Gillian Tett: Untangling the global financial meltdown

Gillian Tett unravels the Gordian Knot that made catastrophe inevitable. What can we learn from it?

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Last Updated: 09 Oct 2013

How did it go so horribly wrong? This is the question that many investors, regulators, politicians, businesspeople - and bankers - have been asking themselves over the past 18 months, as they watch the global financial system implode. After all, just two years ago, the western world seemed to have the most sophisticated and powerful banking system seen in history. Now, however, it has produced credit losses of an eye-popping size.

Earlier this year, for example, the Institute for International Finance in Washington estimated that banks and insurance companies had written down more than $1,000bn of credit losses. The Bank of England suggested last autumn that the total market losses on global credit assets had reached almost $3,000bn - a sum that is comparable to the annual output of the entire UK economy (and which has since almost certainly risen).

Such carnage is not unique to the present crisis. After all, there have been plenty of booms and busts in the past. But what makes the current drama so stunning is that this disaster has not been triggered by any external event, such as a war. Instead, over the past 18 months, the financial system seems to have collapsed in on itself - imploding, apparently, out of the blue. Groups that once seemed impregnable, such as Lehman Brothers, AIG, Northern Rock, Bear Stearns, Royal Bank of Scotland and Washington Mutual - to name but a few - have all disappeared, or virtually disappeared, as independent entities. It's an outcome that almost no-one could have guessed at just a year before, and it's not over.

On a macro level, there is no shortage of explanations for what happened. The past two decades have been a period of extremely lax regulation - and outright deregulation - that enabled financial companies to compete and expand at a remarkable rate, with minimal oversight or government control. The era of low interest rates at the start of this decade fuelled the frenetic expansion by providing what seemed like a never-ending stream of ultra-cheap liquidity. A savings glut in Asia contributed further to the flood of money.

However, a wave of innovation in finance was a critical factor in the credit bubble too, since it enabled a host of new financial entities to expand their levels of leverage, along with their risk exposures, in ways that regulators failed to understand - or even see - until it was too late. The creativity of bankers, as it were, ran way ahead of the comprehension of those same financiers, as well as the regulators, politicians and stock market investors.

Until the summer of 2007, this heady brew of innovation - and its opacity - did not cause alarm in the regulatory world. Much of the innovation was centred on the task of turning bank loans, or other forms of debt that had formerly been un-traded, into tradeable instruments that could be sold in the capital markets. Sub-prime loans, corporate bonds, credit-card debts and almost any other form of loan were all transformed into securities that had exceedingly complicated names and structures.

Most policy-makers believed that the process of slicing, dicing and packaging debt in this way made the system much safer than before. After all, by shedding credit risk through the use of tools such as loan sales, securitisations or derivatives contracts, it seemed that banks had managed to reduce their concentrated exposures to certain sectors or geographical zones. Thus, whereas a downturn in the Texas housing market in the 1980s had triggered the savings and loans crisis in the US in an era when banks held loans on their books, the dispersion of credit risk should make banks less vulnerable to an S&L-style shock in the future - or so the argument went.

And for their part, banks were happy to support this creed, since the process of slicing and dicing debt enabled them to garner much higher fees than before. Moreover, precisely because banks seemed to be shifting risk off their books, they were permitted by regulators to extend more loans (thus garnering even more fees).

The system as a whole was overwhelmed by a kind of groupthink that enabled the level of leverage, complexity and opacity to increase to such dangerous heights that it stoked a huge credit bubble. When it burst, the resulting wave of de-leveraging across the financial system was so violent, and so much worse than policy-makers had expected, that it hurt banks, companies and consumers alike.

But on a micro level, there was a range of specific failures that fuelled this boom-to-bust, particularly in the way that many financial firms structured and organised themselves. Thus far, the public debate has focused on the issue of the bonus culture at banks, or the fact that bankers have reaped vast rewards in recent years in exchange for taking risks. But that is just the tip of a much bigger iceberg of structural problems and management failures. Most notably, in the past three decades, the internal dynamics of many financial firms have developed in a manner that made them extraordinarily ill-suited to cope with the dangers posed by intense innovation.

Clues to the nature of these problems can be seen by looking not just at the list of firms that have suffered particularly badly but also at some of those that have not. In the investment banking world, the groups that have experienced the most dramatic losses on complex credit instruments include Citigroup, Merrill Lynch and UBS, all of which were devastated by horrendous write-downs caused by specialist products known as 'collateralised debt obligations of asset backed securities' (CDOs of ABS).

Before the summer of 2007, the senior parts of these instruments (which are essentially bundles of mortgage debt) were deemed to be so safe that they carried a triple-A tag from credit rating agencies. Moreover, Citi, Merrill and UBS each stockpiled large quantities of senior tranches, believing they would never default - or even move in price. But by the autumn, the value of these assets tumbled in a way that wrong-footed the models that banks had employed to analyse risk. As a consequence, these three institutions had, by spring 2008, posted a collective writedown of $53bn.

But while that was a shocking blow, equally striking was the fact that a few - a very few - rival banks had shied away at an early stage from the idea of holding CDOs of ABS on their own books. One that had ducked that bullet was JPMorgan Chase; another was Deutsche Bank, and a third Goldman Sachs. And although some of that represented sheer luck (and the banks concerned have all made other mistakes), canny judgment was also at work. And that, in turn, reflected subtle distinctions in the internal management patterns.

An issue that seems to have influenced what happened to banks - or did not happen - pertains to the background of those running them. At JPMorgan Chase, the CEO Jamie Dimon is a notorious hands-on meddler who prides himself on being not just risk-averse but also highly involved in the granular details of how his business is run. The investment bank is run by Steve Black and Bill Winters, also hands-on managers - and Winters has an extensive derivatives background, having risen through that part of the bank. As a result, Winters and Black decided in the mid-Noughties, when the credit boom was becoming increasingly intense, that it did not make sense to get too involved in CDOs of ABS or to hold that type of risk on the bank's books. More striking still, senior management reiterated that decision often, in the face of pressure from equity investors for JPMorgan Chase to boost its earnings by jumping into that field.

There was similar caution at Deutsche Bank, partly because Anshu Jain, the co-head of the investment bank, has risen to his position after a career in derivatives, which left him well placed to analyse risk. And the stance of Goldman Sachs has been influenced by the fact that it has former traders - including derivatives specialists - in senior positions, among them Lloyd Blankfein, the CEO.

However, Citi, Merrill and UBS had a paucity of senior managers who understood fully how complex finance worked and had the skills to analyse risk. Citi was run by a former lawyer (Chuck Prince), Merrill Lynch had a former wealth manager (Stan O'Neal), and UBS too was dominated by commercial bankers and wealth managers. The ranks just below them tended to include a large proportion of former equity and bond salesmen and corporate advisers, who focus more on revenues than embedded risks.

Perhaps even more important was the banks' structural organisation. At Merrill Lynch, for example, the risk department existed in a silo separate from the trading operations and carried lower status. Indeed, the chief risk officer never reported directly to the CEO. As a result, risk managers were in no position to challenge the actions of traders. Similarly, at UBS and Citi, risk managers mostly had lower status than the traders they were supposed to monitor.

To make matters worse, the internal structure at all three organisations was marked by segmented silos that operated largely in fierce competition with each other. At any one time, the silo that earned the most money - or produced the highest volume of profits - tended to wield the most clout within its group.

In the early 2000s, the silos at Citi, Merrill and UBS involved in CDO trading were producing fat profits. That made it difficult for other parts of the bank to monitor their antics, or even work out what was going on. And although these CDO silos reported ultimately to the top of the bank, the most senior managers didn't know enough to exert much control. After all, the men running these three banks had only limited knowledge of how these instruments worked; and the men (and occasional woman) on the CDO desks had little personal incentive to enlighten their managers. After all, as long as they kept producing profits, they would earn fat bonuses.

The companies that ducked the worst of the CDO headaches tended to place far more emphasis on risk management within the firm as a whole. Goldman Sachs, Deutsche Bank and JPMorgan Chase, for example, had all invested heavily in risk-monitoring systems in recent years, and the risk departments tend to command more status within their respective groups - to the point where those running the risk team all report to the senior management. Moreover, the risk departments of these three banks have all emphasised a holistic approach to risk.

A central goal of this approach is to foster a wider level of interaction across the banks as a whole. At Goldman Sachs, for example, the history of operating as a partnership seems to have encouraged a collectivist mentality among senior managers. Meanwhile, at JPMorgan Chase, Dimon has been ferociously trying to break down silos. He has promoted a culture in which staff are encouraged to challenge each other - and thus move away from any groupthink.

But an equally crucial issue that has separated the banks in recent years has been their approach to models. At UBS, for example, senior managers have hitherto relied heavily on models based around formulae such as the Value at Risk (VaR) to measure risk levels. If VaR suggested that an instrument was safe, it tended to be ignored in the risk reports - and only the thinnest sliver of capital would be retained against any risk. At JPMorgan Chase, however, managers were highly cynical about the worth of VaR, even though (or perhaps because) the bank itself had helped to create the concept a decade earlier. VaR measures were taken but, typically, used alongside other techniques for analysing risk. So although these models seemed to suggest that senior tranches of CDOs of ABS were safe in 2005 and '06, senior managers at JPMorgan Chase did not believe it and were reluctant to let these securities pile up on the bank's balance sheet. A similar stance was taken at Deutsche Bank.

A focus on holistic risk management has certainly not saved these three banks from all the possible mistakes: the storm that has blasted through the financial system in the past 18 months has been so intense that it has made even some relatively well-run banks look vulnerable at times. But it does reveal a wider point: that in the final analysis, it was not innovation in itself that caused the financial carnage but how that innovation was used - or misused.

Behind the vast numbers and the complex alphabet soup that mark out the modern credit world lie a set of human beings, social organisations and incentive schemes. During the past decade, most banks have woefully mishandled the element of human management. But hard lessons can now be learned. It is to be hoped that the next generation of managers will learn them, not just in terms of what has gone so terribly wrong across the financial world, but also in terms of what did not go quite so badly wrong at the few banks that are now emerging as survivors.

Gillian Tett's new book, "Fool's Gold: How unrestrained greed corrupted a dream, shattered global markets and unleashed a catastrophe", will be published on 30 April by Little, Brown. MT readers can buy a copy of the book at the special price of £16.99 (RRP £18.99), including free p&p, by telephoning 01832 737525 and quoting reference LB076.

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