The Default Line: THE INSIDE STORY OF PEOPLE, BANKS AND ENTIRE NATIONS ON THE EDGE (27 page)

The FSA chairman Lord Turner told me: ‘I don’t think we did fail as regards AIG, because although some of the execution was done through the London office, the legal entity… which really should have been regulated more effectively, was the American legal entity. I think the Americans all understand that what happened with AIG was probably the worst case across the world of something literally falling between the stools of the regulatory process.’ AIG’s US government bailout would eventually turn in a profit. But in October 2008 it was far from certain that Treasury Secretary Paulson would do it. Only the sheer panic that followed the Lehman collapse changed his mind. At Barclays, which was minutes away from saving Lehman, there was a big ‘What if?’ If Barclays had bought Lehman Brothers and prevented its bankruptcy, then the US Treasury probably would have allowed AIG to fail. If AIG had failed, many more banks, particularly in Europe, would have failed too. AIG was an earth-shattering one-way bet on the global credit boom, yet at the same time it was an essential cog in producing that boom. And its credit sorcery occurred in London.

London was the capital of the shadow banking world. The City hosted AIG FP, the creation of the CDS market, as well as much of the Lehman Brothers mortgage business and the hedge funds that traded the mortgage bonds. But there was no clear divide between these high-risk operations and the conventional banks. The ‘universal’ banks that bestrode this divide were increasing risky exposures to, say, property on their trading books, while reining in property exposure on their conventional loan books. It made little sense.

It goes back to the deregulatory Big Bang of 1986, and even before that. One British financial CEO filled me in. ‘What is the City since Big Bang? Mostly American-owned or American-influenced,’ he told me. ‘You should stop thinking of the City of London during the boom time as anything other than an extension of Wall Street.’ The City grew fat on offshore dollars traded internationally (nicknamed ‘eurodollars’). From the 1960s a US tax change called ‘Subpart F’ offered huge tax breaks to US multinationals on dollars earned abroad, as long as they stayed abroad. Again this boosted the City. Eurobonds were created after another change to the US tax code. ‘It was American corporate interests creating American pools of money,’ another senior financier told me. ‘American investment banks then snapped up all the British banks that then directed those American pools of money that were outside of America in London.’

London was clearly far more than the financial equivalent of George Orwell’s ‘Airstrip One’. But seeing the City as essentially a part of Wall Street is a useful way of looking at the boom and the bust. It did seem as if London was where Wall Street did its dry-cleaning. There can be no doubt that the UK FSA started the race to the bottom on lenient treatment of derivative exposures. It boasted about the business won through this approach. Wall Street regulators tried hard to keep up. David Cameron himself, in a speech to the City after the crisis began in March 2008, fully endorsed the strategy of outcompeting Wall Street on deregulation. ‘The UK has a long history of benefiting from over-regulation elsewhere,’ he told his audience. ‘The worst response to the current crisis would be a knee-jerk response and proscriptive over-regulation.’ A crisis bank chief executive concurs: ‘There’s some truth in the Americanisation story. The City moved to take advantage of the Sarbox Act, and Gordon [Brown] was not interested in taxing “nondoms”. The Nondom rules were designed specifically to attract American bankers.’

The Americans brought meritocracy, technology and a can-do attitude to the cosy gentlemen’s club of the pre-Big Bang City. Many City figures bitterly resisted the Big Bang reforms forced upon them by Mrs Thatcher. It was another example of the City not even knowing what was good for itself – at the time, at least. But Big Bang was clearly a necessary, though not sufficient, condition for what followed two decades later.

The two biggest casualties of the credit crisis, AIG and Lehman Brothers, ran their riskiest operations through their London offices. US investigators found Lehmans operating an extraordinary trade through London called Repo 105, which saved on Lehman’s capital requirements. The entire deal required the sign-off by City lawyers for something that would never have been allowed in the USA. Even more shockingly, both Lehman and AIG had senior London-based executives who were loudly warning of the consequences of the credit cataclysm. At AIG it was Bernard Connolly. At Lehman Brothers it was John Llewellyn. Both were seasoned watchers of global finance and of economic history. They were the same age, and of a similar background – former international government economists, from the European Commission and the OECD, who had ended up in the City. It is frankly incredible to read back the apocalyptic forecasts of Connolly, AIG FP’s chief strategist, and realise that at the same time, at the trading desk just outside his office, they bet the farm on a never-ending credit boom and nearly brought down the entire European banking system.

John Llewellyn was a little more reserved. But in many ways his intervention was even more subversive, as Lehman Brothers unknowingly hurtled towards oblivion. He had developed a magic formula that was proving rather effective at predicting which economies were about to succumb to their economic imbalances. It was called ‘Damocles’. And in 2003 he applied it to the USA, partly as a spot of pre-Christmas amusement. The USA came out as flashing red on the Damocles analysis. It turned out that America was the nation with the riskiest finances in the world. Llewelyn briefed Dick Fuld, Lehman’s combustible chief executive. Fuld told him to stop publishing the Damocles assessment of the US economy. Llewellyn chaired Lehman Brothers’ risk committee during the height of the boom. He was the elder statesman who was supposed to try to take away the punch bowl from the likes of Mr Fuld. In practice that proved rather difficult.

Back at the Number 11 table, it is possible to see why the likes of Peter Sands of Standard Chartered and Douglas Flint of HSBC were a little detached from their fellow bankers. Sands had helped shape the recapitalisation that was about to be announced. As for Flint, during the boom HSBC had been under repeated attack from a Chicago-based hedge fund, which called for the lumbering giant to be broken up and handed over to ‘proper’ capitalists. HSBC did not really participate in the boom. It maintained a capital ratio of 8 per cent, double that of its soon-to-be defunct competitors sitting around the table at Number 11. Even though HSBC was the most directly exposed to subprime, after a disastrous purchase of US consumer-finance company Household International, it sailed through tests of its solvency. HSBC’s equity was higher while its returns were lower, as, unlike the other banks, it had eschewed chasing the yields of risky loans. HSBC had not joined in the party. It was only at the funeral out of politeness. Flint determinedly told the table that the government should be extremely careful that actions taken to protect weak banks would not lead to questions about strong banks.

John Varley, CEO of Barclays, cut an owlish figure at this supposed ‘last supper’. He did not say very much at all. Most of the talking was being done by the Scots, Douglas Flint and Sir Fred Goodwin. But in many ways it was Varley who found himself under the most pressure. The Scottish banks and Lloyds had no actual choice other than to cleanse themselves of their delusions. They would all be taking the government capital on offer and going into varying degrees of state ownership. Barclays, however, had a way out. As Varley would tell me a few days later, he had to ‘protect Barclays’ self-determination’ from the dead hand of even partial ownership by the British government. Lest anyone confuse John Varley with Woodrow Wilson after the First World War, the banker defined self-determination as the ‘freedom to compete aggressively’. To some of those around the table, it seemed that the freedom that Barclays wanted to hold on to was the freedom of its top bankers to go on receiving large pay packets.

A chairman of one of the banks being bailed out was to telephone Treasury minister Paul Myners hours before the final agreement, at 2 a.m. in the morning, to say that his chief executive was insistent on keeping his bonus. Another chairman told the Treasury that he would resign if there was ‘any hint’ of direction or interference in their failed corporate strategies, now that the government was on the shareholder register. ‘Can I stop you there?’ Myners broke in. ‘It is a condition of this recapitalisation that you resign anyway.’ The bankers gathered at Number 11 were not a particularly self-aware bunch.

Barclays felt it could escape Gordon Brown’s embrace. The foundations of the recapitalisation plan were laid months before. Gordon Brown and the FSA had prodded the banks to raise their own capital in January 2008. Brown wrote articles in the
Financial Times
urging transparency on balance sheets, and called in accountants and the accounting regulator to explain what was going on in dark corners of the balance sheets of the UK banks. In March 2008 Mervyn King, the governor of the Bank of England, had outlined to the US ambassador in London and the visiting US Treasury deputy secretary, Robert Kimmitt, a plan for global recapitalisation of the over-leveraged banking sector by a small group of countries. The account of that meeting, in secret US embassy cables published by Wikileaks, indirectly quotes the governor as telling his American guests: ‘It is hard to look at the big four UK banks [i.e. RBS, Barclays, HSBC and Lloyds TSB] and not think they need more capital.’ The big banks and also the smaller ones all attempted to raise more capital from shareholders in the following months, with varying degrees of desperation, failure and the odd success. By summer it had dawned on officials and ministers that a ‘showstopper’, if necessary a forced recapitalisation with taxpayers’ money, was on the cards. There were all sorts of different views within the tripartite committee representing the Treasury, the Bank of England and the FSA. Britain going it alone on recapitalisation had risks, and so the various UK authorities were keen on a concerted international plan. However, just after the collapse of Lehman Brothers, the US Treasury secretary, Hank Paulson, announced TARP (Troubled Asset Relief Program) – an entirely different type of rescue plan involving the purchase of toxic assets, rather than bolstering up the banks with new capital. Britain paused its bank recapitalisation plans.

In August 2008 two senior government figures communicated to the bosses of Lloyds TSB and HBoS that ‘If you want to ask us a question then you should ask.’ HBoS was causing the government more sleepless nights than RBS. An HBoS rights issue had failed weeks before. In addition it was hugely dependent on the Bank of England’s Special Liquidity Scheme, a £185 billion pawnshop for toxic mortgage assets. And HBoS was coming to be seen, quite rightly, as fair game by aggressive speculators. The fear was that an HBoS collapse would have hit RBS, then Barclays, then the domino effect would have been impossible to stop. The question HBoS and Lloyds did ask was whether competition law could be waived to enable a merger. The Treasury was split, as was most of the tripartite committee, and there was a dither. It took the collapse of Lehman Brothers to convince the doubters. At this point, many in government were convinced that having seen HBoS’s rotten books, Lloyds would drop its bid. It did not. ‘Taxpayers got a great deal. It would have cost a lot more to separately bail out HBoS,’ reflects a former minister. Nonetheless, separate plans to do just that were prepared in case Lloyds pulled out of the HBoS deal. Eric Daniels of Lloyds reached a point where he felt it necessary to take lengthy longhand notes of everything being said at these meetings.

On 26 September 2008 Gordon Brown met President George W. Bush. It was during the latter’s frenetic last months at the White House. Markets were still reeling from Lehman’s collapse ten days previously. British officials were still trying to come up with the show-stopping number for a bank recapitalisation. While Gordon Brown was in the Oval Office, a fax arrived from the Bank of England. Mervyn King was suggesting that £100 billion of government capital be forced on the banks, including the relatively healthy HSBC and Barclays, even if they had access to the private capital markets. The governor feared the impact of market stigma on bailed-out banks if the recapitalisation was optional. But he was also taken with the aggressive stance of the Swedish government in 1991–92, when it had pushed through a recapitalisation by threatening nationalisation. In the end, profits from sell-offs refunded almost all the cost of the Swedish bailout. Governor King even suggested employing some of the Swedish pioneers to run the UK bailout. The USA too, by October 2008, would be forcing government money on its banks, even on the likes of Goldman Sachs. A hundred billion was the number they worked with, but it ended up being half that. On the flight home from DC, Brown and his team began to work on the numbers. Peter Sands of Standard Chartered also began developing the recapitalisation plan from his office in the City. The Treasury joked wryly that if Mervyn wanted £100 billion for the banks, then he had better start printing money quickly (‘printing’ began five months later).

A significant problem arose. There was no legal means to oblige a bank to take the capital. ‘We were beyond the point of legal precision,’ said one minister. ‘If they had declined, we might have had to say it was not in the national interest for the Bank of England to provide central-bank funding.’ Sir Fred Goodwin, for one, resented this combination of implied threat, bluff and incentive. He said his only difficulty was liquidity, not capital. The only problem in terms of capital was that RBS had ‘the wrong sort’, and that could be solved by a liability-management exercise. Until the markets stabilised, RBS told Paul Myners at the Treasury that all the bank required was continued covert funding. By the early hours of the next morning Sir Fred had spoken to his board, and also to Treasury officials and business minister Baroness Vadera, and decided RBS only needed a smallish pot of government capital, around £5 billion. Vadera was shocked that the number was so low. It ended up being four times that amount. The Treasury tactics were working. It made access to cheap, guaranteed, medium-term funding conditional on some form of recapitalisation. Crucially, though, this recapitalisation could be privately funded, where possible.