead regulator for an internationally active bank, with responsibility for providing support in the event of financial collapse, would be the regulator where the bank’s headquarters was located. Given the obvious inability of Iceland’s taxpayers to provide adequate backing for the country’s banks, home country regulation was starting to look almost delusional.

  The time for cogitating about such long-range issues was negligible — policy makers had to scramble fast just to avoid the worst from happening. On October 7, a particularly brutal day in the markets, Darling — who was attending a finance ministers’ meeting in Luxembourg
, got a phone call from Tom McKillop, chairman of the Royal Bank of Scotland:

  He sounded shell-shocked [Darling recounts in his book]. I asked him how long the bank could keep going. His answer was chilling: “A couple of hours, maybe.”...If we didn’t act immediately, the bank’s doors would close, cash machines would be switched off, cheques would not be honoured, people would not be paid.12

  12 Darling (2011), Back from the Brink, chapter 6.

  The British government unveiled the broad outlines (although not the final details) of its bank recapitalization plan the next morning, after a long night in which a number of bank executives were effectively bullied into going along with the idea of accepting government money and the oversight that would imply. Meanwhile, the world’s central banks had been readying their own equivalent of a life-resuscitating jolt for the financial system — a coordinated cut in interest rates, which they announced on October 8, the same day as the British move. The central banks also disclosed that they had agreed on an arrangement to swap massive amounts of each others’ currencies, the main purpose being to help countries whose banks were encountering constant shortages of US dollars needed for international transactions. This was a salutary example of international coordination at a time when it had been in dangerously scarce supply. It also showcased one of the great merits of the BIS as an institution that brought central bankers together, thereby fostering a level of comfort and trust that wouldn’t exist otherwise.

  But these moves, desirable and welcome as they were, led to only modest respites from the panic that was gripping markets. By a remarkable stroke of luck, nearly all of the world’s key economic policy makers were due to be in Washington at the end of that week to attend the annual meetings of the IMF and World Bank. This afforded a golden opportunity for countries to align policies and send coordinated messages — and they got the signal loud and clear from markets about the necessity of such action, with Japan’s Nikkei index plunging nearly 10 percent that day, and Britain’s FTSE index faring just as poorly at the start of trading. Volatility in US stocks as the meetings got underway was mind-boggling; on Friday, October 10, the Dow Jones Industrial Average dropped 680 points at the opening of trading on the NYSE, dipping under 8,000, then roared back to nearly 9,000 before dropping anew to 8,451, finishing 128 points below the previous day’s close.