They say they didn't see it coming. They say there was no way they could have known.
But they were warned. And here's the proof.
On April 17, 2007, famed short-seller Jim Chanos and other hedge fund managers met under tight security at the World Bank in Washington for the G-8 meeting. Chanos and Paul Singer briefed prominent policy officials about the growing financial instability. They gave irrefutable evidence that a catastrophe was building. They told officials that banks that were about to sink the global economy. They called for decisive action.
And they were ignored.
Gordon Brown was there. His presence has sparked a recent uproar in the UK following a radio interview with Chanos. Timothy Geithner was also there. Gillian Tett's best-selling book Fool's Gold outlines the meeting and how Chanos's dire warnings left little impression on the powerful men in the room.
Robert Johnson, Director the Economic Policy Initiative of the Roosevelt Institute, talks to Chanos about this meeting and its consequences. Complete transcript and audio available.
Jim Chanos: ...If you recall, before April of '07 there were some very, very ominous cracks in the walls of finance that occurred. You remember that the Bear Stearns hedge fund blow up occurred in June. So that was still two months away. But we had had in the fall and winter of '06-'07 the first falterings of some U.S. non-bank financials in the subprime area, New Century and others, that had begun to stumble with large amounts of default in recent loans.
If you recall the peak in loan issuance, I believe, was late-'05 and early-'06 for this area. And then you had in February, late-January and February of '07, HSBC, the big global banking giant, which had bought Household International, a U.S. subprime lender, began to - through experiencing severe deterioration in its U.S. subprime portfolio.
So there was not just conjecture at this point. There was some sign posts along the road already. Finally, for anybody who was tracking it, the sort of artificial market indices that were set up to track these esoteric debt instruments like collateralized debt obligations, CDO's, and so on and so forth, had begun to crack pretty hard in February, March from par to somewhere, as I recall, par being 100, down to the high 70's or low 80's.
So already a market indicator of subprime health had already become to deteriorate rather dramatically by the time this meeting occurred.
Rob Johnson: And you also mentioned in other conversations we've had about this episode that SEC releases, the 10K reports, were indicating some very, very substantial vulnerability among the major financial institutions.
Jim Chanos: Well, that's what got me very concerned. In the two week period between the end of March '07 and my presentation mid-April, my staff had begun to review the SEC 10K filings, which are the annual reports that companies file at the SEC.
And for the very first time we were getting a glimpse under the hood like we never had. And which big banks and brokers were telling us how many of their financial assets that were securities were either Level 1, Level 2 or Level 3.
Those numbers [for] Level 2 and Level 3 were off the charts when my staff looked at them in April of '07. And I think there was a growing sense on the street in that two week period among some reporters that were writing about it and other hedge fund managers that looked at the same things we looked at, that my God, these numbers were far worse than we thought, and the banks were far more leveraged to the most hard to value illiquid assets than we thought.
Rob Johnson: We actually even saw, as the crisis unfolded, many of them used the mystery of Level 3 assets to mock up valuations to hide their losses elsewhere. I would say we really were in an area that was what you might call pregnant with the possibility of hiding things or misreporting things, but the overall context that you're describing is a system that's way overburdened and very, very vulnerable and potentially gonna drop a big, big bill on the taxpayers shoulders.
Jim Chanos: ...The lessons that we thought we had learned in 2001 and 2002 from the Enron debacle, which led to Sarbanes-Oxley shortly thereafter, you know, less than three or four years later were being repeated in the banking sector. It's quite remarkable if you think about it.
Rob Johnson: ...How did the G7 ministers at the time react to your presentation?
Jim Chanos: Well, I'll preface it by saying that the other manager, Mr. Singer, went first, and I'm sort of glad he did because his firm was actively monitoring some of these esoteric instruments in his hedge fund.
He traded in them. And his presentation involved the instruments themselves and what I - these structured finance products were sold as AAA safe securities to a large number of people because of their structure and because of the various natures of the accounting and the insurance behind them, which we now know in many cases was written by AIG, by the way.
And that these were not AAA securities and that the toxic tranches were at this point almost worthless despite what banks might be carrying them on, and that if there's any more deterioration in the residential real estate market, which we now know, of course, there was, that large amounts of securities that people thought were going to be AAA were not going to be.
And all the assumptions behind this giant structured finance system were suspect, and he gave some examples and then he referred to the HSBC, he referred to these indices cracking. So he sort of set the stage for my presentation which followed his. And mine simply was, "Well, if you believe Mr. Singer, and I do, the problem is not going to be with us, i.e. hedge funds. It's going to be with institutions that you already heavily regulate, the large banks and brokers. Because that's where this stuff resides."
And I began to recount the numbers that we just talked about a few minutes ago in this call, the Level 2 and Level 3 assets to tangible equity, the stunning amounts of leverage involved in the system, the nature of the accounting of these pieces of paper that was highly subjective, the growth in those Level 2 and Level 3 assets in the past two years, and why this all could easily, if there was any distress in residential real estate or subprime spread to other areas, could cause a crack up in the world's largest financial institutions.
And, you know, the numbers were what they were. They were irrefutable. So whether you agreed with the conclusion or not was a different matter, but they were what they were. And that's why I sounded the alarm on the banks and brokers. And, I, of course, indicated that as a result of our work we had gone short for our clients, the largest institutions, most of them anyway.
So I made sure to obviously disclose that. But I felt that on the other hand, the public policy ramifications of pointing this out far dwarfed anything that was gonna happen to my fund or anybody else's for that matter. The fact we were looking at just a giant, giant canyon of capital losses.
Rob Johnson: Let me, before we talk about the response of the officials, underscore what you just said. You would be viewed by a policymaker as someone who's earning their livelihood from your portfolio, and policymakers are skeptical of listing to market participants because they think the investor is trying to cajole them in a direction that enhances their returns.
But in this case you're disclosing that you're short these institutions, and you're talking to them, warning them, in a way that could mitigate a crisis and diminish the returns that you would otherwise obtain.
So in essence, you are talking about public policy here very distinctly from what would benefit you...
Jim Chanos: I do have four children and I sometimes put other things beyond any financial return, and the size of this problem was so large that, you know, if I wasn't going to sound the alarm bells certainly I figured someone else would, and I was being asked by the U.S. government to come and give a presentation and give my thoughts freely and I took that seriously.
I thought it was important if we had done this work that we pointed out at this point already some well respected members of the financial press. I'd already written columns about this Level 2, Level 3 assets relative to tangible equity. So it was, I felt, not the first, but it certainly I wasn't going to also abrogate my responsibility and not say anything. In fact, I thought it was that important.
Rob Johnson: I'm just trying to underscore that they should not see your message as conflicted.
Jim Chanos: Oh, if they had taken the right policy actions at that point I probably wouldn't have made near the amount of money that I made, nor would my clients. You're absolutely right about that.
Rob Johnson: Let's talk about how people reacted to you then and then in the aftermath of the meeting. What - without picking on particular policymakers, what - how did they look at you? How did they react? Were they curious? Were they dismissive? How would you describe it?
Jim Chanos: Well, there was a lot of sort of - you have to keep in mind this was Sunday afternoon. You're at the end of the conference. But I think we were seen probably as much as an annoyance as anything else from people who wanted to catch a plane or get home.
But there was some uncomfortable paper shuffling. There was sort of, you know, that looking at the ceiling across the table. There was a bit of eye rolling. There's no doubt about that.
And at the end of my talk the fellow running the meeting asked if there was any questions. There were literally no questions and at that point the Chair of the meeting said, "Well, that's all very interesting and now what do you think about insurance."
And it was just that complete realization that we've got - it just didn't sink in, the import was not grasped, certainly by the Chair, that they were gonna move on to the next item on the agenda with nary a bit of discussion.
And then shortly after the meeting ended, a few hours later, there were two central bankers, both EU central bankers who came up to me and with their assistants and we exchanged contact information, and both said they thought that my presentation was very interesting and if I had anything additional please send it to them, and to keep in touch and blah, blah, blah.
And that was sort of it. I was thanked by the U.S. delegation and we went on our way. And both Paul Singer and I left the room sort of incredulous that the presentation...really elicited no official questions or comments.
Rob Johnson: And let's take and now look at - we've had a crisis, we have many policy officials, including Gordon Brown, who will attest that there was no way they could have seen it coming, which I would say today's conversation contradicts rather violently.
And now they've made a series of proposals. You have the G20 reports, the Financial Stability Forum, which is now called the Financial Stability Board, and others are going to meet more. You're going to appoint the Federal Reserve as the systemic regulator.
It feels to me like we're kind of shuffling the deck chairs. It feels to me like the same people who ignored your presentation are the people who are trying to reassure the public that they have the expertise and if they just talk a little more on the phone or meet a little more frequently that somehow that's gonna solve the problem.
Am I being too cynical?
Jim Chanos: I don't... think you're being too cynical at all. The ability of these organizations to move quickly and consult each other is glacial. So in markets that move so quickly and deteriorate so rapidly, you know, the need to call a G20 staff meeting or, you know, convene boards and get everybody together and then, first of all, you know, agree on protocol, and then agree on the principals and then agree on steps. You know, by that time the target in question of their interest might be in smoking ruins.
...We're going to have this problem come up again and again, because, in fact, institutions like the large banks and brokers will do their best to both engage in regulatory capture and use whatever accounting rules are open to them legally to obfuscate any problem areas.
We've seen this time and time again in the banking industry and the brokerage industry in the 20th Century. I see no reason why that won't continue.
We've already seen a movement toward it in the move - the lobbying by the banks in the spring of '09, this year, to liberalize the mark-to-market rules and make more opaque balance sheets.
You should think, if anything, we've learned to tighten up the accounting and to make things more transparent so that the Jim Chanos', the Paul Singer's, can make these warnings in the future and point these things out.
Instead, they've made that job more difficult at the request of the banks. So you've already seen that this is not going to work.