The Alchemists: Three Central Bankers and a World on Fire (16 page)

King’s players tuned up in the lengthy Friday afternoon gatherings leading up to a Monetary Policy Committee meeting the following Thursday—although some were clearly more favored by their conductor than others. With many of the hundred or so bank staffers in attendance presenting their latest economic data and analyses, the “bank agents,” who are scattered around Britain and charged with staying in contact with commercial banks and businesses, were consigned to a minor role. “The meeting would go on for three hours,” according to David “Danny” Blanchflower, a member of the Monetary Policy Committee whose private disagreements with King eventually turned into a very public feud. “And it would all be theory, and in the last ten minutes, the agents would report—and they said something that was completely different than what the theory said.”

At the much smaller meetings of the MPC itself, the discussion was focused on applying the bank’s various models—models that assumed a functioning financial system—to current economic circumstances. Even when King was dealing with deepening problems in the banking system in the summer of 2008, he kept the conversation theoretical, sharing little of what he knew with his fellow committee members. “The Monetary Policy Committee was kept out of the loop,” said one person who was on the committee in that era. “Mervyn was holed up in his office reading and thinking. There wasn’t a sense of urgency or a lot of meetings. The rest of us were like, ‘My God, what are we doing?’”

As the crisis expanded, financial markets were enveloped by uncertainty. But there could be certainty of one thing, at least: At the Bank of England, the King of Threadneedle Street reigned supreme.

•   •   •

A
t the end of August 2007, the three men were in different places, figuratively and literally. Bernanke was at the Jackson Lake Lodge, plotting crisis response from the secret crisis center set up one floor up from the ballroom. Trichet canceled his voyage there at the last minute, citing personal reasons. King, who usually dispatched deputy Charles Bean to the gathering, did so once again.

On the evening of Friday, August 31, 2007, buses lined up at the lodge to take conference attendees and their spouses to the evening’s entertainment. Economists and bankers don’t necessarily wear jeans and cowboy hats well, but on this occasion they wore them nonetheless. While they nursed light beers, a local rancher tried to demonstrate the techniques of horse whispering. The bucking mare ignored the rancher’s reassuring body language and quiet words and refused, no matter how delicate the rancher’s approach, to submit to a saddle. The parallels with the financial crisis then just starting to unfold were so obvious that a murmur went through the crowd: Central bankers were whispering to the financial markets, trying to calm them. But just as in the show, soothing words might not be enough.

The rancher suggested that his guests might want to go ahead and get their buffet dinner of beef brisket and baked beans while he kept working on the horse. Sure enough, by the time dinner was done, the animal had calmed down enough to allow the rancher to ride her. The financial markets would be harder to tame.

Over by Christmas

T
he morning of Friday, September 14, 2007, Mervyn King and Alistair Darling flew to Porto, Portugal, for a scheduled meeting of European Union central bankers and finance ministers. The timing of their trip to the riverside city best known for its sweet fortified wine was terrible.

For the past several weeks, Northern Rock PLC, a bank based in the North East of England with £100 billion in assets, had been in crisis. Its business was to issue mortgages, which would then be packaged and sold on financial markets—and since August, mortgage securities had been toxic to global investors. Northern Rock faced a cash crunch, as depositors discovered just how bad its situation was, a classic bank run. Television news programs showed ominously long lines of Northern Rock customers waiting to pull their deposits. “
You don’t want to be the ones in the end of the queue
that the money’s run out,” an uncertain customer said to the cameras outside a branch in Reading.

In a palatial Moorish hall, the governor of the Bank of England and the chancellor of the exchequer watched from afar—on TV, just like many of those Northern Rock customers determined not to be in the end of the queue when the money ran out. “
They’re behaving perfectly rationally
, you know,” King told Darling, the chancellor later recalled.

It was an accurate statement—but hardly what Darling wanted to hear. Britain had seen a number of bank failures over the years. But the two men had overseen the first run on a British bank since Overend & Gurney’s in 1866.

Known before 1997 as the Northern Rock Building Society
, Northern Rock had established itself as a very modern variety of bank. Much of its deposit base came from the Internet, with people all over the country parking their savings there electronically to take advantage of high interest rates. Its home mortgage loans—many made to buyers in the gritty shipbuilding and coal-mining towns of the North East—weren’t held on its own books the way lending banks had done for centuries. Instead, Northern Rock sold them as securities—as quickly as it could, to investors around the world. It had expanded at a breakneck pace, growing around 20 percent a year for seventeen years straight. By 2007, it was a large bank, with shopping-center branches around the UK, but hardly enormous—it was about one twentieth the size of Barclays, for example.

When the financial system started to shudder in August 2007, what had previously seemed like Northern Rock’s strengths turned out to be terrible weaknesses. Investors, newly fearful that mortgage securities could turn out to be worthless, had little interest in buying more of them. They also didn’t want to lend money to a bank that was built almost entirely on home lending.

In continental Europe or the United States, this wouldn’t have been much of an issue, because the European Central Bank and the Federal Reserve had relaxed their emergency lending programs so banks like Northern Rock could get money on favorable terms. But King’s concerns about moral hazard meant that the Bank of England would offer no such accommodation until it was too late.
When Northern Rock needed cash
, it explored using its one branch in Ireland—part of the eurozone—to access money through the ECB. It concluded that getting the legal details in order would have taken two or three months—far too long to wait.

As the weeks passed, Northern Rock’s cash crunch became increasingly self-perpetuating. With its future in doubt, the bank was less likely to get any money from lenders on private markets; their reluctance made its cash shortage all the more acute.

The weekend of September 9, King was meeting with the other central bankers in Basel when Darling and chief British bank regulator Callum McCarthy reached him by phone. They argued that the Bank of England needed to follow the lead of the ECB and the Fed by supporting the banking system more actively. King was typically stubborn.

“
During the conference call
, I became increasingly frustrated at Mervyn’s insistence that normal judgments could still apply in what were obviously deeply abnormal circumstances,” Darling wrote later.

King may have been insistent on making banks pay for their previous mistakes, but the Bank of England’s job for three hundred years had been to prevent a bank collapse and the broader public panic that might ensue if British subjects no longer believed their deposits were safe. His strategy was to step in as lender of last resort to Northern Rock, if necessary—but he insisted on ensuring that the Bank of England truly was the bank’s last resort, and on charging a “penalty” interest rate for emergency loans, making them an undesirable option for any other banks that might wish to go to Threadneedle Street for help.

King argued that an emergency loan to Northern Rock would be most effective if it was covert. After all, if the public knew that Northern Rock had had to turn to the Bank of England for funds, it could increase the sense of panic. But lawyers for both banks fretted that a failure to disclose the loan immediately might be illegal, giving Northern Rock shareholders an inaccurate impression of the bank’s health. A subsequent investigation questioned that interpretation of the law but acknowledged that it would have been hard to keep any large-scale loan to Northern Rock secret for long in the “
febrile and fevered atmosphere
of that period.”

Indeed. On Thursday, September 13, the Bank of England was pulling together a funding deal for Northern Rock that was to be announced the following Monday, in a carefully plotted rollout meant to reassure depositors and investors that their money was safe. At 8:30 that evening, however, BBC business editor Robert Peston went live on the air to break the news that a bailout was imminent. There’d been a leak, and the careful rollout wouldn’t be an option.

Depositors suddenly knew not only that Northern Rock was desperate enough to go to the Bank of England for funds, but also that there was no guarantee from the government that their deposits were safe. The bank’s tiny storefront branches filled up with even two or three people lined up inside; new arrivals had to wait outside. Once queues started forming and TV news cameras started broadcasting them, the “Run on the Rock” was well under way. People who had made deposits online began withdrawing at such a pace that the bank’s servers couldn’t handle the load. When word got around that Web customers were unable to withdraw, the panic worsened still.

The run ended Monday, September 17, when Darling announced that the government would stand behind all deposits to Northern Rock—despite the fact that there was no clear-cut legal authority allowing it to do so. “It was pretty shambolic,” said one British official involved. But it was enough. The lines abated; the run stopped. The government had bought time to nationalize the bank and shut it down in an orderly way, with depositors’ money protected.

That same day, Darling had a previously scheduled meeting with Hank Paulson, the U.S. treasury secretary. “
Your guy Mervyn has a high pain threshold
,” Paulson told him. “I hope you have, too.”

During the summer and fall of 2007, the major central banks all had different interpretations of the emerging crisis. King and the Bank of England saw a necessary and even healthy market correction after years of excessive risk-taking by the banks. They were disinclined to step in and rescue the banks from their bad decisions, lest they reward dangerous behavior. Jean-Claude Trichet and the ECB saw a banking panic. Their banks were more exposed to shaky U.S. mortgage securities than anybody had realized, but the ECB and bank regulators across Europe pumped euros into the system to keep their banks awash in liquidity. It would be enough, they hoped, to prevent the European economy from facing any real peril.

Ben Bernanke and the Fed saw a dual threat of a banking panic and recession: The crisis endangered both the financial system and the U.S. economy as a whole. They would use their tools to keep banks afloat, just as the ECB had. But Bernanke’s study of how the financial system interacts with the rest of the economy made him fearful that lending would dry up and slow the U.S. economy to a crawl—or worse. To combat that risk, in mid-September the Fed started cutting the federal funds rate, and by extension lowering the cost of money across the economy, to try to encourage overall economic growth.

Meanwhile, many of the other leading central banks, including the Bank of Japan and those in the emerging nations of Asia and Latin America, took an isolationist stance: The difficulties in the American and European financial markets are someone else’s problems. They probably won’t affect us here, and we have our own domestic issues to worry about. King was the first to discover how severe those domestic issues could be—and just how connected to the rest of the world’s problems they really were.

After the big interventions by the ECB and the Federal Reserve, and the more halting efforts of the Bank of England, the sense of crisis ebbed in October. The U.S. stock market even reached new highs that month. But that reversed at the end of the year, as the patchwork of measures the world’s central bankers had put in place started to reach the limits of their effectiveness.

It was time for the bankers to stop working individually, at different speeds and with different tactics, and begin addressing the crisis together. In the run-up to the crisis, what few policymakers or private economists fully understood was just how important European banks had become to the U.S. financial system.

As economist Hyun Song Shin
—he of the prophetic Millennium Bridge metaphor—explained in a 2011 paper, European banks, more than any others, had the ability to buy the allegedly risk-free mortgage and other assets being created by Wall Street with little or no capital to protect against losses. That helps explain why, by early 2008, non-U.S. banks—most of them European—had more than $10 trillion in exposure to the United States, equivalent to about 70 percent of U.S. economic output. They had roughly that much in both assets (bonds that they owned) and liabilities (money they owed someone else), particularly money market funds. It seemed like a system in balance: A German bank might have lots of dollar assets and lots of dollar liabilities, but they were more or less equal.

But when mortgage securities backed by home loans in Florida began to tumble, the assets side of that ledger fell in value—and what that German bank really needed to ride out the losses was dollars, not the euros that the ECB was able to offer. Typically, it could have easily borrowed euros from the ECB and temporarily swapped them for dollars on international currency markets. The very nature of this crisis, however, was that trust had evaporated among the banks that would normally help each other out in just that way.

At dinners in Basel, at a late September conference honoring the fiftieth anniversary of the German central bank, and in countless phone calls, the world’s central bankers brainstormed how they might overcome this problem. The conversations were so open-ended and wide-ranging that different participants have different recollections of how particular ideas originated. Bernanke, Trichet, and King discussed things in one-on-one conversations, then brought in representatives of the smaller central banks. They all dispatched staff, mainly their market operations chiefs, to hammer out the details, including how and when to put out an announcement and what it would say.

On December 12, 2007, they released a statement: “Today, the Bank of Canada, the Bank of England, the European Central Bank, the Federal Reserve, and the Swiss National Bank are announcing measures designed to address elevated pressures in short-term funding markets.” That they were all moving together, the central bankers hoped, would send a signal to the world that would have its own benefits to confidence.

The five banks announced that they would be reemploying a measure they had used in the aftermath of the September 11, 2001, terrorist attacks: They would swap currencies with each other to ensure the free flow of funds around the globe. For example, the Fed could give $10 billion to the ECB in exchange for an equivalent value of euros. The ECB could then lend those dollars out to banks in the eurozone that were suffering a dollar shortage. After some fixed period—say, ninety days—the two central banks would return each other’s money. The Fed was, indirectly, funneling dollars to the eurozone and Swiss banks that desperately needed them.

The second arm of the strategy was for the major central banks to force money out the door in sufficient volume, and on sufficiently relaxed terms, that commercial banks would see the wisdom of taking advantage of it. It was an attempt to overcome the stigma that had kept commercial banks from taking central-bank money—basically, an offer they couldn’t refuse. For the Bank of England, that meant increasing the amount of cash it would lend out for a three-month span almost fourfold, to £11 billion, and accepting even AA-rated bonds as collateral, not just the higher-rated varieties it usually required. Both international bankers and some Bank of England insiders believed that the global nature of the effort allowed King some face-saving: It seemed less like a flagrant reversal of policy than it would have had the Bank of England acted on its own.

The Fed, meanwhile, introduced a new program that would essentially force money into the banking system. Instead of waiting for banks to come to the discount window, the central bank announced that it would reverse the process: It would distribute $40 billion by the end of the year in two auctions, guaranteeing that money would go out the door to
someone—
that someone being whatever bank would pay the highest interest rate. It was called the Term Auction Facility, or TAF. What the American public didn’t know at the time—and Fed officials were in no rush to enlighten it—was that the someone in question was, overwhelmingly, the U.S. affiliates of European banks.

Out of the first $20 billion lent out under the program, only trivial amounts went to American banks—$10 million to Citibank, for example, and $25 million to Wachovia. Taking out $2 billion each, meanwhile, were the New York–based arms of WestLB, Dresdner, DZ Bank, and Landesbank Baden-Württemberg, all German, and Dexia, headquartered in Belgium and France.
The list of those borrowing substantial amounts
from the Fed in that auction also included banks from Britain, Japan, Canada, Spain, and Finland, all of which took out far more than U.S. banks.