The Default Line: THE INSIDE STORY OF PEOPLE, BANKS AND ENTIRE NATIONS ON THE EDGE (29 page)

On a trip to Mumbai, Lord Turner of the FSA found himself excitedly explaining to the chief of India’s central bank how Britain was reining in the excesses of its banking system. His hosts were rather sceptical. No Indian bank had fallen during the great financial crisis of 2008. Half the British banking system had. But this did not stop Britain’s banks from pressing their government to help prise open the doors to India’s middle classes and their growing desire for financial services. Lord Turner explained to his hosts how in the future UK banks indulging in risky property lending would be forced to set more buffer funds aside. He was somewhat taken aback when his hosts told him, ‘Oh, we do that already.’ A somewhat incredulous Lord Turner asked when the Indians had discovered this radical new form of financial regulation. ‘Oh, we never stopped doing it since you the British told us to,’ his Indian host replied, pointing out that India, unlike Britain, had simply not stopped features of bank regulation that had been standard issue for decades. Britain’s chief bank regulator had been taken back in a time machine to the 1970s.

The story of Barclays’ escape from state ownership does shine a new light on Bob Diamond’s eventual fate in the 2012 Libor scandal. From the moment Diamond became chief executive, the British economic establishment had been extremely concerned that the boss of the worrying side of the bank’s business had been promoted. There were a number of skirmishes over such things as Barclays’ aggressive tax schemes and its accounting wizardry. When details of the Libor scandal broke, the Barclays boss was still standing, despite Andrew Bailey at the FSA warning of a ‘fundamental breakdown of trust’. The Barclays chairman, Marcus Agius, tendered his resignation, but the regulators thought the wrong man had resigned. Diamond was fighting for his job. He even phoned Ed Miliband to gauge support, but Miliband publicly called for him to resign. Agius’ resignation simply set the hares running. Two days later, Barclays released damaging email notes for a parliamentary committee, seemingly ascribing a role in the Libor affair to the deputy governor of the Bank of England, Paul Tucker. Diamond appeared to be taking on his own central bank. Threadneedle Street was apoplectic. But it had no formal legal regulatory power over Barclays at the time. Mervyn King believed enough was enough. He contacted Adair Turner and George Osborne, before calling Agius and Sir Michael Rake, who was still on the Barclays board, to see him at the Bank of England. He had no power, he said, he was not the regulator. But the Bank of England was to become Barclays’ chief regulator within a year. ‘Bob Diamond no longer enjoyed the support of his regulators,’ he told Agius and Rake. The two board members went straight from the Bank of England to Diamond’s house. ‘He [King] does not have the authority to do that!’ was Diamond’s response to the news about the governor, he told the
New York Times
a year later. He resigned the next morning. I spoke to Marcus Agius, who had by this time ‘unresigned’, and he did not deny the pressure from King and Turner: ‘Last night Bob Diamond made a personal decision which we discussed.’ He told me, ‘We have let the public down, we have let our shareholders down… I am truly sorry.’

At a packed parliamentary committee, Diamond’s testimony was no longer about saving his job. Diamond was never actually shown to have acted improperly in the Libor-rigging scandal he is most associated with, and he would later say that the truth was that he did not even know how Libor was set, let alone how to manipulate it. But his enemies had taken their opportunity. A series of leaks from highly confidential internal FSA assessments revealed a litany of more general concerns about Mr Diamond’s style. The committee chairman Andrew Tyrie caught Diamond unaware. He ended up confirming the idea that the Barclays board thought the Brown government was trying to nationalise it. The comments were lost amid the drip-drip of documents about the conduct of the bank under his leadership and Diamond’s saccharine comments about ‘loving Barclays’. Diamond protested that his bank had remained profitable throughout the crisis. His trading book turned out to be profitable too. The ‘stress test’ pass was vindicated, but the politics had become even more toxic. It was all too late. His defenestration from the highest floor of British banking was complete. More importantly, after a relentless globalising process since the Big Bang, Britain had reasserted some national sovereignty over its errant banking system. The war over the shadow banking system, though, was far from over.

Dramatis personae

Motorcycle courier, transporting mortgage documents

Anonymous UK mortgage securitiser

Oldrich Alfons Vasicek, the ‘V’ in KMV Corporation, who split the atom of credit risk

Donald MacKenzie, Nicholas Dunbar, Felix Salmon, writers on derivatives

Jon Taylor (name changed), part of the Northern Rock securitisation team

Adam Applegarth, chief executive of Northern Rock

Nassim Taleb, trader-turned-probability philosopher and anti-economics campaigner

Andy Haldane, Bank of England executive director for banking

Anand Sinha, deputy governor of the Reserve Bank of India

Hyun-Song Shin, banking expert, Princeton University

The chief executive of one of the world’s biggest banks

The courier had been knocked off his motorbike and lay dead on the side of the road. For the man himself, and for his family, it was a human tragedy. But for the mortgage securitisation team at one British bank, it was a waking nightmare. They had to get his package to London before the close of business. This was how banking from the shadows actually worked on the ground.

The business of this particular banking team was built on transferring mortgages that they had written off their balance sheet into offshore trusts based in tax havens. But the transfer of the mortgage, and the cash, had to be made the same day, in one go. Ordinarily this could be done electronically. The ‘pain in the arse’, as far as the team was concerned, was the insistence in Scottish law on ‘declaration of trust’. In essence this meant that physical signatures were required on the first and last pages of a printout that included all the names and addresses of those whose mortgages were to be transferred. So the bankers had to hire a courier to transfer a large parcel of papers to get the mortgages signed off in London. But then he crashed.

‘We had to get his package down to London though,’ a former member of the team told me. ‘So some other courier came, took the package from the back of his bike. Because if you don’t get that package, the deal won’t happen.’ After this tragic fiasco, they stopped using motorbike couriers. Instead they sent an office junior on the train.

The indecent haste of this British bank to shift a pool of mortgages off its balance sheet is just one of the inside stories of an industry that created a quarter of a trillion pounds’ worth of mortgages in Britain alone. In Britain this industry involved only about thirty people, called ‘originators’. Credit that used to flow regionally and locally from savers to borrowers through building societies had through securitisation become a matter of massive flows of hot international money. It was part of the ‘shadow banking system’ of flows of credit that seemed to bypass the banks. These mortgage transfers seem complex, and yet they are one of the more straightforward aspects of this murky world.

After the great San Francisco earthquake of 1906, only one building remained standing in the red-light area known as the Barbary Coast, just north of Telegraph Hill. It was a mill built in 1884 by Del Monte, the food-processing company based in the city. A photograph was recently discovered of 1620 Montgomery Street on fire, as the rest of the area lay in rubble. Around that time, the streets surrounding the mill were notorious for opium dens, whorehouses and ‘shanghaiing’ – the trickery used to get sailors tempted by California’s gold fields back onto merchant ships.

San Francisco lies on the most active geological fault lines on earth. But nine decades on, within the steel-reinforced walls of the old Del Monte building, something far more shaky was going on. The former mill had now become the global epicentre of market credit-risk analysis. The San Andreas Fault of finance ran through this building, and through the office of one brilliant mathematician. Three formulae that shook the foundations of finance were written not on Wall Street, nor in the City, nor at Chicago, MIT or Cambridge, Mass., but here at the understated warehouse offices of the KMV Corporation.

The chances are you’ve never heard of KMV, nor of the man behind the ‘V’ in KMV, a Czech-born mathematician called Oldrich Alfons Vasicek. Vasicek’s formulae made complex credit derivatives possible. They also form the basis of credit ratings, and became the regulatory core of how most banks calculate the capital they keep aside to stop them going bankrupt. And yet the formulae were basically beautiful abstract mathematical theories proven only under such restrictive conditions that they were of limited practical relevance.

I met Mr Vasicek in California’s January sunshine. The Master Yoda of credit appeared opposite me wearing a Californian peace insignia pin badge. The peace is a little upset when I explain how the final Vasicek formula has become central to the Basel rules on bank safety. No one is more surprised by how his formula has been applied to the core of the banking system than Mr Vasicek himself.

‘It’s completely nonsensical. Completely silly. These are completely independent parameters,’ he tells me forcibly. ‘How can you hardwire them together? Who came up with that? People at Basel? It blows my mind. If this is right, they should go into revolution with barricades and send Basel to hell.’ Bankers, traders and regulators used derivations of Vasicek’s work to create the so-called ‘Gaussian copula’ (named after the brilliant German mathematician Carl Friedrich Gauss, 1777–1855) that would come to be known as the ‘formula that killed Wall Street’. The arc of credit complexity that led to the crisis began more benignly here, at 1620 Montgomery Street, San Francisco.

Vasicek’s first innovation was to assess the probability of individual corporate loans defaulting. He used information from share prices to calculate ‘asset values’, also known as ‘enterprise values’. It drew on the theories of two of his friends, the Nobel prize-winners Robert Merton and Myron Scholes (later to come to grief at Long Term Capital Management). Vasicek’s formula estimated a probability of default based on the movement and volatility of the share price. It was a more timely and useful measure than, say, a credit rating. KMV was surprisingly successful at selling these default predictions for vast sums to financiers sceptical about the assessments of the Big Three credit-ratings agencies.

‘We saved a lot of clients a lot of money on assorted Enrons,’ Vasicek told me. ‘That was an accounting fraud not really revealed until late November 2001. But there were very strong signals in the equity market that something strange was going on. I don’t know what generated these signals, but I guess some strange news must have found its way to equity investors. The way it manifested itself was a drop in share prices maybe six months before.’ But even more significant, Vasicek opined, was an unusual increase in the volatility of the share price.

Traditionally credit had been a staid, inert and boring corner of finance. Banks held loans for the long term, earning a modest amount of interest, and hoping there would be no default. Vasicek had connected that staid world of credit with the daily trading frenzy of the stock markets.

Vasicek’s first formula opened up the revolutionary notion that credit risk, instead of marinating for years on a bank’s balance sheet, could begin to be traded like a share on a stock market. Vasicek took his analysis a stage further, by coming up with an equation to model the losses on a portfolio of loans. Under a certain set of simplifying assumptions, he could solve the maths with a pencil and paper. The credit revolution began here. ‘Our model could find an implied correlation between 5,000 listed US businesses in 1989,’ Vasicek pointed out. ‘By the mid-90s we had extended 25,000 time series of the enterprise values for every listed company in the world.’

Vasicek had introduced the idea of a daily valuation of default probabilities and loan losses. Prior to this innovation, corporate loans would be measured by credit rating and the associated historic default record. KMV were directly competing with the credit ratings agencies. The agencies were worried about this revolution from San Francisco and talked down KMV’s approach to clients. With Vasicek’s new method, data on past losses, arrears and defaults were not required. His work had split the atom, making credit risk tradable. From the mid-1990s J. P. Morgan would then industrialise these insights to develop credit derivatives – which are at the same time both the atomic power stations and the weaponised nuclear warheads of credit risk. The rest of Wall Street and the City would then start dropping these weapons from the so-called shadow banking system in the easy money years before the crash.

But it was Vasicek who found the mother lode that sparked the credit gold rush. Through the mid-1990s, risk officers from thousands of the world’s banks made pilgrimages to KMV in San Francisco. Three-quarters of all the globe’s major banks were KMV’s customers. Many of the visitors would get lost, not realising that this part of the street was not part of the skyscraper-laden Lower Montgomery (‘the Wall Street of the West’) containing the headquarters of Wells Fargo and Bank of America. A large hill bisected Montgomery, and north of that lay the offices of KMV in the historic docklands area. It didn’t feel like the epicentre of the credit revolution. At first the purpose of these visits was to access KMV’s database of default probabilities and correlations for alternative measures of bank credit risk. This was a relatively straightforward task, and KMV would send monthly CDs full of data to their clients. ‘KMV was the most advanced of the credit modellers quantitatively, so it was a very useful input and really helped our portfolio-management techniques in the late 1990s,’ says one of J. P. Morgan’s pioneering credit-risk team. A British bank chief executive adds: ‘We were certainly quite early in reaching for KMV. The idea was to have a common language across your risks. KMV created a common language across our trading and loan book. It created comparability and it was rigorous and innovative, an important part of how risk was analysed in any sophisticated bank.’