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 (20 page)

The position of Timothy Geithner, the youthful president of the New York Federal Reserve, was more ambivalent still. Unlike the men running the Fed and the Bank of England, Geithner had no background in academic economics. He arrived at his post in October 2003, aged just forty-two, after a career in the Treasury. Free from rigid economic dogmas, he was a deeply pragmatic man who sometimes observed that his aim in life was merely to do “the least bad job possible.” Like almost every other American policy maker and official, Geithner believed that in an ideal world, banking should be based on the principles of free-market competition. In the real world, though, he recognized that governments sometimes needed to jump in. In his eyes, the financial system was often plagued with what he called “collective action problems”—or cases when the banks were so busy pursuing their own interests in a competitive and greedy fashion that they failed to rationally consider long-term outcomes.

Competitive forces, in other words, did
not
always produce efficient or safe results, Geithner believed. That view was different from Greenspan’s faith in laissez-faire finance. Geithner’s approach was much closer to that of the former New York Fed president Jerry Corrigan. That was no coincidence, as after Geithner arrived at his post, he took to calling Corrigan regularly for advice, along with other experienced financiers.
Corrigan was only too happy to play the avuncular adviser. He and Geithner not only shared similar attitudes to the markets, but both had a “geeky” fascination with the technical details of market infrastructure. “I guess you could say Corrigan and Geithner are in the same church pew. Greenspan is not,” observed one senior American official who knew them all well.

The ever-pragmatic Geithner was careful never to express any public sentiment that might dissent from Greenspan’s views. Compared to Greenspan, Geithner was not just younger, but he also commanded far less clout and respect. As the decade wore on, though, he became privately uneasy about some of the trends in the credit world. From 2005 onwards, he started to call on bankers to prepare for so-called “fat tails,” a statistical term for extremely negative events that occur more often than the normal bell curve statistical models the banks’ risk assessment relied on so much implied. He commented in the spring of 2006: “A number of fundamental changes in the US financial system over the past twenty-five years appear to have rendered it able to withstand the stress of a broader array of shocks than was the case in the past. [But] confidence in the overall resilience of the financial system needs to be tempered by the realization that there is much we still do not know about the likely sources and consequences of future stress to the system…[and]…The proliferation of new forms of derivatives and structured financial products has changed the nature of leverage in the financial system. The addition of leverage imbedded in financial instruments to balance-sheet leverage has made this source of potential risk harder to assess.”

The most tangible sign of unease was that Geithner clamped down on the trading infrastructure of the credit derivatives world. Back in 1993, the J.P. Morgan bankers who wrote the G30 report had considered and dismissed the idea of instituting a mandatory clearinghouse for tracking and settling derivatives trades. One huge benefit of a clearinghouse would have been protecting against undue “counterparty risk,” or the danger that if two institutions traded and one suddenly collapsed mid-trade, the deal could not be completed. The clearinghouse idea was rejected because the bankers who wrote the G30 report argued that
investors had sufficiently strong incentives to monitor that counterparty risk themselves. Their strong bias was for keeping the derivatives markets private, subject only to voluntary oversight.

By late 2004, though, it was clear to Geithner that self-policing had not removed counterparty risk. What particularly alarmed him at the time was the situation in banks’ back offices. Though credit derivatives were supposed to be the epitome of efficient “virtual” banking, many banks were still using faxes to confirm deals. In the early days of the market, that wasn’t a problem, but as the markets exploded, the volume of trades overwhelmed the banks’ back offices, creating long backlogs in the processing of the paperwork. By 2004, the delays were so bad that it took almost eighteen working days
on average
for banks to confirm their deals. Worse, a new fashion had started for “novating” deals, or assigning them to someone else. If Bank A cut a CDS deal with Bank B, for example, it might later decide to sell that deal to Bank C—without actually telling Bank B. That left vast quantities of deals in a legal limbo land.

In the rational market conceived of by free-market economists, the banks would have responded to this problem by voluntarily investing to create better trading systems. However, the banks weren’t doing so. At most banks, the derivatives traders had not only no control over the back office but no desire to sacrifice their profits to pay for infrastructure investment. With the notable exception of Jamie Dimon at JPMorgan Chase, most bank CEOs also knew very little about trading infrastructure. And no individual bank wanted to stop doing trades until a new system was in place, as that would let its competitors leap ahead. To Geithner, it was a classic case of a “collective action problem.”

In late 2004, he acted, encouraging Corrigan to head a study of a group of leading Wall Street financiers to examine the state of the complex financial world. By then Corrigan was working as a managing director at Goldman Sachs and had already conducted one such exercise, back in 1999, which set out the lessons to be learned after the Long-Term Capital Management hedge fund collapsed. This second study would have a much wider agenda, analyzing the state of complex finance more generally. When the three-hundred-page report was finally released in
the summer of 2005, it duly demanded that banks overhaul their back office procedures for credit derivatives. “Dear Hank,” Corrigan wrote in a letter to Henry Paulson, then CEO at Goldman Sachs, that accompanied the report. “I want to call your particular attention to [our recommendations] which call for urgent industry-wide efforts to cope with serious back-office and potential settlement problems in the credit default swap market and to stop the practice whereby some market participants assign their side of a trade to another institution without the consent of the original counterparty to the trade…this practice has the potential to distort the ability of individual institutions to effectively monitor and control their counterparty credit exposures.”

In September 2005, Geithner summoned representatives from the fourteen largest Wall Street banks to attend a meeting at the New York Fed. It was the first time the banks had gathered for a collective meeting in the Fed since the implosion of the LTCM hedge fund. Determined to make his point, Geithner solemnly lectured the banks that they had to overhaul their systems or face a regulatory clampdown. It worked. By the end of 2005, the average time for confirming trades fell to eleven days, and in 2006 it fell sharply again. Geithner and Corrigan were thrilled. They appeared to have nipped this problem in the bud with deft, proactive action involving regulators
and
banks. “Often it takes a crisis to generate the will and energy needed to solve a problem,” Geithner observed in an article in late 2006, coauthored with Callum McCarthy, head of Britain’s FSA. “Here, the industry deserves credit for acting in advance of a crisis.” British officials fervently backed what Geithner was doing, as they had also been worried about the backlogs, but since regulatory responsibility was split between the Bank and FSA, it was unclear who should clean up the mess.

Yet when Geithner and Corrigan reflected on the backlog issue in early 2007, they felt little sense of triumph. Cutting backlogs was a relatively easy issue to address. There was consensus about what needed to be done, and there was also tangible data that
proved
why everyone needed to act. But what if the problem in the banks’ back offices epitomized a much bigger problem in the system as a whole? What if “collec
tive action problems” were distorting the credit markets in a myriad of other, less transparent ways? Was there anything regulators do about those intangible “collective action” issues? Neither Geithner nor Corrigan was sure.

On April 17, 2007, Corrigan traveled down to Washington for a meeting organized by the German Finance Ministry. That year the Germans held the revolving chair of the G8 grouping, the body that brings together leaders from eight of the world’s leading industrialized nations for debate. They wanted to use the gathering to focus on the thorny matter of financial stability. Like others, German financial officials feared the credit bubble might be spinning out of control. However, they had an unusually clear idea who might be the culprit—the hedge funds. Almost exactly a decade earlier, in the autumn of 1998, the financial system had been rocked to its core when LTCM imploded. LTCM had been leveraged no less than 100 times and had used that money to place massive bets in the interest-rate derivatives world, which later turned sour. After that event, banks and regulators had scrutinized the funds, spurred on by the lessons outlined in Corrigan’s report. Nonetheless, the Germans remained alarmed by the lack of formal regulation over these funds.

Even if they did not know exactly why credit conditions seemed so extreme, they were convinced that the high-rolling, risk-loving hedge funds must somehow be to blame—and they hoped to persuade the rest of the G8 to regulate them. If nothing else, that would show that global leaders were willing to act to prevent another bubble burst. “There needs to be a proper debate about what hedge funds are doing,” Peer Steinbrück, the German finance minister, declared.

On a Sunday afternoon, the G8 delegates met at the World Bank’s headquarters to discuss the German proposals. Among them were senior US officials, including Robert Steel, US Treasury undersecretary, and Tim Geithner. Senior central bankers and treasury officials from Europe also attended, ranging from Mario Draghi, governor of the Bank of Italy, and Nigel Jenkinson, a senior official at the Bank of England. Some private-sector financiers had been invited too. Corrigan was one. Another
was Jim Chanos, the founder of the hedge fund group Kynikos, famous for taking the type of aggressive “short” positions that the Germans hated.

The delegates trooped into a large conference room in the World Bank. Security at the meeting was tight. Corrigan was one of the first to speak. With his usual gruff manner, he outlined the key issues that were dogging the world of complex credit in relation to hedge funds and other investors. The good news, he observed, was that trading backlogs were falling. The bad news was that innovation was occurring so fast that it was posing a host of new risk management challenges—so many, in fact, that Corrigan admitted he was far from sure that the regulators—or even bankers—really knew what risks were building up.

One of the Italian officials jumped in. A few months earlier, he observed, the Bank of Italy had asked twenty-eight financial institutions with operations in Rome to complete an anonymous survey on their level of exposure to credit derivatives and other areas of structured finance. “But as of now, not one has replied,” he observed. The room erupted in nervous, embarrassed laughter.

Then Chanos was summoned. Steel, of the US Treasury, had asked him to come to make sure that the hedge fund community got a chance to defend itself. The Treasury didn’t agree with the Germans that hedge funds were the key problem, and it wasn’t keen on regulating them. Doing so would fly in the face of Alan Greenspan’s argument that it was good to have some freewheeling risk takers in the system to disperse risk across a wider group of players.

“So what are your views about hedge funds and financial stability?” a senior German official asked Chanos. As succinctly as he could, Chanos tried to defend himself. The hedge funds, he argued, were in the business of taking calculated risks, and precisely because they were in the risk-taking business, they tended to monitor those exposures. Other parts of the financial system, though, were far more dangerous because they were taking risks that nobody could see. “It’s not us you should be worrying about—it’s the
banks
!” he declared.

He explained why he was worried: leverage at investment banks was surging; banks were holding huge piles of opaque credit assets on their
books that no one understood; strange CDO and SIV vehicles were springing up with all manner of tentacles into the banks. Worrying about what hedge funds were doing amid all that litany of dangers was like fiddling with the deck chairs while the
Titanic
was heading for icebergs. “It is the
regulated
bits of the system you should worry about!” he said, explaining that he was so concerned that his own fund had taken out numerous “short” positions on the share price of most large investment banks and many monoline insurers. The Germans looked utterly unimpressed. “Thank you, but do you have anything to say about the risks that hedge funds pose?” one official asked. “No,” Chanos said and sat down.

He had the impression that most of the officials around the room had barely heard what he had said, far less agreed with him. In part, the problem was one of data. The main way that the regulators and central banks judged whether banks were healthy was whether they were meeting the terms of the Basel Accord. All banks needed to set aside capital worth 8 percent of their assets, and by that measure the banks all looked extremely healthy. In early 2007, British banks had a capital ratio of 12 percent, while the American ratio was just slightly lower—way above the minimum that regulators required. Given that, it was very hard for regulators to make a case for getting too worried about the banks. What they didn’t know, and Chanos had tried to alert them to, was that those capital reserves were set against only a relatively small portion of the banks’ true risk exposure, because so much of that risk was tucked away in shadow banks or measured using only very narrow and flattering tools.