Headline: Crisis simulation - US experts play at global meltdown
Source: Euromoney
Date: March 2000
Author: David Shirreff

It's July 2000 and the world economy is in crisis. Who will save it? The US cavalry of course. Sixty grown men and women, some of them high rankers in the US government or civil service, spent a full Saturday in a New York mansion, wrestling with a hypothetical global meltdown, sending frantic messages from room to room, while the snow fell outside. David Shirreff was a fly on the wall




Russia is close to invading Ukraine, which has repudiated its foreign debt; Brazil has agreed to pay the European banks but refuses to pay the Americans; the equity derivatives market is thrown into chaos by a UK insurance subsidiary; thousands of Americans are suing their pension funds for being overweight equities when the stock market dived.
These are just a handful of the crises that hit four teams of US policy-makers as they sat in their respective rooms trying to hammer out a response - for the White House, for Congress and for the American people.

The setting was the imposing Harold Pratt house on the upper east side of Manhattan, headquarters of the US Council on Foreign Relations (CFR), a body founded in 1921. These modern policy-makers bent to their task were watched quizzically by the busts and portraits of their illustrious predecessors - Cyrus Vance, David Rockefeller, Walter Mallory and General Tasker H Bliss.

Why were they doing it? The CFR decided its members should pay more attention to financial and economic crises. This is a way of"forcing us to think our way through high-cost, low-probability events" says CFR senior research fellow Roger Kubarych, who led the project.

Simulations or"hypotheticals" are increasingly used to test people and their organizations. Historical models extrapolate the past and might help us fight yesterday's battles. But scenarios based on projections of the future may give us a better flavour of what lies ahead. Policy-makers need to be prepared for extreme situations, even if they are highly improbable and uncomfortable to think about.

Euromoney has reported on two previous simulations, The Crash of Mulhouse Brand (September 1997) and The Sigma Affair (October 1998). The CFR plot was designed to test US policy-making in the financial and economic sphere, rather than, as in the other cases, to have a cast of bankers, regulators, policy-makers and others, including villains, attempting to outsmart each other. The protagonists in the CFR game were anonymous committees. The committees included people who are, or were previously, in the US administration, at the forefront of policy-making. To name just a few: John Heimann, chairman of the Financial Stability Institute; Ernie Patrikis, former number two at the Federal Reserve Bank of New York (NYFed) now with AIG; Peter Fisher, current head of capital markets at the NYFed; Bob Hormats of Goldman Sachs; Jessica Einhorn, former treasurer of the World Bank; Scott Pardee, economics professor, formerly with the NYFed; Bob Carswell of Shearman & Sterling; David Hale, chief economist of Zurich Financial Services.

Kubarych and his team, which included naval research fellow Captain David Duffie, fired salvoes of economic and foreign policy whammies at four expert groups. The groups covered respectively foreign policy and national security; economics and trade; central banking; and financial regulation. They were expected to absorb the information and send recommendations to an overall decision-makers group - representing the US congress and the White House administration.

Kubarych and seven controllers played god on the fourth floor, from the Cyrus Vance Board Room. They sent email messages to each group, containing new information such as market data, US indicators, special intelligence, or news of further disasters. Each group had to decide what news to act on and what to ignore. The hope was that, whatever the disaster, and whatever crazy solutions the policy-makers came up with, the decision-makers group would take action optimal to the interests of the US and the world economy.

July 1 2000

A crisis has been brewing since April when the US stock market first started its decline. The trigger was the downturn in demand for IT hardware and software after Y2K proved such a non-event. Political violence has erupted in Mexico just before a presidential election; computer hackers with links to Venezuela threaten to jeopardize a giant US-Mexican bank merger; a robust oil price has tempted Venezuela and Saudi Arabia to throw their weight around their own regions. Wall Street uncertainty is exacerbated by the class action against US pension funds - they may have to do a massive rebalancing of their portfolios, while the US securities affiliate of a UK insurance company, a market-maker in equity derivatives, abruptly liquidates its positions, causing panic. Turkey has torn up an agreement with the IMF and a banking crisis looms. China is threatening to devalue the renminbi.

These are the challenges facing the teams of experts in their separate rooms. They can communicate by telephone, by email and by physical visits to other expert groups. But for a while they need to sit tight and absorb the information. The trick of these games is to separate the important issues from the noise, to anticipate the effect, and take action accordingly.

The US financial regulators' first concern is the state of the US stock market. They wonder whether to intervene as the Hong Kong Monetary Authority did in 1998 and buy a proportion of the country's stock market.

"I doubt if we have the resources to stop this market adjustment," says one wise participant. They decide to convene the president's working group on financial markets. They also call the Financial Services Authority (FSA) in London about the UK insurer."The easiest way to deal with a subsidiary is to put pressure on the parent," says one regulator. As they sit in their room, on day one, they wonder whether it is early enough to label this a systemic crisis."It's not unlike LTCM [Long-Term Capital Management]," notes one.

The Central Banking group, one floor higher, is worrying about interest rates and the weakness of the dollar. The Dow is at 8,800 (from a high of 10,000 in April), the Nikkei at 16,800, the Dax at 5,000, the yen at 92 to the dollar and the euro at $1.07."The interest-rate differential with Japan is huge," says a central banker. Risk premiums are widening, however. The spread between US treasuries and high-yield bonds has widened by 150 basis points and Mexico's sovereign risk spread has moved to 500bp. But the inclination of these central bankers is to stay calm and avoid any indication of alarm.

The Foreign Policy group across the corridor is considering Venezuela's threat to limit fuel exports to the US, and its suspected interference in the Mexican elections."It won't cause a national gas crisis. We'll be able to absorb this," says one policy-maker. The group looks at the latest domestic figures: the Nasdaq index has fallen to 3,000, the Dow to 8,500."Retail sales are down. What's the Fed doing - isn't it time for them to pump in liquidity?"

"Our job is to deal with foreign policy and not worry about the politics," corrects a colleague.

"But this is a Clinton administration."

"The importance of Venezuela isn't oil," claims one expert,"it's whether Venezuela is going to start a wave in Latin America." What message should they send to the interfering president Chavez? Should the Treasury seize Venezuelan assets? Should they assassinate Chavez?"Before there's a covert action we have to get clear what are the foreign policy goals," cautions one staffer.

The foreign policy-makers seem to be a trigger-happy bunch compared with the regulators and central bankers. This may be because international relations are slower-moving and less volatile than financial markets. A hint that assassination was being considered to solve a tricky central banking question would hit asset prices in seconds.

July 4



The complex art of simulation is still in its infancy.
Independence Day. The financial regulators learn that Brazil has repudiated its debt to American entities, while agreeing a deal with the Europeans and others. Can the Brazilians get away with this discriminatory behaviour.

A former senior regulator reacts as follows:"We need to do some prophylactic work. We need data from supervised parties on Brazilian exposure. We need to figure the knock-on effect of Brazil defaulting on dollar debt. Events will come fast. Will the government apply exchange controls?"

The Decision Makers group is focusing on Saudi Arabia and Russia. The Saudis, they learn, are trying to secure new solidarity with Iraq and Iran, by getting UN sanctions lifted from Iraq and by a joint pact to defend Gulf shipping lanes. That would threaten US bases in the Gulf.

More information keeps pouring in, about a rate cut of 50bp by the Federal Reserve and positive response by the Dow; but bad news from Brazil, Ukraine, Turkey, Mexico."This is typical of what happens to the president," says a decision-maker."There's a huge flow of information. The important thing is to keep his eye on the ball, to get him to stop watching the Simpsons on TV and write that speech that tells the people the world isn't collapsing."

Decision-makers discuss the use of the government's exchange stabilization fund to bolster Brazil and other emerging markets. But they fear the congress on Capitol Hill"don't have a clear sense of what's going on"

July 5

There are signs that the US has become horribly isolated. (This may have been a flaw in the structure of the game, since only US policy-makers are playing. When they want a response from the European Central Bank (ECB) or the G7, they have to ask the control room. The control room tends to stonewall. For example, the Central Bankers ask the control room:"What happened to other interest rates after we lowered ours? Did any banks match us and did they make any comments about our move?" The control room replies:"Other central banks have kept short-term rates constant. Only the ECB has criticized the Fed's easing of rates.")

In the Economics & Trade group one expert complains:"It's almost inconceivable that US influence has fallen so far in six months. It seems that Europe and Japan want to deal differently with Brazil and Mexico than through the US-led IMF."

Towards the end of the day Argentina suffers contagion, asking for a new swap line with the Fed and access to the US exchange stabilization fund"otherwise it may have to abandon its currency board". The Bank of Japan says it can't go on supporting the dollar.

A central banker shows that the health of the US economy is the main concern:"We've been concentrating on interest rates and maintaining a strong US economy. We're not targeting any response to asset prices."

Up in the control room the requests are coming thick and fast:

How much capital do US banks stand to lose?

Up to 50% of their pre-crisis capital.

Can I talk to the G7?

We don't have in the game a separate G7 negotiating team, talk to me.

The treasury secretary says he doesn't intend to close markets, is that OK?

We don't care what their decisions are we just want them to make them.

July 7

The Dow has recovered to 8,100; the dollar is down, to ¥95 and $1.07 against the euro.

Bad news for equity derivatives and the equity market generally. The Bank of England believes the problems of the derivatives subsidiary should be dealt with by the US and local US regulators. But the UK's Financial Services Authority suggests that financial support from UK and US authorities will be needed to stave off"large-scale refutation of existing equity derivatives contracts". The potential maximum loss to counterparties is $75 billion.

The Central Banking group wants to know US entities' exposure to Turkey, and whether that means problems for the payments mechanism. Figures come back from the control room: $20 billion but mostly on the books of hedge funds and insurance companies. The Central Bankers are relaxed:"If the hedge funds are getting hit, let them be."

A delegate enters from the Foreign Policy group to ask:"What's your response to the Asian financial crisis?"

"What crisis?"

China's 35% devaluation has hit other Asian currencies and their stock markets.

The Central Bankers, ever sanguine, observe:"Under these circumstances the dollar is actually strengthening, on a trade-weighted basis."

July 8

The Central Bankers consider a rate cut:

"I believe it's time for concerted action by the G3 (the US, Europe and Japan) on short-term rates," says one.

"I don't want to get trapped into doing something like that," says another.

"We should put out a statement: 'We urge everyone to avoid a cycle of competitive devaluation'."

"Logically the short end of the money market is awash with money. But somebody must be buying."

"A week has gone by since the crisis started. Let's adjourn and play tennis." This quip by a senior Fed official makes a strong point. The worst thing a central bank can do is overreact and overshoot, adding to market volatility.

The Central Bankers' biggest problem is lack of co-operation from Europe, which is becoming endemic."There's a lot of hostility in Europe for this US go-it-alone stuff. We should keep reaching out. If we can't make it with [Wim] Duisenberg [the ECB governor], we should call that nice Italian [Tommaso Padoa-Schioppa, board member of the ECB]."

They decide to call a G10 central bank governors' meeting.

The Foreign Policy group, looking at the Saudi situation, believe the oil price will soon fall, given the state of world stock markets."It's primarily a financial crisis," says one expert. He suggests liquidity should be pumped into Asia, but"through the multilateral route rather than the US".

July 9

Now the focus of the crisis appears to be Japan. Japanese banks, heavily exposed to Asia, have also taken a capital hit because of the falling Nikkei index."We know the Japanese banks get hurt if the Nikkei goes below 15,000," says one regulator. Their intelligence is that the Japanese ministry of finance and the Bank of Japan are studying a tax on foreign bank deposits.

"This is not a regulatory issue," says a regulator, neatly sidestepping responsibility."It's a discrimination issue. It will hit the big foreign banks, but it's not as bad as the German stance."

Germany has been hit by a new real-estate crisis, and has decided to bail out its own banks, but not foreign banks or the subsidiaries of foreign banks in Germany.

Each step of this crisis appears to be pushing the US and its banking system into further isolation. The Europeans seem to want to solve their problems on their own. Is this a sign of fortress Europe learning to flex its muscles?

The US regulators' first concern is their own banking system. A check with the control room reveals that, although eight banks are under special surveillance, no US institutions' marked-to-market exposure to Turkey, Brazil, equity derivatives, Asia, or Germany has taken it below its minimum capital. The regulators don't want their concerns about the eight banks to be made public."The only time we said anything about institutions in difficulty was with Drexel [the liquidation of Drexel Burnham Lambert in 1990]."

The regulators conclude that these eight institutions would quickly be underwater if they took their losses. Does this denote a systemic crisis?

"Five banks and three securities firms will face capital problems. I don't think that says we're on the brink of a systemic crisis," argues one regulator. But they conclude that an easing of US interest rates would help.

July 10

The Decision Makers group is preparing a presidential speech as a means of calming the situation. With a president who is not running for re-election, although it's an election year, they reckon he can call wholeheartedly for Americans to unite for the sake of"the overall stability of the world".

The biggest worry is Japan's threat to discriminate against foreign banks. This calls for swift action, which they fear they won't get out of Congress. One decision-maker suggests invoking the president's Emergency Powers Act, which evolved out of the Trading With the Enemy Act of 1970. In 1971 president Nixon forced Japan to back down on trade protectionism by secretly giving it a 60-day deadline."The Japanese waited 59 days and 23 hours but then caved in," recalls a decision-maker. The Federal Reserve could also put the heat under Japanese banks in the US by saying that they"hadn't met their capital standards", a decision-maker suggests.

The decision-makers don't want the president's speech to isolate the US, however. They want him to mention the support of the multilateral agencies,"not forgetting Nato"."The president also has to say something about the stock market, which is 30% down. Maybe about tax cuts."

At the end of day 10 the Dow is at 7,700, the Dax slightly up at 5,200, the yen strong again at 90 to the dollar and the euro at $1.12

Half-time summary

At a press conference after the president's speech, the administration try to reinforce what they hope was its calming effect. Why didn't the president do this himself?

"Is the president incapacitated?"

"No, he's in fine shape."



Ernie Patrikis, at 12 o'clock,
spearheads the regulators in
familiar crisis territory


Secretary of state Madeleine Albright sums up the geopolitical situation. There's a resolution in the UN security council to keep Russia out of Ukraine. There have been overtures to dissuade the Saudis from allying with Iran and Iraq, backed by a threat to send US forces into the Gulf, where an aircraft carrier battle group has already been dispatched. The president will veto any congress action against Turkey on human rights, provided the US can continue to use Incirlik air base.

Treasury secretary Larry Summers sums up the financial situation: concerns about the banking system in Mexico; fear of contagion from the Brazil crisis - where US banks, insurance companies and hedge funds have ruled out debt reduction, while European banks have been willing to cut their loans."There's a moratorium just for US entities. We went to the G8 [top industrial nations plus Russia], but the G8 is basically not co-operating. They're saying the US banks should share the pain." The treasury is now considering seizing all Brazilian assets in the US. Despite these trouble spots,"the US economy is still very strong," Summers says.

Federal Reserve chairman Alan Greenspan denies there's a rift with the Europeans and the Japanese. The ECB had simply criticized the Fed for wanting to lower rates and hadn't followed suit. The German banking problem is one for the ECB, he says, but the Fed is prepared to provide liquidity to US banks where necessary. So far it hasn't seen numbers bad enough to require any action. The Fed's job first and foremost, he says, is to"do no harm".

But the crisis continues.

July 12

Talk of tax cuts to revive the economy is in the air. The Central Banking group believe there should be a US undertaking"to provide sufficient liquidity to the system". They debate a proposed rate cut of 150bp.

"You don't want to do things you can't do again. 100bp would be pretty aggressive and less likely to scare people."

"Every study says the flaw of using monetary policy instruments is you tend to move too slowly."

"There's a big increase in delinquency rates."

"I would second 150bp, because we are likely to go to 3% by the end of the game."

"We can't say our expectation is that things will get worse."

"We'll do what's best for the US economy and let Europe and Japan adjust."

"I think it's a little excessive, but for the game let's do it."

"All the indicators show a decline in the US economy."

"The yen is at 82. The currency is anticipating our move."

"The Japanese are screaming for a rate cut."

A rate cut of 150bp is decided, partly to have some impact on the game.

July 15

The Economics & Trade group are discussing tax cuts to pump confidence back into the economy. One suggestion is to remove withholding taxes on interest income and the savings of foreign investors.

"Removing the tax on dividends would help the stock market," affirms one expert.

"I think the focus should be on the economy and unemployment, not the stock market," objects another.

The Decision Makers are wondering how much damage will be done by class actions against pension funds for overweighting their portfolios with equities. Should they now be forced to rebalance, causing even more of a market sell-off?"It's not that easy for a CalPERS [the $140 billion California Pension & Retirement System] to rebalance - in terms of the integrity of the financial system."

The Economics & Trade group brings them a tax-cut package: cut all tax rates; provide people with a sales tax rebate from treasury; invest some of the social security funds in the stock market; bring forward all government spending; announce that an additional 13 weeks of unemployment benefit will be paid.

July 16

The Regulators send a delegation to the Decision Makers group, saying they have been able to do very little to avert the crisis."In a crisis we can shut markets and shoot the wounded, but nobody has failed. The US banking system has lost 50% of its capital. But only eight institutions out of 11,000 are causing concern. What started out as a liquidity crisis may now turn into a solvency crisis, but as regulators we can't do anything because the real funds aren't there." As an afterthought they add:"The Japanese banking system is now probably dead in the water."

But noises from the Federal Reserve, that it will make"significant loans to institutions in trouble", are greeted with scepticism.

"The Fed hasn't done that since 1933. It's a highly complex thing."

The Fed has advised its regulated banks to honour their commitments to brokers and refrain from foreclosing in the event of failure to pay margin.

July 17

New economic figures say that confidence is at its lowest since 1987. The Dow is at 7,100, the Nikkei at 17,000, the Dax at 4,600, oil at $36 a barrel, the long bond at 6.7% and the euro at $1.22.

The Central Bankers are worried that the split with Europe is widening.

"I think they [the controllers] are building us up for a trade war with Europe."

"In terms of the euro, oil is very cheap."

"The euro is only 2% stronger than it was in January 1999," points out one expert. But the downturn in consumer confidence"would hit the Fed's open market committee (FOMC) like a ton of bricks", warns one central banker.

"Let's give them a 100bp cut - there's only half-an-hour left in the game."

"We can't just put the rate down. We have to say 'in the light of consumer confidence, we...'."

The Decision Makers group, despite problems with Libya and Russia, are more concerned with the US economy, which shows further evidence of decline, despite the rate cut to 3%.

"We're risking a trigger effect where we could really have a panic," says one decision-maker.

"We need to get to the Economics & Trade group and agree a statement by the president."

"The president has got to say how we got into this mess. It's not good enough to blame Greenspan and $33 oil."

July 18

In the Economics & Trade group, methods of protectionism not seen for 30 years are being discussed, such as a"temporary import surcharge" and"wages and prices controls".

The Regulators and Central Banking group are suddenly faced with a new crisis. Two of the biggest mutual funds have come to the SEC saying they are experiencing redemption rates that could be life-threatening. They need an injection of cash to meet the payments without having to dump their portfolio on the market at fire-sale rates. Failure of one, let alone several mutual funds, would cause a huge loss of public confidence, and a run on the entire multi-billion dollar US mutual fund industry.

The Regulators approach blue-chip bank JP Morgan and discuss the Fed secretly guaranteeing a huge line of credit to the two funds. Morgan would take excess collateral, but it wouldn't be taking the credit risk of the mutual fund companies themselves. That would be borne by the Fed.

Fed chairman Greenspan is uncomfortable but he agrees to the deal.

"All the public will see," says one regulator reassuringly,"is that the Fed's volume of loans to banks has gone up."

The game ends.

Conclusion

There hasn't been a financial or economic meltdown, although the world seems to be approaching one. The exercise was a test of the policy-making process, rather than the robustness of the global economic architecture.

There were other geopolitical crises that aren't dealt with here. For example, a report that Libya had acquired a nuclear weapon from the Russian mafia. There was also a Turkish banking crisis, with the US promising to help if it kept an important air base open. Saudi power-broking in the Gulf also prompted US sabre-rattling. These were a backdrop to the economic and financial crises, which are of more interest to Euromoney readers.

Until the tapes are transcribed and the emails collated no-one has a full picture of what was said or decided. What you have read is the experience of one observer moving from room to room, following only snatches of what each group was discussing. The sense of crisis and information-overload was palpable.

Participants familiar with the committee process said it felt close to the real thing, as they tried to block out the noise and reach the most important decisions."It had the feel of a task-force group at the State Department," said one veteran."But there weren't as many egos in play as there would have been on our seventh floor."

Said a New York Fed official:"It was realistic, sitting in isolation with a cavalcade of information. But I don't believe that all relative prices can go in the same direction. Where does all the money go?"

The unthinkable doesn't happen, until it happens.




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What did it achieve?
For some it was just an amusing way to spend a Saturday and a chance to fraternize with their peer group. But it meant more to those who believe simulation has a future as an aid to crisis management.

The January 22 exercise was an interesting variation. The emphasis was on policy, which meant that egos were suppressed in favour of policy-making by committee. Only in a couple of cases were people assigned roles, such as those of treasury secretary Larry Summers and governor of the Federal Reserve Alan Greenspan. So the debate was free of oratory and overriding political bias. It was a highly cerebral game played by high-level, experienced people. That meant they brought to it their own baggage and their own sense of how they would behave in a crisis.

On the other hand, the game lacked built-in drama. The groups were bombarded with information, and they were forced to make decisions, but those decisions tended to get lost in cyberspace. They appeared to have little impact on the course of the game, apart from one swingeing rate cut of 150 basis points by the Federal Reserve.

Players instinctively wanted to talk to their global counterparts, the G7, the European Central Bank, the IMF. But these weren't represented except by controllers.

In the end it was a policy game played by the US against itself. The US needed some opposition - the Japanese and the Europeans, and maybe a needling press corps.

This is now planned. The next simulation to be arranged by the Council on Foreign Relations, as part of its"financial vulnerability" programme, is likely to be played globally, with Europeans and Japanese participating in real time by email and telephone.

The use of email to transmit news and messages instantaneously showed that these games could also be played entirely in cyberspace, although the aspect of personal interaction, and peer group networking would be lost.

That leaves two questions: first, should players be assigned characters and individual roles, or are these crises played out more meaningfully by committees? In the first case, maverick characters and criminal minds can affect and perhaps distort the outcome; in the second case, perhaps it is unrealistic to rule out egos, manias and personalities. A mix of both techniques could be the answer.

The second question is the time horizon: what speed should the clock be ticking at? Compressing time adds to the sense of urgency, but that risks leaving less scope for negotiation and deliberation.




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