Here’s an experiment not to try: Drive down a country road on a moonless night and kill the headlights. Try to navigate only by the dials on your dashboard. How far do you think you’d go without crashing?
Depends, right? On how fast you’re driving, on how sharply the road twists, on whether there are guardrails lining the shoulder. It makes a huge difference what you’ve got on your dashboard. Ideally you’d want a GPS and an array of infrared cameras. But imagine using only a speedometer.
Last year, a new and obscure government agency tried that experiment, in thought anyway. The car was the U.S. financial system, and regulators were in the driver’s seat. The point was to assess the dashboard at their disposal. The agency looked at 11 of the best gauges economists have developed to measure the likelihood that the financial system is headed for another crash. And it found them, taken together, to be as useful as a speedometer — “which does not predict crashes but is still a useful risk indicator.”
What that exercise tells us is how little the government knows even today about what could trigger the next big financial wreck.
Five years after a Wall Street crisis ran the U.S. economy into a rock face, regulators are barreling ahead without a clear idea of where the risks lurk in the financial system — or even how much risk there is.
It’s Richard Berner’s job to fix that.
Berner is the newly installed director of the Office of Financial Research, the first federal agency devoted to quantifying threats to financial stability. In other words, he’s trying to build a dashboard that sees around corners, in the dark.
You’ve probably never heard of that office or of the economist running it. So it might hearten you to learn that seeing around corners is Berner’s specialty.
In November 2007, Berner walked into the office of David Greenlaw, a colleague at the investment bank Morgan Stanley. Berner was the firm’s chief economist, Greenlaw was one of his deputies, and together, they compiled the economic forecasts that Morgan Stanley sent its clients to guide their investment decisions. Usually the two men thought so similarly on economic matters that they barely needed to discuss them. This time, they were in for a long chat.
“I think we’re in recession,” Berner announced.
Berner had spotted real trouble long before most leading economists. In late October, Federal Reserve officials had called growth “solid” and said the strains in financial markets were letting up. They were predicting growth for the following year. So were the Congressional Budget Office and the academic and business economists in the renowned Blue Chip forecasting survey.
What Berner saw, and others missed, were lending standards tightening across the country, businesses pulling back on big investments and global growth slowing down. He saw warning signs flashing in the financial system, which he thought would cause big problems for the economy. Sitting in Greenlaw’s office, “I tried to make my logic as compelling and convincing as possible,” Berner said. Eventually, Greenlaw came around.
On Dec. 10, 2007, Morgan Stanley told its clients in a research note: “We’re changing our calls for U.S. growth and monetary policy.” A recession, Berner and Greenlaw wrote, “is now likely.” It was the first big Wall Street firm to make such a prediction, and it was spot on — the National Bureau of Economic Research would later declare that the Great Recession officially began that month.
In the years that followed, Berner and Greenlaw were more spot on in their forecasts than anyone else in the Blue Chip survey. Last fall, they accepted an award for their precision from Arizona State University, whose contest judges praised their ability to foresee how deep the recession would go and how long the jobless rate would stay high. By then, Berner wasn’t issuing forecasts anymore. He was building new forecasting tools.
President Obama had nominated Berner to lead the barely up-and-running Office of Financial Research, which was created under the Dodd-Frank bill in 2010 after the financial crisis exposed regulators’ blind spots when it came to Wall Street.
Berner was an in-house pick: He had already retired from Morgan Stanley and advised the Treasury Department on setting up the office, which supports the work of the new federal Financial Stability Oversight Council — the group that brings together the country’s top financial regulators. And in a bit of a surprise in such a polarized Senate, his confirmation sailed through on a voice vote in January. It was more than five years after he made his famed recession call; the office had a lot of ground to make up.
Late last month, Berner flew to New York, where he was scheduled to speak to several dozen economists and MBA students from New York University’s Stern School of Business. It is the nature of Berner’s new job that the speech was titled “The Office of Financial Research: What is it and what does it do?”
Berner is 66 but looks at least a decade younger, with the carriage of a former competitive swimmer. He was a standout undergraduate at Harvard and a standout economics doctoral student at the University of Pennsylvania, and before he hopped to Wall Street, he spent seven years as a researcher for the Federal Reserve.
In New York, he wore a dark banker’s suit, a red tie and horn-rimmed glasses. He spoke in a low, serious tone, scrolling through PowerPoint slides on a large projector screen beside him. He looked like a business school professor, or maybe that professor’s accountant.
It was an accountant’s warning he brought to the crowd.
“Gaps in our knowledge, and in data,” Berner said, as the speech began, “are themselves threats to financial stability.” In other words, what we don’t know can cripple.
The Great Recession has sparked a data race of sorts among economists who study the financial system, one that Berner is working hard to escalate. Central banks have begun to administer “stress tests” to simulate how large financial institutions would fare if they suffered a shock to their balance sheets, of the type that felled Bear Stearns and Lehman Brothers in 2008. Researchers, including a team at NYU, have developed complex indexes that use public financial data to measure risk in the system, down to the level of individual firms. Economists have begun using network theory — which builds mathematical models of links between members of a system, such as financial traders — to chart the patterns of assets and liabilities that connect banks.
“There’s been quite an explosion of these things that measure the current condition of the financial system,” said Stephen Ong, a vice president in the banking supervision and regulation department at the Federal Reserve Bank of Cleveland, which is teaming with Berner’s office to sponsor a conference on financial stability data in May. Already, Ong and his colleague Joseph Haubrich say, they’ve received 90 academic paper submissions for the conference, from economists, legal scholars and computer scientists. The Office of Financial Research is commissioning its own studies too; it started with an evaluation of 31 financial stability indicators.
That’s a lot of new instrumentation on the dashboard. Could it be enough to keep the economy on the road and crash-free?
Some of the economists who came to see Berner in New York think it might be. One is Robert Engle, the director of Stern’s Volatility Institute, which in recent years has created sophisticated risk indexes. Engle won a Nobel Prize in 2003 for his work developing computer models to measure financial volatility. He sits on an expert panel that advises Berner’s office. In an interview in his office, Engle said it is possible that regulators have enough information, from newly developed tools, to avoid another crisis — if they can summon the will to follow the numbers and move in time to defuse threats. In other words, the issue might be the driver, not the dashboard.
“Enormous amounts of things we know now that we didn’t know before,” Engle said. “And on top of that — and perhaps more importantly — we’ve become more able to act on what we know.”
Other NYU economists worry the Office of Financial Research is chasing a mirage. Bruce Tuckman, a finance professor fresh off a long career in risk management at big Wall Street firms, said the financial system is so complex that a whole control room of indicators wouldn’t suffice to understand it. “That’s the danger with OFR,” he said. "They spend all this time on getting this data that doesn’t tell them where the risks are.”
That’s the big question: Where are the risks? Almost everyone missed the big ones in the mid-2000s. Could you have spotted those risks before they blew up, knowing what researchers know now? Berner seems confident his office could have.
If the office had existed in 2005, for example, Berner says it might have noticed the proliferation of financial products tied to mortgages. It was easy enough to see at the time that a lot of people were buying and selling a new type of security that was predicated on housing prices going up and up and up. What you couldn’t see was who owned big bundles of those securities and, thus, was vulnerable to huge losses if the housing market tanked. The office, Berner says, might have compiled the data to bring those risks to light. And best-case scenario, it would have caught the dangers that had piled up on the books at firms such as Lehman and AIG — and then regulators could have stepped in.
“We might have had a better chance of seeing [threats to financial stability] as they unfolded,” Berner told the crowd at NYU.
But those are old threats. New threats are emerging in the financial system every day, including those that no one thinks to look for.
Berner is casting a wide net. His office is, in fact, working with regulators to identify an unprecedented amount of public and private data from financial companies, to better understand balance sheets and exposure to risk. (Berner stresses that the security of that data is a top priority for the office. If that data were made public, it would be like exposing trade secrets.) To learn more about the gritty business of who trades what with whom, and which firms have built up big exposures to other firms’ portfolios, the office is helping establish a legal record of every party that conducts a financial transaction — a sort of bar code for Wall Street participants.
It’s not just a quantity issue: The office is also pushing hard to standardize all sorts of records; if everyone agrees to a common set, their numbers will be comparable and lend themselves to more useful interpretation. Another example from before the last crisis: Different banks, and even divisions within banks, defined “subprime” loans in different ways; they used varying credit scores as thresholds. A standard definition would have allowed regulators and the institutions themselves to add up all the subprime risks on each balance sheet.
The risks Berner worries most about today lie in the far corners of the so-called shadow banking system, the firms that act like banks but are not regulated like them. (For example, the so-called “repo market,” which allows firms to raise money by borrowing against securities in their portfolios.) The office’s research agenda includes learning more about how that and other funding markets function, and what might trigger runs on them.
“There are still pretty big gaps in our knowledge” — particularly in shadow banking, Berner said in an interview.
“Securitization has changed since the crisis,” he added, “and the links in that securitization chain, from origination to funding, have all changed. We need to know more about each of those links.”
Most Americans don’t worry much about those things, which is why Berner worries about them so much: “It’s the things that people aren’t focused on that may sneak up and give you problems,” he said.
On this, too, Berner’s personal experience is instructive; it’s worth noting what was wrong in his prescient recession call of 2007.
He expected housing to drag on the economy in 2008 — but to recover, at least in name, in 2009. He didn’t foresee that the problems of U.S. banks would spread to Europe. Most notably, he predicted that the recession “will be short and mild,” with minimal damage to the labor market. But even then, Berner was cognizant of spelling out what he did not know.
He and Greenlaw wrote that their forecast could be too optimistic, because they paid “too much attention to the economic resilience of the past, and not enough to the future effects of financial and economic head winds and the dynamics of the downturn.” It was possible, they wrote in closing, that the national economy was stronger than it appeared from Wall Street.
Berner held that thought for exactly one sentence. Then he killed it: “In our view,” he wrote, “downside risks still dominate.”
Then, as now, he worried most about what he couldn’t see.