Anniversaries

Today is the tenth anniversary of the largest bank failure in US history, which is an event rather close to my heart.  The bank was Washington Mutual, at the time the fourth largest retail depository in the country, and unlike the recent anniversary of the failure of Lehman Brothers, it is unlikely that there will be any news items commemorating the failure.  The Financial Times won’t run an article about the employees who were there at the time and what they lived through and what they learned.  Lehman was a bigger institution, of course, and its failure – a simple collapse, with the financial world completely uncertain of what would take place next – was far messier.

But Lehman wasn’t a bank – it owned a small thrift, Lehman Brothers Federal Savings Bank, but tellingly, that bank simply ceased operations and paid off depositors without incident.  Lehman was an investment bank, which in the United States meant that it was really a securities brokerage firm that was transformed by the miracle of derivatives into something different, less of a broker which bought and sold securities and more of a warehouse for offsetting risk positions.  None of those obligations were “deposits”, and while many of them had the same monetary effect as banking transactions, Lehman’s balance sheet positions had little to no direct impact on individuals (well, putting aside the extremely wealthy individuals who may have had the capacity and legal ability to trade derivatives).  Lehman was, in essence, a giant storage unit.  Because it had been profitable, and because “the industry” trusted Lehman – institutional trading and funding is and always will be a confidence game – it used the earnings capacity of the storage unit to enable it to convince people to lend it lots of money on short maturity, and used the borrowings to then buy longer-dated, less liquid assets.  When the confidence of the system broke, and Lehman’s short-term borrowings matured without its ability to refinance them, its capital quickly disappeared – the capital which allowed regulators to be comfortable with Lehman running its storage unit.  Lacking any more flexible tools, the regulators told Lehman it was in violation of the rules associated with storage units, and Lehman was forced to fold.

Washington Mutual was very different.  I’ll use the personal plural “we” and “us” here because I was a mid-level executive in the bank’s treasury department, and I had a fairly central role in navigating the course of the bank’s failure.  We failed but we did so in a setting where the rules for failure were well-known, and we failed a kind of financial warehouse which was (and remains) well understood by American regulators.  We failed in the right way, and thus, no one – except those of us who were there and who loved the bank and remembered its brighter days – will remember it.  We failed well, and in that lies a lesson.

How the global financial crisis happened

Other people have written cogently about why the global financial crisis occurred.  A frequent commenter on this site, Mark Hannam, recently wrote a fine piece about the why and, by extension, where blame lies, and earlier this week Ray Dalio, head of Bridgewater Associates, a large hedge fund complex, released a co-authored book on why such crises are historically tractable to analysis and understandable as part of the cycle of capitalism.  But the how has been relatively glibly described, at least in my readings (which are as broad as I can make them – again, I lived at the core of this particular crisis).  So before I talk about Washington Mutual’s specific failure, I want to set the stage with how this particular systemic collapse occurred.

I’ve read Bridgewater’s book (I read fast, and it’s free online), and nothing in it was particularly interesting.  At its core is a description of the lifecycle of credit bubbles, which really isn’t a lifecycle of bubbles but a description of the cycle of capitalism.  At any given time, we are in some part of a six stage cycle:

• Stage one is “normal credit creation”: Capitalist systems create credit – money – when participants in aggregate have a more or less equilibrium attitude towards the risk of repayment failure and the opportunity of profitable returns from lending to businesses and individuals.  In this stage, credit expansion is approximately equal to the rate of population growth plus the rate of productivity improvement plus an inflationary rate targeted by central banks to allow for long-term nominal debts to be extinguished at par without undue risk of those nominal debts becoming unserviceable due to the impact of deflation.

That’s not a simple concept, so let me explain in more detail.  If the aggregate money stock’s value with respect to the aggregate value of all stores of value (ie., “stuff” that can be bought and sold, like houses and artwork and shares of stock and dollar bills and – well, you get the picture) remains constant through time, then a debt – the promise to repay a given amount, obtained today, in the future – denominated as $100 today is still worth $100 tomorrow with certainty.  But the aggregate money stock does not remain constant.  If the aggregate money stock falls over time (which is deflation), then debt denominated as $100 yesterday is actually only supported by the potential value of less than $100 tomorrow.  That makes paying it back more difficult for the individuals of tomorrow, who have less value of “stuff.”  If the aggregate money stock increases over time (that’s called inflation), then the ability of people to repay yesterday’s debt which is denominated at $100 is relatively easier.  If we accept the idea that what we really want is for $100 yesterday to equal $100 tomorrow, then oddly, we need to actually build in a buffer of very mild inflationary trend in monetary value so that, when the system experiences “normal” volatility and risk, it doesn’t encounter sustained periods of time where $100 yesterday is unable to be supported by new asset values today.

This has always been the case – in aggregate – although in an era where money was thought of as “gold” or some other natural asset, it wasn’t understood as such.  In a world where people accepted “absolute” values in everything, monetary value was also absolute – nonsense of course; value is a human arbitrary determination and always has been, but then again, a world in which absolutes of human construction are thought to exist always will be nonsense.  Perhaps the economics’ greatest contribution to the human experiment is the way in which it has allowed us to quantify the fact that there are no absolutes.  But I digress.  The point here is that in the “normal” or “stable” part of the credit lifecycle, credit expansion remains in a kind of quiet equilibrium.

Interestingly, though, the need to maintain a buffer of inflationary monetary growth sows the seeds of a credit crisis.  Over time, that buffer slowly increases asset values in nominal terms – that is, in terms of the numeraire in which value is expressed (units of dollars or pounds or euros or whatever).  That leads to stage two.

• Stage Two is “credit expansion”: As asset values slowly accumulate, lenders start loosening the terms on which they will offer credit.  Why?  Well, easy.  First off,  human beings are learning creatures – which means what’s happened in the past seeds future behaviour.  If asset values steadily rise, then the human beings who make lending decisions will, over time, become complacent about the likelihood of future increases in value.  And because the need to have a buffer on value creation is accepted as a given, they aren’t necessarily wrong – although we in theory we should always remind ourselves that the modest inflation built into monetary expansion expectations is just a buffer, and should be ignored for the purposes of underwriting future value.  But we don’t. At this point we’re in stage two of the capitalist cycle: real credit expansion.  Note that at this point, credit expansion may be good – for example, when very long term infrastructure is financed which will have multiplier effects on economic activity, like railroads and ports and core research and development.  That’s why some credit expansion is a good thing – but it usually proceeds neatly to stage three.
• Stage Three can be avoided through policy, but in historical practice, it’s only deferred.  We’ll call it “bubble inflation”.  Stage three takes place when credit expansion begins to accelerate to the point where, even with modest inflationary floors built into the system, future asset values cannot support present lending expansion.  In this stage, shorter lived assets are being financed in the expectation of above-inflation rates of value accumulation, and without regard to multiplier effects.  In the years leading up to the financial crisis, this was when mortgage lending started expanding rapidly.  This stage usually doesn’t last long but, because of deferral actions, it can be sustained longer than one might otherwise think.
• Stage Four can be described as “bursting the bubble.”  It doesn’t require much; a small group of suddenly risk-averse investors – or short sellers – can trigger it.  Basically, in stage three, the system requires continuous expansion to support the expansion of asset values.  If that expansion takes even a short pause, some debts will become due without the support of asset values to repay them.  These small failures quickly erode the overall system’s belief in asset value expansion, and more debts are called instead of being refinanced.  Acceleration in asset value deterioration occurs as failed debts force the sale of assets into “fire sale” prices, leading more lenders to believe their lending is at risk – remember, we’re a learning species, and recent experience will strongly impact our expectations of near-future potential events – and they will also call in debts.  This leads to a rapid destruction of asset values, and in the worst case, will lead to an erosion of belief in the nominal value of money.

At this point, Dalio and the Bridgewater people assert that there is a kind of path divergence.  Either a capitalist system has control over the nominal quantity of its currency or it doesn’t; in the former case, the system will create new nominal currency and thus expand the nominal value of assets via inflation.  In the latter case, there will be an absolute collapse of values until such time as normal human needs force the system to restart – albeit with much lower activity, and thus much lower real value.  That essentially jumps the system to Stage Six, which is a slow recovery of activity back to Stage One albeit from a (potentially) lower starting point.  This can be observed in plenty of economies in the 19th century, for example, where the gold standard meant that most monetary systems lacked any control over the amount of nominal money inside them.  Depressions in those economies often resulted in decades of poverty.

Stage Five, though, is available to those economies which have full control over the absolute amount of nominal monetary units available in which to denominate relative value of assets.  In those economies, the control function – a central bank or a government – simply prints money.  It can lead to a hyperinflationary cycle if the control function is corrupt or incompetent, but in modern economies, we seem to have largely mitigated those risks, and with a robust but controlled printing press (Ben Bernanke famously called it “helicopter money” – dropping $100 bills from helicopters), the monetary control function can essentially force a return to nominal inflation by supplying more money than the broken system “needs.”  This leads to inequality and (one might argue) injustice: those who owned assets before the bubble burst, and either had financing terms which didn’t require repayment into the bubble bursting or who were fortunate enough to own them outright, suddenly see the value that they possess in nominal terms stabilize and, relative to those who owned them on pre-bubble credit terms, increase.  Those who were unfortunate enough to be caught in the credit destruction Stage Four of bubble bursting will become much worse off relatively speaking.  But the reinjection of normalized inflation buffers prevents a full crash, and enables Stage Six to begin.

Sorry if I’m wandering.  Basically, after the Stage Three bubble inflates, the system moves towards the following:

• Stage Four is the bubble bursting, and the emergence of a free-fall in asset values as lenders call in loans in the face of declining asset values but in so doing, accelerate the fall in nominal values.
• Stage Five is the intervention of a monetary control function to stabilize values, which may or may not occur.
• Stage Six is the re-initiation of credit creation, albeit at lower levels than can sustain ongoing economic activity due to the feedback process by which credit creators are influenced by recent events, and thus credit is created at a rate meaningfully below that of population growth plus productivity growth.

Of course, the emotional capacity for human beings to just get fed up with the whole damn thing can intervene – often Stage Four leads to social unrest, war, or some other violence which acts to exogenously reset the system and which itself through violence destroys assets and eliminates their value entirely.  Stage Five, moreover, embeds inequality into the system which makes it more likely that a future cycle will generate said social unrest or war.  It’s fear of that radical change – combined with the real fear that asset holders (ie., the property-owning class, which generally also holds the reins of political power in modern democracies) have of the destruction of value – that normally inspires monetary control functions (usually staffed and overseen by asset holders) to engage in Stage Five remediation.  As a learning species we’re focused on those lessons most recently learned; but as an economic species, we’re also focused on our own personal well-being, and if we kick the can down the road to our children or grandchildren to deal with the consequences, most of us will do so.

So with that background.  The global financial crisis really began in the late 1990s, when a more globally-interconnected world than had been the case in prior years experienced a set of localized crises.  There was the Asian monetary crisis, where localized Stage Four credit bubbles burst in Indonesia, Malaysia, and elsewhere, and there was the US dot-com Version 1.0 bubble which burst.  Both were localized but because they happened in a number of diverse economies more or less at the same time, the US Fed – then as now the manager of global valuation in its role as manager of the US dollar’s nominal value – moved to a Stage Five response by rapidly dropping interest rates and, with the complicity of Congress and the federal policy making apparatus, loosened financial regulation to enable (and indeed incent) the creation of additional credit for non-productive assets like houses and cars.  By 2002, the economies of the world had more or less stabilized and re-emerged into a Stage One phase, but because some of the responses were structural (ie., the loosened regulatory standards), the global economy moved rapidly to Stage Two.

Stage Two lasted from roughly 2002 to 2004.  By that time, the success of the localized Stage Five responses in 1998-2001 had become embedded in the memory response of the overall system, and lenders started believing – quantitatively through models which embedded historical trends, qualitatively through a gradual but accelerating forgetfulness of older cycles which weren’t as resonant in their evaluation process as recent history – that asset values would not, in fact, fall.  Thus began a global process of bubble inflation, which lasted roughly from 2004 until… well, that’s where you start to get into a “he said, she said” debate of what happened where and when to whom.  For me, it lasted until late 2006; for the world at large, it lasted until early 2008.

Why the financial crisis definitely began by July 2007 and no later

In late 2006, Washington Mutual’s various lending divisions started reporting disturbing results.  Namely, borrowers weren’t repaying their loans – which in and of itself was just part of the cycle of lending (not everyone will repay; it’s why lending in aggregate is profitable over time – you take risk).  The borrowers who were defaulting were defaulting in the first three or four months after taking out a loan – meaning that they probably never thought they’d be able to repay unless everything worked in their favour.  In other words, they didn’t want a loan – they wanted equity.  They wanted capital which was extinguishable without risk – which is only created in the form of credit during periods of credit bubble inflation.

However, the fact that they couldn’t repay meant that the credit bubble had already reached maximum inflation.  Someone else out there – probably their own liquidity availability – was calling in their loans.

Now, this was invisible to most credit market participants in 2006.  That’s how Stage Four begins – someone out there loses liquidity, and has to stop their own party.  When one party stops, it makes another party seize up, and so the chain begins.  Washington Mutual just was one of the first banks to see it.  I say that only because I had the privileged position of seeing it early; clearly it was happening elsewhere too.  Countrywide, for example – the largest mortgage lender in the US – was also seeing it, and as a result they started tapping their “backup lines”, the contingent sources of lending they had access to who had granted those contingent lines on the basis that they would be loans of last resort.  We in the US saw it as loan delinquency and loan default data started to creep, and then ratchet, up.  The rest of the globally connected world didn’t pay attention until it was too late, but they were two or three steps removed, and only the most cautious paid attention.  Why?  Well, because we’re a limited learning species.  The data in prior years didn’t demand attention, indeed it incentivized not paying attention because that required energy which, for years, hadn’t been justified by the reward of being right; only skeptics, loners, anti-social types who thought the worst of people without justification would have bucked the trend.

In the nine or twelve months from late 2006 to July of 2007, though, it was only those people who paid attention.  In July 2007, though, Countrywide – to the surprise of everyone – tapped all of their backup lines to the maximum extent possible.  Inside that organization, someone realized that the bubble had burst, and their only hope of surviving was to term out their credit to the maximum time possible – in other words, to try to borrow the money to possess outright their assets for at least long enough to survive a Stage Five response of the system.  The trouble was, their actions signalled to many more participants that Stage Four bubble destruction was in full swing, and thus they initiated the actions that would magnify Stage Four and make it unsurvivable even with their newly tapped monies.  Those other participants therefore tried to tap their own liquidity sources, tried to extend their own monetary supply, and as all parties tried to do so at once, the system realized the assets backing the liquidity were not worth as much as expected, and counterparties initiated a spiralling cycle of credit destruction.

Meanwhile, lending was still taking place, although it was slowly shutting down.  As it shut down, the ability of new buyers to find financing to support asset prices went away, which itself accelerated the pace of asset value destruction.  Keep in mind that during Stage Three, asset price increases support additional lending; stop the asset price increases, and the lending will dry up, leading to asset price falls, leading to the calling in of shorter term debt supported only by those asset prices.  The negative spiral simply accelerates.  Countrywide’s shareholders were lucky; Bank of America – led by management which believed strongly in the ever-increasing asset valuations driven in Stage Three – bought them out in the belief that the dip was temporary and because they wanted to get ever bigger.  Washington Mutual’s shareholders were less lucky because they believed the same thing – why sell out now, when there was a temporary dip in value, when the company would surely take advantage (with its scale and borrowing capacity) of the dip to grow more in the future?  In 2007 we bought back an enormous amount of stock at what still was very attractive share prices.  At least, we did in the first part of 2007; by July, we were aware that we needed to conserve that value internally.

How good failure really happens

One of the things I’ve said a thousand times since the financial crisis is that America is unique because we not only acknowledge the possibility of failure, we’ve engineered failure into our system.  Having worked in finance in over thirty countries, I’m more sure than ever that this is essential – and this moreover is an existential observation.  We build our philosophies of life, of the “good life,” with the idea that we must pursue goodness, without the idea that failure is not only a possibility but it is inevitable in many circumstances.  That idea – that the pursuit of the good is accompanied by the potential for the realization of the terrible – is something that human beings are simply very, very bad at, as bad as they are at realizing that probability is a neutral assessment of chance instead of a negative rejection of success.  But America – for all of its faults – embedded in its constitution the idea that Congress should establish a regime for orderly commercial failure – bankruptcy – which was unique at the time and mostly remains unusual.  Most states view commercial failure as a kind of sin, only allowing restoration of rights and privileges once full “restitution” is achieved.

America, endowed in a special moment of post-Christian deism but still inhabited with the not so much Christian but rather Christ-like notion that forgiveness only comes without full recompense for the sin which has been committed, built into its commercial code the idea that bankruptcy should be quick, should result in the punishment of the bankrupt but not ignore the complicity of the bankrupt’s creditors, and afterwards, should enable all parties to move forward without any lingering questions or arguments.  We all take our pain, in other words, and after the fact, while we might emotionally feel bad, as citizens and as contractual counterparties, we move forward.  Bankruptcy in the US allows for elimination of pre-bankruptcy debts within certain parameters, but it also kills any future claims to the value creation of the bankrupt.  After the Great Depression in the 1930s, this concept was extended to banks with the creation of a proper bank failure regime, battle tested over time, and the creation of a special class of “innocent” creditors – small depositors – who would have their obligations guaranteed by government funds.  Thus even banks – creators of credit, and essential engines in the Stage One through Six cycle above – could fail, in an orderly fashion, with privileged depositors getting their funds while those who had the resources to know better, but lent to the bad banks anyway, would be served their share of pain.

In Lehman’s case, all the creditors were presumed to know better, and were expected to share the pain – but because of the nature of the credit cycle, in Stage Two and Three, many of those supposedly intelligent, should-have-known-better participants, lost their way.  When the human system consisted of isolated money regimes, each of which had only very indistinct and indirect impacts on other regimes and in which all of the regimes essentially tied themselves to a false notion of absolute value in gold, that assumption wasn’t globally deadly.  But once we released ourselves from the falsehood of absolute value, those regimes slowly, imperceptibly, but really lost the barriers that separated them.  In this new world, there is no Stage One to Six in isolation; there might be localized bubbles but because of the lack of barriers – and the lack of barriers is because of information freedom, it’s not because of monetary or export-import or capital barriers – those bubbles will inform credit appetite and learning processes across the entire global human landscape.  And the financial crisis of 2007-2009 was just the first, true instance of that fact pattern.

But local circumstances still matter, which is why Washington Mutual failed and no one remembers or cares or even needs to care, except as an object lesson in why failure management and the acknowledgement of the possibility of failure needs to be a part of any learning system.  My bank emerged from July 2007 knowing that failure was possible, and internally, we did everything we could to shore up our defenses.  We stopped loan origination; we tried raising additional deposits on term; we sold high value assets and we used the ones we couldn’t sell as collateral to borrow on terms from everyone we could.  It wasn’t enough, and because enough of us internally knew that failure was, in fact, an option, we prepared the runway for those who would have to pick up the pieces.  And admittedly, not everyone acted in the same way.  Much of senior management got stuck in vapor lock, unable to act when faced with the possibility – the likelihood – that we would become unable to meet the demands of our depositors when they came due.  But there were enough of us who did get the joke that we were able to prepare the way.  We wired the bank, as it were, to die gracefully – not in the way you wire a bridge to blow up behind you when your army retreats, but instead, metaphorically speaking, we reinforced the bridge to make it as strong as possible, to enable the successful army (or regulator, or successor bank) to get their victory – and by extension, our defeat – over with quickly.

A couple of months before the failure, we started putting in place what we called “day zero” procedures, which would enable the bank to quickly exist under new ownership.  We liked to convince ourselves that someone would buy us and we’d all still have jobs, but at least for the dozen or so of us who knew that failure was an option, we knew that it was also an effort to allow the government to take us over and quickly keep operations running.  We were lucky because even at our size – again, we were the fourth largest retail deposit taker in the largest, by several orders of magnitude, banking system on earth – we knew the rules for failure.  And we knew that if we acted blindly, without reference to those rules, we would create havoc for the system, for our customers, and because we were both part of the system and customers ourselves, the havoc would be very much our own.  We were invested in the outcome – or at least enough of us knew that, with enough influence in the bank, to enable the navigation of a successful failure.

I think that’s essential, really – the operators of the bank were aware of our simultaneous existence as managers of the banking object, and as depositors, and as members of the broader economy.  I’ve worked at other institutions where that connection is lost; the managers see customers as others, and see their membership in the broader economy as a kind of zero-sum game.  If such people win, in other words, they do so without caring about the other participants – even though the system as a whole only defines “winning” in its own terms, not the terms any one of us choose to create.  It’s a broader lesson, in fact.  Lots of people I know want to define their own success, their own self-realization as individuals, on their own terms – even as their self-realization depends on others seeing their success, appreciating it, giving their adulation for it.  While we may want full independence, none of us has it – we are defined by history, even as we have the ability to change its path.  We are defined by others, even as we know we have the ability to change others’ perception by our actions.  Washington Mutual failed well – failed correctly – because we didn’t lose sight of the recursive impact of our actions, of the recursion that makes as at once actors in the human space and subject to the actions of others that we only indirectly influence.

Lehman’s management forgot that, if they ever were aware of it (and knowing quite a few senior leaders there, I’m inclined towards the latter interpretation).  Thus their failure was chaotic.  Not that the regulatory mechanisms were in place to make it possible of being orderly on its own, but the actions taken at Lehman ahead of time – or more accurately, the denial of reality engaged in by its employees and management – made its failure that much more destructive.  It forced Congress and the Fed into the most aggressive Stage Five action ever seen – a general recapitalization of the banking industry to the tune of nearly half a trillion dollars, printing three trillion dollars in central bank money to ensure the stability of nominal credit – while Washington Mutual’s failure was invisible and forgotten, without any assistance whatsoever.  (I note that JPMorgan, who absorbed our assets and most of our privileged liabilities, took TARP money in the crisis, but it only served to increase their already-above-necessary capital buffers and give them the capacity to absorb massive asset growth which they didn’t, per se, need.)

So ten years ago today, the bank I loved more than any other, the project that represented the culmination of my career, failed.  And the failure in a real way represented the high point of my life to date.  Failure isn’t good, but good failure is still a kind of good.  I’ve divorced since then, but I still love my ex-wife, and we’re both still working together to raise a son, and he’s doing great.  I’ve had ventures that have had various degrees of success since then, but I’ve managed to move on, and move forward, because I’m comfortable with failure.  I don’t like it – no one does – but living with a keen sense of its possibility, and with an acceptance of its inevitability on a certain level, enables me to thrive, despite inevitable failures, as an individual.  I know far too many people who can’t face that, whose existence requires them to succeed or else all is lost, whose definition of life is to thrive or to cease.  They are wrong.

I read Kate Chopin’s masterpiece, The Awakening, a couple of weeks ago.  The short novel tells the story of a wife who has drifted through existence but suddenly becomes aware of her own power as a human being, and begins to defy convention (in late 19th century upper middle class New Orleans) in her pursuit of a new kind of beauty.  But it doesn’t work out.  She falls in love with someone who doesn’t know how to reconcile his love with her own attachments, and she realizes her own inability to support her own desires in a world fundamentally hostile to them.  One of the foils at one point feels the protagonist’s shoulders and says, in effect, that she hopes that such an angel has strong wings, to overcome the pressures which will otherwise force her to earth.  I’ve read some literary criticism of the book and what I’ve come to realize is that very little of it sees a much different message that to me seems obvious.  The protagonist became aware of her own power, but she forgot – or never realized, as no one in the book ever is shown to realize except for a minor character who is her doctor and the woman who tests the strength of the angel’s wings – that failure is still possible even as we become aware of our potential for greatness.

A beautiful life is possible, but only if we remind ourselves that circumstances might conspire to ruin it.  And failure is not inevitable, but to forget that it is possible is to condemn ourselves to despair if the possibility emerges in full force.  Washington Mutual died ten years ago today but, thankfully, it didn’t matter, because we knew, the system knew, that it was always possible.

So tonight, to former WaMulians out there – yeah, it’s a horrible word – but for those of us who really believed in being fair, caring, human, dynamic and driven, I say thanks.  We did better than most.  Let’s not forget our lessons and let’s do it even better next time, especially if we’re lucky and good enough to get find success in the future.  Happy anniversary.