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  • IntroductIon the end of a Great IllusIon
  • ‘liquidity’ and the crisis of invented money
  • liquidity illusion and the Global credit crunch
  • the staGes of the Meltdown
  • The Prelude: The american sub-Prime crisis
  • from sub-Prime crisis to the Global credit crunch
  • from Global credit crunch to Global recession
  • The controversy over financial innovation
  • offshore: The uses and abuses of sPVs
  • northern rock and Granite
  • how the crIsIs has Been understood
  • Ex-Ante and Ex-Post Visions of the credit crunch
  • structural Theories of the credit crunch
  • cyclical Theories of the crisis
  • soMe uncoMfortaBle Puzzles of the credIt crunch
  • Ponzi capitalism: a crisis of fraud?
  • 2002–7: the three PIllars of the lIquIdIty IllusIon
  • The alchemists: Turning Bad debts into ‘money’
  • The Three stages of the Policy response
  • conceptual dilemmas and Traps
  • conclusIon: a very Mundane crIsIs
  • notes
  • BIBlIoGraPhy
  • index

Financial Alchemy in Crisis

Financial Alchemy in Crisis
The Great Liquidity Illusion
AnAstAsiA nesvetAilovA

3–6. Chapters 2. northampton. eX10 9JB. england Printed and bound in the european Union by CPi Antony Rowe. england typeset from disk by stanford DtP services. 33 livonia Road.First published 2010 by Pluto Press 345 Archway Road. nY 10010 www. Chippenham and eastbourne . Conclusion Anastasia nesvetailova 2010 Copyright © Chapter 2 Anastasia nesvetailova and Ronen Palan 2010 the rights of Anastasia nesvetailova and Ronen Palen to be identified as the authors of this work has been asserted by them in accordance with the Copyright.com Distributed in the United states of America exclusively by Palgrave Macmillan. london n6 5AA and 175 Fifth Avenue. nY 10010 Copyright © introduction. 175 Fifth Avenue. sidmouth. a division of st. 10 9 8 7 6 5 4 3 2 1 Designed and produced for Pluto Press by Chase Publishing services ltd.plutobooks. British library Cataloguing in Publication Data A catalogue record for this book is available from the British library isBn isBn 978 0 7453 2878 2 978 0 7453 2877 5 Hardback Paperback library of Congress Cataloging in Publication Data applied for this book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. logging. new York. pulping and manufacturing processes are expected to conform to the environmental standards of the country of origin. new York. Martin’s Press llC. Designs and Patents Act 1988.

For Alexandre Gennady Palan .


How the Crisis has been Understood Ex-ante and ex-post visions of the credit crunch structural theories of the credit crunch Cyclical theories of the crisis 4. the stages of the Meltdown the prelude: the American sub-prime crisis From sub-prime crisis to the global credit crunch From global credit crunch to global recession 2. the tale of northern Rock: Between Financial Innovation and Fraud (Anastasia nesvetailova and Ronen Palan) the controversy over financial innovation offshore: the uses and abuses of sPvs northern Rock and Granite 3. some Uncomfortable Puzzles of the Credit Crunch Dismissed: the warning signs and the whistleblowers Ponzi capitalism: a crisis of fraud? ix x 1 4 17 24 24 28 33 40 43 48 51 62 62 71 80 90 91 100 .Contents Abbreviations Acknowledgements Introduction: the end of a Great Illusion ‘liquidity’ and the crisis of invented money liquidity illusion and the global credit crunch 1.

After the Meltdown: Rewriting the Rules of Global Finance? the three stages of the policy response the crisis and geopolitics: a new special relationship? Conceptual dilemmas and traps Conclusion: A Very Mundane Crisis Notes Bibliography Index 113 113 121 131 143 144 149 156 172 177 184 197 .viii fI nanc IaL a Lchemy In cr Is Is 5. liquidity as a ‘state of mind’ the alchemists: turning bad debts into ‘money’ 6. 2002–7: the three Pillars of the Liquidity Illusion liquidity and the paradigm of self-regulating credit Playing with debt – together.

Abbreviations ABss Bis CDos Ceo CRA eCB FsA FsF FsB GDP iMF MBAs MBss niFA oFC oRD otC siv snB sPe sPv vAR Asset-backed securities Bank for international settlements Collateralised debt obligations Chief executive officer Credit rating agencies european Central Bank Financial services Authority (UK) Financial stability Forum Financial stability Board Gross domestic product international Monetary Fund Mortgage-backed assets Mortgage-backed securities new international financial architecture offshore financial centre originate and distribute (model of banking) over-the-counter (trade) special investment vehicle swiss national Bank special purpose entity special purpose vehicle value at risk (model) ix .

london. Paul Davies. would not have been possible without the generous assistance. this book. Most of all. Roy Keitner. i am also grateful to my students and colleagues at City University. Duncan Wigan. Robert Wade. i thank Ronen Palan for everything. x . Randall Wray. Jakob vestergaard. i am particularly indebted to Rory Brown.Acknowledgements the booming industry of credit crunch analysis is a tough competition for anyone trying to draw out systematic lessons from the global financial meltdown. Jan toporowski. and elsewhere. Giselle Datz. Christine Desan. Bruce Carruthers. summarising my own attempts to learn from the financial meltdown. Kees van der Pijl. encouragement and patience of Roger van Zwanenberg and the editorial team at Pluto Press. Assaf likhovski. Gary Dymski. victoria Chick. Michael Zakim and many others for constructive comments and feedback on earlier versions of the text. Angus Cameron. Randall Germain. Dick Bryan.

take one part motor car debt. sometime in sixteenth-century europe sometime in the twenty-first century. Call in the Wizard. as purged as crystal. Alchemical gold is made of three pure souls. Pierce the Black Monk. Fire of earth. invented a new formula. ask him to throw the Bond in the air.take earth of earth. soul. Bond. and spirit grow into a stone. then sell to a bank. today’s experts have become as adept as their sixteenth-century forebears in the dark arts of wealth-creation. not to be outdone by their sixteenth-century brethren. and Water of the Wood. add two parts credit card debt and three parts house mortgage debt. earth’s Mother (Water of earth). Alchemy makes gold from base materials. ask for an AAA rating. these are to lie together and then be parted. When it falls to the ground. . Body. this is to be cast on Mercury and it shall become most worthy gold. and mix well together. leave for six days. and call the whole. new monks. wherein there is no corruption. a man versed in mathematics.


once considered a buttress of the high plateau and a built-in defense against collapse were really a profound source of weakness. Indeed. of which people only a fortnight earlier had spoken so knowledgeably and even affectionately. as is argued in this book. (Galbraith 1955) Sounds familiar? John Kenneth Galbraith wrote these words in 1955 in his celebrated text on the 1929 Wall Street Crash. With remarkable celerity it removed all of the value from the common stock of a trust. it is the illunderstood process of modern financial alchemy that has become the real cause of the global credit crunch. as George Santayana famously wrote. The turmoil that engulfed an unsuspecting world one Tuesday in early August 2007 has paralysed the 1 .IntroductIon the end of a Great IllusIon By now it was also evident that the investment trusts. The general opinion among financial experts had been rather reassuring: ‘innovative techniques of corporate finance have led to more careful evaluation of corporate wealth and more effective allocation of capital’ (Bernstein 2005: 2). Yet. The leverage. ‘those who cannot learn from history are doomed to repeat it’. Few thought that his classic study on economic history would be applicable to a crisis of advanced twenty-first-century capitalism. was now fully in reverse.

Yet there were some who had been writing about the possibility of such a collapse for years. on a par with. even decades. then. In fact. the only industry to have done well out of the credit crunch appears to be the booming business of crisis commentary and theorisations. still appears to escape the vast majority of observers – observers who. . Some had warned about the historically unprecedented debt burden in Anglo-Saxon countries and predicted a crisis of debt-driven consumption (Pettifor 2003). So why another book on the global credit crunch? Because despite the plethora of theories and approaches. The crisis that began in a seemingly isolated segment of the so-called sub-prime mortgage market in the United States soon engulfed the international banking system and was transformed into a deep global recession. others had even detailed the imminent banking crisis in the ‘advanced’ financial systems (Persaud 2002). the major cause of the global financial meltdown. did not foresee the crisis in the first place. if not of greater significance than.2 f inancial alchemy in crisis world of finance and. the entire global economy. incidentally. Complex in its nature and origins. the crisis has spurred a myriad of reflections. There is little doubt that the meltdown will be remembered as an historical watershed. 9/11 or the fall of the Berlin Wall in 1989. How was it. some had been warning against super-inflated asset and housing markets. criticising the traditional vector of monetary policies (Toporowski 2000). and the reason why it was inevitable though not widely anticipated. since then.

Intellectually. a few economist celebrities like Paul Krugman. political economy. many of them come from the same school as John Maynard Keynes. Joseph Stiglitz and Nouriel Roubini aside. If the party is so good. why listen to the killjoys who want to spoil it? This book offers an analysis of the credit crunch from the same perspective that warned about the dangers of the financial system in the first place. Suspicious of purely econometric techniques and abstract models in their analyses. they often sound like unenlightened sceptics of finance-led economic progress.inT roducT i on: T h e end of a Gr e aT i l l u s i o n 3 that these people were not heeded? And why did the global credit crunch come as a massive shock to the world of finance? The trouble is that the sceptics who had been asking awkward questions and voicing concerns about debt levels and asset bubbles during the credit boom were. or critical. As a result. and their concerned voices were simply muffled amidst the general sense of a credit bonanza in 2002–7. Detecting historical parallels with previous socio-economic and financial crises and warning against history repeating itself. Hyman Minsky and other scholars who form the tradition of heterodox. Still others ventured their prognoses on the basis of intuition and gut feeling. these scholars prefer critical historical inquiry into the dynamics of financialised capitalism. they are rarely invited to air their views in the pages of glossy business periodicals or high-profile policy forums. as a rule. There . not ‘mainstream’ economists.

what ‘price’ is. even cultural – have shaped the preconditions for the global malaise. it remains current in the wake of the credit crunch. During the boom years of 2002–7 this fallacy. apparent to many in the aftermath of the crisis. strikingly. a substantial part of the discipline operates with concepts that are better described as metaphors rather than as a coherent conceptual grounding or a set of definitions. Specifically. but for centuries scholars of political economy have been arguing among themselves about how best to define the concept of ‘value’.4 f inanci al alchemy in crisis is no doubt that complex sets of factors – historical. today’s financiers create money and wealth. social. it is the idea that by inventing novel credit instruments and opening up new financial markets. Keynes famously described the financial market as a ‘beauty . the key cause of the global credit crunch can be traced back to one pervasive and dangerous myth. geopolitical. technical. strict. Yet as the following pages contend. for instance. ‘liquidity’ and the crisis of invented money There is a certain oddity about the realm of finance and economics. rational and calculative. As will be argued below. including its major casualties. Although apparently precise. economic. the global credit crunch has shown this idea to be a dangerous – and costly – fallacy. was concealed by one great myth of today’s finance: the illusion of liquidity. We all know. They have yet to reach an agreement. This belief had been shared by many participants of the crisis.

But it is much less clear what such a statement means. Just weeks before the crisis erupted. the world economy may require not just a facelift. these worries turned into the fear of a global liquidity meltdown. after the financial wreckage of 2007–9. leading policymakers were concerned with what they believed was a structural ‘liquidity glut’. Most people. Everyone knows that liquidity is the lifeblood of any financial market and that it is essential for general economic activity. That fear soon materialised in a very real financial and economic crisis.in T roducT i on: T h e end of a Gr e aT i l l u s i o n 5 contest’1 and the metaphor stuck – albeit we know that things in this beauty contest often turn rather ugly. Yet within a matter of days. rather than as a clear. however. but a major transplant. As one official put it: ‘liquidity clearly ain’t what it used to be. is that economists and finance professionals would probably never agree on what liquidity actually is. . still less whether that is a “good” or a “bad” thing’ (Smout 2001). even those outside finance. The problem is that ‘liquidity’ is precisely one such category in contemporary finance that seems to be easier understood by means of metaphors and allusions. would intuitively prefer to be in a position that is liquid rather than one that is illiquid. The irony. agreed definition or framework. Most commonly the global financial meltdown has been defined as a ‘credit crunch’ or crisis of liquidity: liquidity simply melted away from the world markets in the space of just a few days. In this sense.

Liquidity is also about depth – of a market for a particular class of assets – and speed – with which a certain transaction can be completed. national economy and finally. complex. a segment of the market. portfolio. Liquidity also denotes a quantity – most often associated with the pool of money or credit available in a system at any given time. Liquidity is also an intertemporal category: liquidity in good economic times is not the same as liquidity in bad times. Or. The liquidity that was widely assumed to be abundant during the pre-crisis period was not the same liquidity that melted away during the crisis. as economists like to stress. an institution or even an economic system as a whole. Liquidity is a very fluid. . a market. multidimensional notion. the liquidity of an individual bank. It describes a quality – of an asset.6 f inancial alchemy in crisis The problem is conceptual. Liquidity can literally vanish overnight. Liquidity is also a probability – a calculated chance of a transaction being completed in time without inflicting a major disruption on the prevailing trends in the market. liquidity can also comprise all these things and describe several layers of economic activity at the same time – for instance. the global financial system as a whole. illiquid debt when confidence and optimism evaporate. liquidity to sell is not always the same as liquidity to buy. Assets that are easy to sell when investors are confident about their profitability and risk profiles often turn out to be unwanted and expensive bundles of poor quality. To make things more complicated still.

Not many buyers. importantly. There is no clear . financial institutions employed armies of young MBAs. it now transpires. these and many other puzzles of the credit crunch centre on the problem of liquidity and its metamorphoses in the modern financial system. All they seemed to care about was that the market for these products appeared highly liquid and that they – and. their competitors – were making money.500bn of loans were securitised in the US.inT roducT i on: T h e end of a G r e aT i l l u s i o n 7 This is exactly what happened to trillions of dollars of securitised loans and a plethora of highly sophisticated and opaque financial instruments during 2007–9. synthetic financial products were exposed for what they actually were – parcels of toxic debt – and their market liquidity evaporated. The new generation of finance professionals turned out to be nothing but a highly motivated sales force. Bankers could confidently sell highly complex instruments in bulk to clients around the world. Most chronicles of the crisis concur that the global meltdown centred on. As will be argued below. or at least started as. took the trouble to learn about the nature of these instruments in depth. in 2008 almost none were sold to private sector buyers (Tett and van Duyn 2009). liquidity drainage from the markets. bent on persuading even the most sceptical clients to part with their cash for bundles of securitised loans. as did the markets for these products: whereas in 2007 $2. gave them fancy job titles and paid them handsomely. When the boom came to a halt. At the height of the 2002–7 liquidity boom.

the diversity of views becomes ever more apparent. As such. ‘liquidity’ was generally assumed to describe a quality of an asset and ultimately was related to the notion of money.8 f inancial alchemy in crisis consensus. it is conditioned by the market context. the state lost its monopoly over the process of credit-creation. into an industry of trading and optimising risk. however. But then the real life of the financial markets complicated matters. As the field of credit crunch studies expands. And even though the concept of ‘money’ remains probably the most controversial aspect of economics and finance. In 1971. The financial sector has been transformed from being part of the service economy. on what the concept of liquidity actually implies today. but crucially it is intimately related to the notion of money: liquidity is ‘an asset’s capability over time of being realised in the form of funds available for immediate consumption or reinvestment – proximately in the form of money’ (Hirchleifer 1986: 43). Not that long ago things were somewhat simpler. the concept of liquidity has undergone its own series of mutations. an intermediary between lenders and investors. . In the brief age of Keynesian economic stability. As a result of the financial innovations that led to this collapse. most students of finance at the time would concur that liquidity is a property of an asset. the postwar system of fixed exchange rates and financial controls was dismantled. In parallel.

The idea behind this principle is economic flexibility: by securitising previously non-traded products and putting them on the market. second. Theoretically. With the collapse of the Bretton Woods regime and the rise of private financial markets. The second mutation of liquidity has been the so-called securitisation revolution. During the centuries of metal-based money. By doing so. both functionally and conceptually. the banking system’s ability to extend credit. the transformation of liquidity has paralleled the rise of private financial markets. widen . liquidity was closely associated primarily with state-generated credit money and. and became prone to overextension of credit. this trend manifested itself in the global debt crisis of the 1980s (Guttman 2003: 32). the Euromarket. one can design several securities (tranches) with different risk-reward profiles which appeal to different investors (Cifuentes 2008). has been gravitating towards the realm of the financial markets themselves. the Eurocurrency market became the global engine of liquidity-creation and debt-financing. and later in the era of the Gold Standard and even the fixed exchange rates of the Bretton Woods system.in T roduc Ti on: T he end of a G re aT i l l u s i o n 9 First. A key factor in this trend was the emergence in the late 1960s of the unregulated financial space. securitisation is a technique used to create securities by reshuffling the cash flows produced by a diversified pool of assets with common characteristics. financial institutions attach a price to these assets. Created by commercial banks to avoid national regulations. the notion of liquidity. Most dramatically.

More recent examinations of liquidity as a category of finance have moved away from associating it with notions of money or cash. as well as the spread of the derivatives markets. by expanding the web of economic transactions. Facilitated by technological and scientific advances. The explanation for this . Boosted by the resolution of the debt crisis of the 1980s. creating the sense of much greater liquidity of these markets and the depth of the credit pool (ibid.10 f inancial alchemy in crisis their ownership and hence. The business of securitisation has been assumed to bring many benefits to the economy. have viewed liquidity as necessarily a twofold concept. Indeed. stressing instead the link between market liquidity and risk (Allen and Gale 2000). With banks rapidly becoming major players in this global financial market. and with their greater reliance on securitisation techniques in managing their portfolios. therefore. while emphasising its evasive and multidimensional character (Keynes 1936). the earlier political-economic conceptualisations of liquidity. the notion of liquidity as tied to the pure credit intermediation mechanism or a state-administered monetary pool began to fade away. the securitisation of credit has greatly increased the variety and volume of trade in the global financial markets. In theory. strengthen the robustness of the economy as a whole. obscure loans have been transformed into securities and traded in the financial markets. securitisation is supposed to enhance liquidity and economic stability. the securitisation of credit became a process through which often poor quality.: 40–1).

As a result. As one web-based financial dictionary suggests. liquidity has been presumed to relate . it may seem odd to link liquidity to categories of cash. the privatisation of financial and economic risks and the denationalisation of money have shifted the process of liquidity-creation away from the public sphere of political economy and into the realm of private financial markets (Holmstrong and Tirole 1998: 1). a market characterised by the ability to buy and sell with relative ease’ (Farlex Free Dictionary). After all. liquidity describes ‘a high level of trading activity.in TroducT i on: T h e end of a Gr e aT i l l u s i o n 11 change in the analytical approaches is to be found in the financial developments of the post-1971 era. the global financial system is based on credit and a multitude of economic transactions. The policies of financial deregulation and liberalisation reinforced this trend. over the past few decades. thereby institutionalising liquidity firmly as a category and instrument of the market and its pricing mechanism. With money itself becoming increasingly dematerialised. but rather an indicator of the general condition and vitality of a financial market. Instead. Specifically. Also. analyses of finance in the macro-economy have assumed that liquidity is no longer primarily a property of assets. The outcome of this chain of mutations – both analytical and market-based – is that in most contemporary readings the connection between ‘money’ and ‘liquidity’ has waned. allowing buying and selling with minimum price disturbance. high-powered or state-backed money.

trade. In terms of understanding what liquidity is and how it behaves. liquidity has progressively lost its public good component. The first trend concerns the expansion of the global credit system and can be described as a process of demonetised financialisation. marked by the inherent contradiction between money as a public good and as a private commodity. liquidity has increasingly assumed the features of a private device of the financial markets in the sense that it is created by agents seeking to benefit individually from that privilege (Guttman 2003: 23). and second. an important assumption correlated with this trend. therefore have been progressively abstracted from the dynamics of productivity. therefore. It encapsulates two intertwined tendencies in contemporary capitalism: first. the deepening of the financial sector and the growing role of finance-based relations in shaping the nature of socio-political developments today. or financialisation. both spatially and intertemporally. Just as money itself is. or what social scientists understand as financialisation. the process of securitisation (depicted above). As financialisation advanced. real economic . centred on financial institutions’ ability to transform illiquid loans into tradable securities. reaping profits in the process.12 f ina nci al alchemy in crisis to the complex mechanism of financial transactions taking place in the markets and confronting a variety of risks. The expansion of the credit system and the accumulation of financial wealth. This in turn has produced several interrelated assumptions that have shaped finance theory and policy in the run-up to the global credit crunch.

crucially.g. developments in the sphere of state-backed or high-powered money. This complex chain of financial innovation is known in mainstream finance theory as market completion. or placing them off the balance sheet. Toporowski 2009). Rather. analytically. as happened with many highly risky securitisation products) (e. the key function of the financial system as a whole is no longer the intermediation between savers and borrowers as such. and (iii) by redistributing the risk to those who are deemed most able and willing to hold risk (i. that role has been assigned to just one sector of the financial system – commercial banking. (ii) by parcelling them into specific financial vehicles (such as tranches of mortgages or structured financial products). often institutions specialising in trading these particular products. In this view. Second. mainstream finance theory and practice supported and guided these trends by embedding the new credit system in a paradigm of scientific finance.in T roduc Ti on: Th e end of a G re aT i l l u s i o n 13 growth and. by pooling a bunch of sub-prime mortgages from several mortgage lenders). for instance.e. In the context of the sub-prime market. by selling it on to third and fourth parties. riskoptimising and market-creating financial innovations have been seen as key to enhancing social welfare more generally: . the ultimate aim of the financial system today is to manage and optimise risk in three steps: (i) by identifying and pricing risks (for instance.

into tradable and liquid financial securities. Financial innovation.14 financi al alchemy in crisis The subprime market provides a market-opening and -completing opportunity … The subprime market allows funding to those who would otherwise not be homeowners. this process – extending far beyond the sub-prime market – symbolised ‘a new paradigm of active credit management’ (cited in Morris 2008: 61). According to Greenspan. even to applicants able to qualify in a prime-only market. therefore. cited in Wigan 2009). (chinloy and macdonald 2005: 163–4) Ultimately. transforms previously unpriced and typically illiquid assets. for instance. by relying on scientific approaches to risk management and calculative practices. thereby optimising risks and enhancing the liquidity of the financial system as a whole (Cifuentes 2008). such as real estate. car or student loans and sub-prime mortgages. . Those applicants obtain a welfare gain by having more choices and flexibility. is believed to create new facilities for risk optimisation and thus complete the system of markets. As the theory holds. securitisation. prime lenders can target some applicants who otherwise might not be qualified … The prime mortgage market allows all borrowers meeting a particular threshold to be qualified … adding a subprime market provides a welfare gain. By pricing the risks of different types of credit quality. ‘financial innovation will slow as we approach the world in which financial markets are complete in the sense that all financial risks can be effectively transferred to those most willing to bear them’ (2003. as Alan Greenspan foresaw.

a set of innovations that were supposed to create freer markets and complete the system of risk optimisation actually produced an opaque world in which risk became highly concentrated – worryingly. as Gillian Tett writes. in ways almost nobody understood. Indeed. the expansion of the so-called shadow banking industry. Generally. such as value-at-risk (VAR) models. the spiral of demonetised financialisation has been underpinned by institutional and operational advances in financial innovation. as the principle of active credit risk management would imply. Yet instead of being traded. the growing sophistication and specialisation of offshore financial centres and techniques (Palan 2003). no less than $450bn worth of ‘collateralised debt obligations of asset-backed securities’ (CDOs of ABSs) were created. .inT roducT i on: T h e end of a Gr e aT i l l u s i o n 15 Third. most were sold to banks’ off-balance-sheet entities. What is striking about the wave of financial innovation that defined the last two decades of the global financial system is that many newly created products of risk management became so specialised and tailor-made that they were never traded in free markets. such as structured investment vehicles (SIVs). or simply left on the books. there has been a remarkable rise in the number of hedge funds. she argues. in 2006 and early 2007. In addition to the structural shift towards the ‘originate and distribute’ (ORD) banking model. and the spread of new methods of risk management and trade. all leading to the extraordinary growth of variety and complexity of financial products themselves.

or between search and funding liquidity (ECB 2006). able and willing to trade at a given point in time at a prevailing price level (Warsh 2007). And although some recent analyses have drawn a distinction between market and systemic liquidity (Large 2005). Namely. the axiom that financial innovation and engineering have the capacity to liquefy any type of asset – or. At the level of financial institutions themselves. more accurately. in the Anglo-Saxon economies it is the concept of market liquidity – describing the depth of markets for the sale or loan of assets or the hedging of risks that underlie those assets – that has come to inform most recent frameworks of financial governance (Crockett 2008: 13–17). debt – has resulted in the now mainstream notion of liquidity that is divorced from any attribute of assets per se. liquidity is most commonly understood as ‘confidence’ of the markets. rather than as a quality of assets as such. it could take a whole weekend for computers to carry out the calculations needed to assess the risks of complex CDOs (Tett 2009). they conceive liquidity fundamentally as a property of the market or an institution. This conceptualisation of liquidity in turn has produced a sequence of analytical fallacies which have . by 2006.16 fina nci al alchemy in crisis Officials at Standard & Poor’s admit that. What does the combination of the three trends imply for the analysis of the crisis offered in this book? It appears that most analytical and policy frameworks of the global financial system have been based on a strong and relatively straightforward assumption. Here.

The first fallacy is the assumption that it is the market-making capacity of financial intermediaries to identify. Second is the view that general market trade and turnover are synonymous with market liquidity. The third and corresponding fallacy is the notion that market liquidity itself – when multiplied across many markets – ultimately is synonymous with the liquidity (and financial robustness) of the economic system as a whole. Hyman Minsky famously stated in his financial instability hypothesis. this line of reasoning has been underpinned by the notion that financial innovation in its various forms ultimately enhances the liquidity of the financial system as a whole. it is . Amidst the ostensible rehabilitation of his name. price and trade new financial products that creates and distributes liquidity in the markets. in the flawed vision – academic as well as political – of the dynamics of the relationship between private financial innovation and the liquidity and resilience of the financial system generally. I believe. consequently.in T roducT i on: Th e end of a G re aT i l l u s i o n 17 contributed to the illusion that this is the real cause of the global credit crunch. the hollow notion of liquidity lies at the heart of the great illusion of wealth and the belief in financial markets’ capacity to invent money that are the real causes of the global meltdown. Therefore. liquidity illusion and the Global credit crunch ‘Stability is always destabilizing’. This misunderstanding. originates in a hollow notion of liquidity itself and. Altogether.

Most observers concur that the major factor in the global credit crisis was the progressive underestimation. Indeed. exuberance and optimism about one’s position in the market and lead to greater reliance on leverage and underestimation of risks. economic prosperity and optimistic forecasts that pervaded North Atlantic economies and financial markets. ‘good’ times breed complacency.. Indeed. notably again identifying the link between the supply of capital from abroad and the housing bubble in North America: The creation of new securities facilitated the large capital inflows from abroad . or misunderstanding. things will be complicated. as stated famously by Citi’s Chuck Prince in July 2007: ‘When the music stops. most commentators on the credit crunch recognise the tendency to underestimate the risks in a bearish market or bubble. But as long as the music is playing.. financial . Economists analysing the crisis do recognise the role of a liquidity crunch in the first stage of the crisis (August 2007–September 2008). based in turn on the general sense of stability. The trend towards the ‘originate and distribute model’ … ultimately led to a decline in lending standards. of risk by financial agents.18 f inancial alchemy in crisis this message that seems to attract most commentaries on the credit crunch. According to Minsky. regardless of their intellectual and policy affiliations. in terms of liquidity. you’ve got to get up and dance’ (cited in Soros 2008: 84). Many American observers continue to believe that the root cause of this problem was the liquidity glut coming from the emerging markets.

this illusion can have very real – and destructive – social. most mainstream analysts of the crisis overlook the core of Minsky’s framework. (Brunnermeir 2009: 78) The BIS arguably went furthest in analysing the repercussions of this collective underestimation of risks for liquidity and admitted that. or a situation in which markets under-price liquidity and financial institutions underestimate liquidity risks (CGFS 2001: 2). it appears that only a fragmented and highly selective version of Minsky’s theory resonates in current readings of the global meltdown.in T roducT i on: T h e end of a G re aT i l l u s i o n 19 innovation that had supposedly made the banking system more stable by transferring risk to those most able to bear it led to an unprecedented credit expansion that helped feed the boom in housing prices. essentially. As the credit crunch revealed. fund manager or a government) has about the safety and resilience of a portfolio and/or market as a whole. many emergent theories of the global credit crunch appear to have strong Minskyan undertones. In this sense. as now commonplace references to a ‘Minsky moment’ in finance or the crisis of Ponzi finance suggest. In other words. this phenomenon constitutes an illusion of liquidity. Yet once we consider the contentious place of ‘liquidity’ in the crisis. Very few indeed cast a critical . the illusion of liquidity is understood as a false sense of optimism a financial actor (be that a company. While noting the risk effects of the general macroeconomic environment and investor expectations. economic and political consequences.

The latest round of securitisation. crisis-prone state. whose liquidity was assumed but in fact was never guaranteed.20 f ina nci al alchemy in crisis eye on the very ability of private financial intermediaries to extend the frontier of private liquidity. Just as the securitisation bubble was beginning to inflate. Yet. According to Minsky. one of the big investors warned about specific liquidity risks faced by his company. propelled by the belief that clever techniques of parcelling debts. securitisation has produced an incredibly complex and opaque hierarchy of credit instruments. the web of debt-driven financial innovations has a dual effect on the system’s liquidity. At the level of the financial system. in fact has driven the financial system into a structurally illiquid. ‘every institutional innovation which results in both new ways to finance business and new substitutes for cash decreases the liquidity of the economy’ (1984 [1982]: 173). On the one hand. as Minsky warned. creating new products and opening up new markets. create additional and plentiful liquidity. Although the firm’s securitisation strategy had been based on the assumption that collateralised mortgage obligations (CMOs) would be more liquid than their underlying collateral – the properties – he warned that this assumption was far too . What is astonishing is that some market players seemed to be aware of this danger. on the other. the velocity of money increases. ultimately accentuating financial fragility in the system and thus accelerating the scope for a structural financial collapse and economic crisis. as financial innovations gain ground.

indeed. in October 2008.. by focusing on the problem of valuations and risk mis-pricing.2 However.in T roducT i on: T h e end of a Gr e aT i l l u s i o n 21 short-sighted and over-reliant on the market’s shared sentiments: ‘as a guide to market discipline. we like the expression. as one risk manager admitted in the wake of the crisis: ‘The possibility that liquidity could suddenly dry up was always a topic high on our list but we could only see more liquidity coming into the market – not going out of it . most discussions of liquidity in the crisis. Yet the evidence is abundant.. “sure they’re liquid. during more benign periods. diagnose the evaporation of liquidity as a result of market failure rather than as a systemic tendency. stating that: The ongoing turmoil has revealed that. A notable outcome of the credit crunch is that it seems to have raised the importance of liquidity in the hierarchy of concerns of some policymaking bodies. unless you actually have to sell them!”’ (Kochen 2000: 112). 9 August 2008). None of the studies. or. makes the connection between the excesses of private financial innovation and its liquidity-decreasing effects. the Bank of England documented a depletion of sterling liquid assets relative to total asset holdings in the UK banking sector.’ (The Economist. some banks sought to reduce the opportunity cost of holding liquid assets by substituting traditional liquid assets such as highly rated government bonds with highly rated structured credit products. For instance. This has been part of a longer-term decline in banks’ holdings of liquid .

and a structure of authority able to legitimise the newly created financial products and thus assure their marketability (the credit rating agencies in the case of the current crisis). or more concretely. this book tells the story of the global credit crunch as a crisis brought about by a pervasive and multifaceted illusion of wealth. as is explained in the following chapters. In what follows. leading people like Greenspan to celebrate ‘the new era in credit risk management’? The answer. these three elements helped sustain the illusion of infinite liquidity during 2002–7. yet it serves an important purpose in unpacking the political . why is it that the illusion of liquidity and wealth was sustained over a prolonged period. illusion of liquidity. can be found in three political-economic pillars of the liquidity illusion: the paradigm of a self-regulating financial system. therefore. Together. (2008: 39–40) In this instance. and if a whole body of scholarship in heterodox political economy can explain the dangers of financial euphoria and innovations. an important question about the credit crunch remains unanswered. which has been replicated in other countries. Such a narrow subject matter may seem far too technical and specific.22 f inanci al alchemy in crisis assets in the united Kingdom. Ponzi-type finance. which thrives in a climate of deregulated credit and robust financial innovation. If the participants of the credit boom themselves did admit that some of the foundations of their innovative techniques were shaky.

. While any economic crisis is in a sense a crisis of belief and confidence – be it in a national currency. or what is widely celebrated as a process of financial innovation.inT roducT i on: T h e end of a G r e aT i l l u s i o n 23 economy of the credit crunch. Not only does the idea of liquidity capture a range of axioms and assumptions that shaped the architecture of the unravelling global financial system. role in the political economy of the credit crunch. and ultimately destructive. a bank or a whole industry – the concept of liquidity has played a crucial. it also encapsulates the politics of financial alchemy today.

By the summer of 2009. the financial meltdown had matured into one of the deepest recessions recorded in the postwar history of capitalism.1 the staGes of the Meltdown Since it began in the summer of 2007. the financial malaise spread to the real economy. A year later. commonly dubbed a ‘liquidity crunch’. However. the global credit crunch has gone through three distinct stages. the meltdown goes back earlier 24 . the meltdown turned into a cross-border banking crisis which threatened the very viability of the financial services in key economies. It began with paralysis in the international financial markets. causing a chain of bankruptcies and job losses in manufacturing and the services sector. this chapter uses the records of the crisis and traces the evolution of the global meltdown through its three distinct stages. Gradually. The Prelude: The american sub-Prime crisis Most records of the global credit crunch start at 9 August 2007. the credit crunch has had no lack of chronologies: every major media outlet and financial institution updates the timeline of key events and figures. To date. Rather than replicate these detailed records.

In global terms. It all started with a boom. supported by opportunities to manage the high risks that the new financial system offered. American MBSs became the largest component of the global fixed income market. housing markets in the Anglo-Saxon economies were booming at unprecedented levels. ‘Sub-prime’ designates a category of borrowers who otherwise would be considered ‘high-risk’ clients: they had poor or no credit histories. In the United States. The great housing boom was supported by cheap and plentiful credit and the widely held belief that house prices would continue to rise. these clients were now granted access to credit and could own a house on what appeared – initially at least – to be favourable and affordable rates.T he s TaGes of T he me lTdoWn 25 than that. In the US in particular a whole new segment of housing finance – sub-prime mortgages – provided a major motor for the credit boom and the expanding financial system. which has been the epicentre of the global malaise. Yet it was as early as 2006 that the price increases in the American housing market slowed down.2 In 2001. or 20 per cent of the $3 trillion mortgage market.1 The expansion of the mortgagebacked securities (MBSs) market drew investors into some of the more risky tranches of MBS debt. But in the booming housing market. the prelude to the global financial meltdown unfolded in late 2006/early 2007. sub-prime loans made up just 5.6 per cent of mortgage dollars. Between 2002 and 2007. In 2006. the US sub-prime market was worth $600bn. accounting for a fifth of its value. and the first .

the trend historically was insignificant (IMF 2007: 5). in 2006 the structure of US sub-prime mortgages shifted many borrowers out of their initial (presumably favourable) fixed-rate terms. By the end of 2006. came from the architect of mortgage-backed finance himself.35 per cent in 2006. compared to 8 per cent in 2005.26 financi al alchemy in crisis wave of mortgage delinquencies started to spread. thereby increasing the interest payment on the loans. Commentators explained this by the fact that in 2006 . their repayments were due to rise in a year or two. Also. many of whom could barely afford their mortgage payments when interest rates were low. According to the structure of sub-prime loans. who said: ‘I think [the risk] is containable … I don’t think this is going to be a cataclysm’ (in Kratz 2007). which climbed to 5. The trigger to the rising number of defaults was the increase in the interest rate. Homeowners. The words of reassurance. Some sceptics warned that against this background a default of one or two financial companies could well spark a worldwide financial crisis. Others began to anticipate a bigger wave of defaults and bankruptcies: most 2006 borrowers were still in the ‘teaser rate’ period of their mortgages. crucially. began to default on their mortgages and defaults on sub-prime loans rose to record levels. for those who needed them. Observers offered different readings of this trend: some argued that despite the notable increase in bankruptcies. Lewie Ranieri. from 1 per cent in 2004. The sceptics were proven right. sub-prime delinquencies more than 60 days late jumped to almost 13 per cent.

The impact of these defaults was felt throughout the financial system as many of the mortgages had been bundled up and sold on to banks and investors (BBC 2009). through the complex web of mortgage-backed finance. started to affect the financial and banking system more generally. the largest sub-prime lender in the US and a leading investment bank globally. news of heavy losses from the ailing sub-prime market hit American building companies. a giant like HSBC could write off the $10bn loss and escape relatively unscathed from the mounting market distress. Eventually. in 2006 it reached almost 4 per cent. compared to 2. This fuelled fears of bankruptcy in several sub-prime lenders. Smaller sub-prime lenders operating on the American markets were in a less healthy position. Many smaller sub-prime lenders were already facing bankruptcy.2 per cent for a similar type of loan originated in 2004.5bn loss in its mortgage finance subsidiary. In March 2007.T he sTaG es of T he me lT doWn 27 some of the more neglected sub-prime loans had reached their refinancing limits. and higher. The winter of 2006–7 brought the first signs of the real magnitude of the coming meltdown.3 announced a $10. the housing boom stalled and. and borrowers could no longer afford to pay the mortgage on a new. The number of bankruptcies and foreclosures also rose: according to Moody’s. Market sceptics immediately read this as a sign of a greater trouble ahead: HSBC’s total annual profits were around $15bn. interest rate. most notably New Century .4 At the time. HSBC Finance. On 22 February 2007 HSBC.

Bear Stearns told investors . for instance. According to the BIS. over the following few months the sub-prime crisis escalated as more and more high-ranking companies. the weaker mortgage collateral was partly associated with adverse trends in employment and income in specific American states rather than with escalating housing markets (IMF 2007: 7). including UBS and the investment bank Bear Stearns. at the time the largest American independent sub-prime mortgage lender. on 2 April 2007. New Century Financial Corporation filed for Chapter 11 bankruptcy. announced write-downs. In just a few weeks. In July 2007. commentary at the time viewed the unfolding downturn as no more than a cyclical adjustment to the otherwise normal trend of rising house prices.28 f inanci al alchemy in crisis Finance Corporation. The IMF. even as the prospects for the housing market and financial boom darkened. rather than as a systemic breakdown in finance and the economy. The fall of the company marks the point when tensions in the sub-prime mortgage markets started to affect Wall Street directly. Interestingly. Specifically. this reflected a ‘seemingly orderly re-pricing of credit risk’. conditioned by changing economic and policy factors in the US economy (Borio 2008: 5). from sub-Prime crisis to the Global credit crunch Notwithstanding the optimism in the markets. explained the downturn as a combination of regional economic factors and a shift in the US mortgage market.

if any.T he sTaG es of T he me lT doWn 29 they would get little. Reacting to the news. other central banks followed with similar actions over the following weeks. the world’s . On 9 August 2007.5 and the German bank IKB. the largest French bank. In the space of just a few days in mid-August 2007. As large financial houses were calculating their losses from sub-prime loans. American Home Mortgage Investment Corporation. the list of casualties of the implosion included the hedge fund run by Bear Stearns. the European Central Bank (ECB) injected €95bn into the overnight markets and the Federal Reserve injected $38bn. On that day. the credit ratings agencies were downgrading asset-backed securities (ABSs). subprime-backed bonds and collateralised debt obligations (CDOs). announced that it was unable to value three investment funds in the volatile market context and informed investors that they could no longer withdraw money from these facilities. BNP Paribas. Federal Reserve chairman Ben Bernanke estimated that the sub-prime crisis could cost up to $100bn. Countrywide Financial. By early August 2007. the world’s financial indices went into free-fall and pretty much remained there over the following months. of the money invested in two of its hedge funds after rival banks refused to help it bail them out.6 The fateful date 9 August 2007 became the official anniversary of the global credit crunch. a US home loan lender. Central banks around the world immediately offered liquidity support in an attempt to stem the panic.

the first run on a bank in the UK for a century. which went bankrupt in August–September 2007 and had to be nationalised. Northern Rock Just days into the unfolding malaise in the financial markets. it was transformed from a crisis in one segment of the market into an international banking crisis and global credit crunch. and a subsequent political scandal. The best known of the casualties during this second phase was the British bank Northern Rock. the first stage of the global meltdown – the sub-prime crisis in the US – had not been brought under control. . Aside from liquidity injections. Northern Rock. started to unfold. in particular.30 financi al alchemy in crisis central banks pumped an extraordinary $240bn into the ailing markets. by harming those financial institutions that relied heavily on wholesale credit markets. With this. the UK financial watchdog. other emergency policy measures employed over the next few months included repeated cuts in interest rates and coordinated international monetary interventions in the credit markets. the Financial Services Authority (FSA). on 13 August 2007. Through its effects on the financial markets worldwide and. might be facing a liquidity crisis.7 Despite these collective and unprecedented efforts to restore optimism in the markets. was reportedly informed that the country’s fifth largest mortgage lender.

). the Financial Services Authority and the Treasury) debated how best to extricate the bank from its difficulties. On 13 September 2007. Northern Rock had a portfolio of loans and assets of £113bn. and cash support from the Bank of England guaranteed by the government (ibid. As the crisis in the international financial markets deepened and credit flows froze up. the authorities also commented that funding problems at Northern Rock were of a temporary (liquidity) nature. Northern Rock and the UK tripartite authorities (the Bank of England. linked to the exceptional market . but it would later emerge that the UK authorities spent around £50bn of taxpayers’ money rescuing the bank. Granting the cash. the Bank of England provided Northern Rock with emergency liquidity support. it could no longer tap the international financial markets for financing. But fortunes turned against the bank in the summer of 2007. At the time. Between 10 August and mid-September 2007. the amount of money used to save the bank was not disclosed. a takeover by another major bank. this ‘aggressive’ business strategy had paid off handsomely. During the years of the credit boom. As credit dried up.T he s TaGes of T he me lTdoWn 31 In 2006–early 2007. while the deposits it had on its books were simply not sufficient to cover its outstanding obligations. the first two options became unfeasible. As Wood and Milne document. but a small customer deposit pool of only £24bn (Wood and Milne 2008). three scenarios of crisis management were discussed: a market solution (Northern Rock would try to obtain the necessary funding by itself).

By March 2008 things had become darker still.32 financi al alchemy in crisis conditions. the bank was nationalised in February 2008. As banks were increasingly reluctant to lend to each other. credit markets remained frozen. depression. entering the year 2008 in the gloom of foundering housing markets. Despite these measures. JP Morgan Chase. On 17 March 2008. the IMF estimated that total losses from the sub-prime crisis could reach $1 trillion. customers launched an old-fashioned run on Northern Rock – on Friday 14 September they withdrew £1bn in what was the biggest run on a British bank for more than a century.8 The collapse of the bank and general market downturn prompted the authorities in the US and the EU to draft the first regulatory policy responses reflecting the unfolding malaise. In the midst of gloomy macroeconomic data now coming from economies around the world and debates about the imminent recession and. potentially. Bear Stearns. Sceptics warned that the true costs would be much higher still. Despite government support. for $240m in a deal backed by $30bn of central bank loans. was acquired by its larger rival. however. Wall Street’s fifth largest bank. Meanwhile the crisis intensified. rather than a serious structural problem. . This continued until the government stepped in to guarantee depositors’ savings (BBC 2009). panic in the financial markets and more losses being revealed by banks and other companies. After a failed attempt by the Virgin group to buy Northern Rock.

On 14 July. it was clear that the fall of the two institutions would harm the value of the dollar and thus affect all holdings of US debt held by foreign creditors around the world. warned that the economy was facing its worst crisis in 60 years and added that the downturn would be more ‘profound and long-lasting’ than most had feared. They had been the drivers of the mortgage securities markets. from Global credit crunch to Global recession The week of 7–15 September 2008 was the darkest to date in the history of the credit crunch. Fannie Mae and Freddie Mac were taken over by the US government in one of the largest bailouts in US financial history. On 7 September. or nearly half of the US’s $12 trillion mortgage market. the two largest lenders in the US – Fannie Mae and Freddie Mac – appealed for help from the US government. came from China. Alistair Darling. In late August 2008. The pressure. the largest holder of US debt. On the other side of the Atlantic.Th e sTaGe s of Th e me lTd oWn 33 the crisis continued to accelerate into the summer and autumn of 2008. owning or guaranteeing $5 trillion worth of home loans. signs of recession were becoming more visible. The next dark moment in the crisis chain came in mid-summer 2008.9 Although the Chinese government made no official comment at the time. . according to market consensus and common sense. the UK Chancellor.

the Federal Reserve authorised an $85bn rescue package for the country’s biggest insurance firm. The collapse of the global bank was a major shock to the international financial system and marked the transformation of a market liquidity crunch into an international banking and credit meltdown.34 f inancial alchemy in crisis Three days later. Markets went into free-fall for weeks in a row.10 Several months later. in return for an 80 per cent stake in the company. Under pressure from an angry Congress. The situation worsened as another high-profile US bank. after several futile attempts to find a buyer or secure governmental rescue. These included top US firms Goldman Sachs . On 15 September 2008. agreed to be taken over by Bank of America for $50bn (BBC 2009). Direct comparisons with the 1930s crisis and projections of a global depression became commonplace.9bn for the three months to August 2008. representing the biggest erosion of financial wealth since the 1930s. AIG. AIG eventually had to list the firms to which the money was actually paid. AIG paid out hundreds of millions of dollars in bonuses to its senior executives. The second half of September 2008 witnessed several attempts by governments to tame the panic in the markets and save individual institutions from bankruptcy. In the US. Alan Greenspan described the fall of Lehmans as ‘probably a once in a century type of event’. it would emerge that having received the bailout. Lehman Brothers filed for bankruptcy protection under Chapter 11. Lehman Brothers – one of the largest Wall Street banks – posted a loss of $3. Merrill Lynch.

In total. though many more receiving smaller payments were unnamed (Williams Walsh 2009).T he sTaG es of T he me lT doWn 35 ($12. Barclays ($8. US mortgage lender Washington Mutual (whose assets were valued at $307bn). It was the biggest public intervention in the markets since the Great Depression and would take weeks to be approved by Congress. The UK’s Bradford & Bingley – the largest provider of ‘buy to let’ mortgages in the country (controlling around £50bn of mortgages) – was part-nationalised. On 25 September. the credit crunch spread further into the European banking systems.2bn).9bn). HBOS. policymakers in the US drafted a massive $700bn rescue package for the American financial system. Towards the end of September. part-sold to the Spanish bank . a banking and insurance giant. AIG named nearly 80 companies and municipalities that benefited most from the Fed rescue.3bn) and Wachovia ($1.5bn) and UBS ($5bn). 12 In the UK at around that time. the country’s biggest mortgage lender.11 Merrill Lynch ($6. Lloyds TSB took over the ailing bank in what would soon prove to be an unwise £12bn deal. Meanwhile. Bank of America ($5. was nationalised. was facing bankruptcy. Political disagreements and uncertainties over the nature of the deal continued to send shockwaves through the global financial system. Citigroup ($2. The deal allowed the Treasury to buy up ‘toxic debt’ from ailing banks. Fortis.5bn). The major foreign banks included Société Générale and Deutsche Bank (nearly $12bn each). was closed down and sold off to JP Morgan Chase.8bn).

Finance ministers from the leading industrialised nations announced action to tackle the financial crisis. On 8 October. Meanwhile. The government also offered up to £200bn ($350bn) in short-term lending support. Eventually. after the company faced short-term funding problems.36 f ina ncial alchemy in crisis Santander. On 11 October. Sweden and Switzerland cut interest rates. When another major UK bank – RBS – required a public rescue the UK financial system came to a standstill. Governments throughout Europe announced multi-billion support packages for their economies. central banks in the US. funding costs rose sharply and for . Over the following days. facing a currency attack and a systemic banking crisis. The Icelandic government took control of the country’s third largest bank. as governments around the world drafted recapitalisation plans for the financial systems. the G7 nations issued a five-point plan of ‘decisive action’ to unfreeze credit markets. Canada. Governor of the Bank of England: in the second half of september. EU. Iceland would approach the IMF for a rescue loan. companies and non-bank financial institutions accelerated their withdrawal from even short-term funding of banks. All these events spurred action. the UK authorities announced details of a rescue package for the banking system worth at least £50bn ($88bn). Glitnir. as carefully described by Mervyn King. Iceland was on the brink of complete financial meltdown. and banks increasingly lost confidence in the safety of lending to each other.

yet as Chapter . recession trends set in and spread globally. (King 2008: 2) The possibility of an imminent breakdown in the UK’s payment system prompted the government to set up a COBRA13-style committee on the economic crisis (Winnett and Simpson 2008).T he sTaG es of T he me lT doWn 37 many institutions it was possible to borrow only overnight. the committee drafted a rescue plan (later known as the Brown-Darling bank recapitalisation plan). similar action was adopted by most countries affected by the credit crunch. these extraordinary policy efforts appeared ineffective. Over the weekend of 4–5 October 2008.14 The continuing crisis and deepening recession prompted multi-level attempts to form a coordinated global policy plan to reform international financial architecture. affecting economic growth in the emerging markets. credit to the real economy almost stopped flowing … eventually. and over the course of the following weeks. Nevertheless. reacting to weakening economic data and ever more tangible signs of economic recession on both sides of the Atlantic. By early November 2008. with the major European countries following the UK in authorising massive recapitalisation plans for their financial system. The US government unveiled a $250bn (£143bn) plan to purchase a stake in a number of banks in an effort to restore confidence in the sector. despite interest rate cuts and other state efforts to restore confidence in the economy. as markets and economies continued to stumble. on 6 and 7 october even overnight funding started to dry up.

and eventually into a global credit crunch which has directly led to a global recession.38 financi al alchemy in crisis 6 below shows. This figure not only exceeds all previous estimates of sub-prime-related losses.2 per cent year-on-year in January. By 2009. At the end of 2008. In March 2009. disagreements over the appropriate course and tone of regulatory action opened up at the transatlantic level. Data reflecting real economic losses globally are sobering. the global financial crisis had been transformed into a global recession. or just over one year’s GDP – suffering more than other regions of the emerging markets. world manufactured output and world trade in manufactures had fallen off a cliff: Germany’s industrial output was down 19. South .16 The loss of stock market wealth alone amounts to $25 trillion. with some believing that the financial markets would not recover their pre-crisis levels until 2012. demand for manufactures. but is close to a year’s world output. the Asian Development Bank (ADB) reported that the crisis had precipitated a total loss of worldwide market wealth of $50 trillion. with developing Asia – where losses totalled $9. the global credit crunch has transformed from a seemingly isolated sectoral crisis in the US sub-prime mortgage market into a cross-border banking and financial collapse. Diagnoses and projections of the nature and duration of the meltdown became more and more pessimistic. Official institutions adjusted their estimates of total losses to much higher levels.6 trillion. over the course of its two-year history.15 Overall.

have spawned a rash of explanations and theories of the credit crisis and its major lessons. let us take a closer look at one particular event that. as argued in this book. The sheer severity and scale of the global meltdown. .T he sTaGes of T he me lT doWn 39 Korea was down 25.6 per cent and Japan down 30. epitomises the politics and economics of the credit crunch: the fiasco of Northern Rock. But before delving into the emergent schools of thought.8 per cent (in Wolf 2009). as well as uncertainties over its potential effects on the economic activity and politics globally.

operational director for securitisation at Northern Rock. London’s Credit Magazine. it was reported. ‘The beauty 40 .2 the tale of northern rock: Between fInancIal InnovatIon and fraud Anastasia Nesvetailova and Ronen Palan In January 2006. it allowed Northern Rock to offload more risk from its balance sheet. three of which were stand-alone issues and the other ten under the Master Trust programme. In technical terms. one of the financial industry’s glossy periodicals. David Johnson.4 million – and one of the largest subordinated debt issuances ever in the European market. explained that the Whinstone transaction allowed the fifth largest UK mortgage lender to reference the reserve funds of 13 Granite transactions. was the first European securitisation programme to transfer ‘first-loss risk’ through a credit default swap contract. congratulated Whinstone Capital Management fund – a part of the British bank Northern Rock – on winning the award for the best securitisation deal of 2005. Essentially. the transaction represented the largest public placement of double-B risk – £117. The deal.

On 18 February 2008. the bank’s shares had dropped to 90p per share. Northern Rock. that securitisation techniques had never discovered new ways of managing or optimising risk. reducing the value of the company to £380 million. In the winter of 2007. he declared. Fortis in Belgium and most of the Icelandic banks. January 2006). quite persuasively. parcelling the reserve funds and writing a credit default swap thereby transferring the majority of Northern Rock’s first-loss risk to the international capital markets’ (Credit Magazine. along with other high-profile financial collapses. by February 2008. became victims of a convoluted chain of securitisation techniques that centred on the sub-prime mortgage industry in the US. but soon paralysed the world financial system. Northern Rock was valued at £5bn. such as Bear Stearns and Lehman Brothers in the US. the UK government announced a controversial decision to nationalise the bank. As the securitisation boom of the decade ground to a halt in the summer of 2007. * * * It is disconcerting how quickly a widely shared belief in new and better ways of managing risk has unravelled and been revealed to have been no more than a grandiose scheme of exuberance. ‘is in its simplicity. greed and fraud.T he Tale of norT he r n ro cK 41 of it’. they merely disguised or . Bradford & Bingley in the UK. observers on the left and right started to argue.

Jersey-based special purpose vehicle (SPV). these three sets of factors can be summed up as market exuberance. Together. The story of the fall of this bank is significant in the analysis of the political economy of the credit crunch. driven by financial innovation. the global expansion of the private risk management industry. how was the securitisation boom sustained for those five years? Why and how were so many dubious debts transformed into liquid assets? We believe that there were three factors supporting the boom of what Claudio Borio. a collective belief that debt – of whatever kind – can be bought and sold endlessly. and third. we focus on one emblematic example of the effects of this process: the fall of the Northern Rock and its offshore. Here. see also Nesvetailova 2007. it illustrates the extent to which the political and legislative environment set the conditions for the global crisis. Granite. The following chapters delve deeper into the analysis of the dynamics driving this complex process. a regulatory environment that occluded the build-up of bad debts and dubious investment practices. chief economist of BIS. 2004. But if the real foundations of financial health in the 2002–7 credit boom never existed. as many analysts now seem to agree.42 f inancial alchemy in crisis reparcelled it. second. regulatory evasion masquerading as innovation and sheer fraud. 2008): first. Encapsulating many wider trends of the global meltdown. . has called ‘artificial liquidity’ (Borio 2000.

Chinloy and Macdonald 2005. as a technologically-driven process of ‘market completion’ (e. Hu et al. most financial innovations – be they institutional changes. financial innovation has been theorised and understood. ultimately brings social and economic benefits and increases social welfare.Th e Ta le of norT h e r n ro cK 43 The controversy over financial innovation For the past three decades. Most theoretical interpretations of financial innovation also concur on the relationship between official regulation and the progress of private financial innovation. lower transaction costs and circumvent outmoded regulation (Silber 1983: 93). Although actors in the public domain tend to lag far behind advances in financial engineering. such as the rise of the hedge fund industry. whether direct or overt. Most accounts of financial innovation explain it as a market-driven process that. much like any other technological innovation in the economy. channels and financial institutions was facilitated by the deregulation of global capital markets and national financial systems starting in the late 1960s (Helleiner 1994. The orthodox view holds that innovations in instruments and institutions improve the ability to bear risk.g. Structurally. Burn 1999). 2005). of the financial industry to official restrictions. at least within financial orthodoxy. . the invention of new credit products. rules or regulations. or product inventions like the myriad of new asset-backed securities and their derivatives – are in fact a reaction.

compliance and other regulatory norms (Chick 2008). financial innovations are often designed. as history suggests. as we noted in Chapter 1. The scheme allowed the SNB and ECB to conduct repo operations1 in US dollars against the usual collateral of the SNB and ECB. accounting. Indeed. Rather. on the other. On the one hand. the precise nature of the relationship between private financial innovation and public control of the financial markets has become the subject of debate in academia and the policymaking community.g. which. tend to involve some type of new financial practice. It is also worth noting that public authorities often tend to ‘innovate’ in their own techniques and methods when reacting to financial crises. as many scholars have pointed out. public monetary authorities and even many analysts have lost track of the essence and purpose of many of today’s sophisticated financial products and techniques. in light of the global crisis. the relationship is reciprocal. in December 2007 the world’s leading central banks – the European Central Bank (ECB). Although .44 fin anci al alchemy in crisis Not surprisingly. be that cross-border trade. the Swiss National Bank (SNB) and the Federal Reserve (the Fed) – entered into mutual currency swap arrangements. reflective and to a large extent cyclical. financial derivatives or mortgage securitisation (e. But. introduced and established in the markets in reaction to changes in official rules on taxation. What is apparent at this stage is that there is no straightforward dynamic between regulation and financial innovation. respectively. Kane 1988).

is. but opted not to leave the Euromarket altogether (Palan 2003).T he Tale of norT he r n ro cK 45 critics at the time said that the measure was neither well coordinated nor justified by the market’s need (Buiter 2007). according to many critics. the interaction between regulation and innovation tends to bring out the evolutionary. The Act was designed to compensate banks for the difference in interest rates between the European and the US financial systems. and attract American funds back into the US economy. character of financial globalisation. Commonly. rather than structured or revolutionary. an outcome of the complex interplay of incentives and governmental controls over finance. economic and structural changes that prompt a wave of financial innovation include: (i) volatile inflation rates and interest rates. In fact. Any new product or practice needs a motive and a context in which to thrive. the notorious Tax Equalisation Act of 1963 was an official US response to the tendency of American banks to invest money in the highly profitable Eurocurrency markets. therefore. Generally. American banks not only failed to repatriate their investments. dating back to the late 1960s. or financialisation. For instance. this example of international regulatory innovation was one of the few of its kind. (The only previous example of such coordinated effort dates back to the policy response to the 9/11 attacks.) Generally. the most recent wave of financial globalisation. (ii) regulatory changes and the circumvention of . Financial innovations rarely emerge ab initio.

with some more able than others to creatively escape even harmonised regulatory restrictions. the ability to avoid regulation may provide competitive advantage to firms in the deregulated market: a legally based level playing-field opens up new sources of competitive advantage. Some 20 years ago. van Horne 1985. interestingly. regulation … becomes a further stimulus for innovative use of law both to defeat unwelcome regulation and to secure advantage over competitors. Specifically. (iv) technological advances. (iii) tax changes. and (vi). cited in Shah 1997). academic work on market efficiency and inefficiencies (van Horne 1985: 622). without necessarily breaking the law’ (Miller 1986. Two of these structural elements are pertinent to our focus on Northern Rock: the circumvention of the regulation and rules of taxation. Shah’s investigation of the workings of regulatory arbitrage in the convertible bond market confirmed that companies are able to design sophisticated schemes of regulatory avoidance with . (v) the level of economic activity. (mcBarnet and Whelan 1992.46 financial alchemy in crisis regulations. the scant literature on financial innovation observed that a great impetus to innovation in finance comes from regulatory arbitrage – ‘a desire to circumvent existing regulations in taxation and accounting. Both factors have been at the epicentre of the global credit meltdown generally and of the fiasco of Northern Rock in particular. The rules of the level playing-field themselves become obstacles to some but not all. cited in shah 1997: 86) At the time.

were at the heart of the Northern Rock fiasco. Thriving in this zone. outright fraud. owing to the significant grey area that exists between compliance with the rules and non-compliance or evasion … The collusion between management. financiers look for alternative ways to make money through commission fees. In turn. These elements. . obscured by the general euphoria of the 2002–7 credit boom and disguised by the sophisticated techniques of modern finance. particularly in common law countries – created a grey zone for competitive financial innovation. lawyers and auditors suggests that there is an avoidance industry out there which is capable of undermining the spirit behind accounting regulations’ (Shah 1997: 99). often.T he Tale of norT he r n ro cK 47 the help of investment bankers and lawyers. bankers. The nexus between these two elements – selfregulation of the financial industry itself and the ambiguity that exists at the juncture between law and new financial practices. financial innovation has produced a skewed structure in the financial system itself. When interest rates are low and the traditional function of financial intermediation – taking deposits and lending – is no longer appealing. Worryingly. tax avoidance and evasion. the regulators. ‘creative accounting’ and. the media and analysts were unable to expose these practices publicly and restrain such creativity: ‘practising creative accounting is not that difficult. they are also representative of more general trends in the financial industry.

at least the one least equipped to handle complex and rapidly changing information. as well as the scandals associated with the dot. entities (SPEs) or investment vehicles (SIVs). The term SPV covers a broad range of entities. if not the stupidest in the room. which ultimately has to bear the resulting risk without enjoying the risk premium that created it. Tax havens have made it exceedingly easy to set up offshore SPVs. but more often than not it is ‘a ghost corporation with no people or furniture and no assets either until a deal is struck’ (Lowenstein 2008). ‘the smarter men in the room’. The argument is that opacity benefits those who are. on the opacity of current accounting practices and the use of affiliate entities based in tax havens either for fraudulent purposes or in pursuit of opacity (Picciotto 2009). Refco. . at least in part. The offshore entities that seem to have caused most of the problems are the special purpose vehicles (SPVs).com bubble. more recently. But these crises revealed a more critical dimension: scandals and frauds not only cheat investors. and have a contagious effect on the entire economy. Parmalat and. The small investor is. The function of both SPVs and SPEs raises severe prudential problems.48 fina ncial alchemy in crisis offshore: The uses and abuses of sPVs Most financial crises in the past two decades. WorldCom. Enron. by definition. they leave many workers without pensions and jobs. have been blamed. Northern Rock and the 2007–9 credit crunch. as one of the directors of Enron reputedly quipped. including those in East Asia and Russia.

The most recent data on external liabilities in all currencies suggest that about 28 per cent of cross-border lending is conducted through such jurisdictions.3 Unsurprisingly. We . A report by the UK’s National Audit Office clearly suggested that they do not (NAO 2007). Luxembourg and Jersey are attracting much of the world’s SPVs. We have no way of knowing.2 to perform appropriate due diligence on what are very sophisticated financial vehicles. There is a broad consensus that the Caymans. For example. however. It seems pertinent to ask whether such small jurisdictions can allocate sufficient resources to monitor and regulate such colossal sums of money. exactly how many of the world’s SPVs are based in these tax havens. The only reliable indicative data can be gleaned from the BIS locational statistics.T he Tale of norT he r n ro cK 49 yet crucially they do not have the resources. Yet considering that they are competing with better equipped but almost equally unregulated centres such as London and New York. Murphy and Chavagneux 2010). the Cayman banking system holds assets of over 500 times its GDP and Jersey holds resources of over 80 times its GDP. Ireland. executives of financial companies do not like to see their names mentioned in the context of scandals or fraud. they have few incentives to ensure that appropriate due diligence and regulation are undertaken. Most of the financial regulations introduced in the past decade are aimed more at placating the Financial Stability Forum (FSF)4 and other such organisations than at ensuring regulation (Palan. especially in terms of people.

50 f inancial alchemy in crisis would like to stress.691.6 2.7 0. Troubb and Winokur 2002: 4).1 205. Enron’s fraud was organised through 3.5 761. partnerships and SPVs in order to shift debt around and make illicit payments to its directors.5 326.3 28. reported that the company created complex financial arrangements. 2008.5 Source: BIS. though.1 The share of ofcs in international financial flows.218. that we do not see the two as being the same thing.8 773.7bn 1. Table 2.226.9 8. International Financial Statistics.7 0.3 1.413.0 % share 5.5 436. not to achieve bona fide economic objectives or to transfer risk’ (Powers.164.0 1.6 1. SPVs hit the headlines following the collapse of Enron.0 71. The report states that ‘[m]any of the most significant transactions [of Enron] apparently were designed to accomplish favorable financial statement results.334.2 2.2 4.3 1. which investigated Enron’s collapse.8 4. The Powers Committee.3 210.1 0.5 1.000 . 2007 All countries Caymans Switzerland Netherlands Ireland Singapore Luxembourg Bahamas Jersey Guernsey Bahrain Isle of Man Total $29.8 4.

T he Tale of norT he r n ro cK 51 SPVs ‘with over 800 organised in well known offshore jurisdictions. northern rock and Granite Northern Rock. Banks. the fall of Northern Rock in 2007–8 raises interesting questions about the role of offshore SPVs in the global meltdown and the nature of financial innovation today more generally. Building societies typically raise the money they lend conventionally. after the wave of demutualisations of the 1990s. on the other hand. including about 120 in the Turks and Caicos. can get ready access to larger sums from the money markets. It appears. began life as a building society in 1965. the fifth largest mortgage lender in the UK in early 2007. Nevertheless. by attracting it from depositors. and about 600 using the same post office box in the Cayman Islands’ (US Senate 2002: 23). rather. This was an aggressive expansion technique: the audit of Northern Rock’s accounts in 2006 showed that it raised just 22 . In 1997. neither the Powers Report nor the congressional hearings demonstrated that offshore structures were palpably more poisonous that the onshore ones in the Enron case. despite headline reports. Northern Rock became a public limited company. Northern Rock was different from conventional commercial banks in that it had a small deposit base and relied heavily on wholesale money markets for its funds. that Enron’s offshore SPVs were set up primarily for tax avoidance purposes. In this context.


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per cent of its funds from retail depositors and at least 46 per cent from bonds. It was this risky financing technique that gained Northern Rock its award for the best securitisation deal of the year in January 2006. Crucially, the bonds that were so instrumental in Northern Rock’s financial success were not issued by the bank itself but by what became known as its ‘shadow company’. This was Granite Master Issuer plc and its associates, an entity formally owned not by Northern Rock but by a charitable trust established by Northern Rock. After the bank failed it transpired that the trust had never paid anything to the charity; the charity in turn was not even aware that the scheme existed. The sole purpose of Granite was, in fact, to form a part of Northern Rock’s financial engineering that guaranteed that Northern Rock was legally independent of Granite, and that the latter was, therefore, solely responsible for the debt it issued. This was plainly a masquerade and one that was helped by the fact that the trustees of the Granite structure were, at least in part, based in St Helier, Jersey. When journalists tried to locate these employees they found none could be found in Jersey. In fact, an investigation of Granite’s accounts showed it had no employees at all, despite having nearly £50bn of debt. The entire structure was acknowledged to be managed by Northern Rock and, unusually, was treated as being ‘on balance sheet’ of Northern Rock and thus included in its consolidated accounts.

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As the credit boom unravelled, Northern Rock faced a dilemma. Granite was used to securitise parcels of mortgages on the money market through bond issues. When in August 2007 the money market lost its appetite for that debt, Northern Rock’s business model malfunctioned: it could no longer refinance the debt. Consequently, it had to support Granite in meeting the obligations it had entered into with its bondholders, even though the company was notionally independent. A similar confusion arose as to whether the company was onshore or offshore. In practice it included elements of both. When Northern Rock was eventually nationalised, debates in the House of Commons ran late into the night: MPs aimed to establish whether the nationalisation of the bank meant that Granite was also nationalised. Yvette Cooper, chief secretary to the UK Treasury, stated that ‘Granite is not owned by Northern Rock; nor will it pass into the hands of the public sector’ (Hansard 2008: col. 277). Alistair Darling reiterated this in a letter to Vince Cable, Liberal Democrat shadow chancellor, on 20 February 2008: ‘Granite is an independent legal entity owned by its shareholders … Northern Rock owns no shares in Granite’ (Accounting Web 2008). In the very same parliamentary debate, however, Cooper also confirmed that ‘Granite is part of the funding mechanism for Northern Rock and it is on the bank’s balance sheet’ (ibid.). So how could Granite be part of the Northern Rock’s funding mechanism and yet be a separate entity? The precise ownership structure of Granite companies


financi al alchemy in crisis

and its financial relationship with Northern Rock are murky. Because Granite is a Jersey-incorporated vehicle and protected under the secrecy laws of Jersey (generally considered an offshore financial centre), there is no way of knowing who really is the trustee of Granite. Consequently, the issue was never resolved. No one seemed to know whether a company wholly managed by a state-owned enterprise but notionally owned by a charitable trust was under state control or not. Despite that, the government had little choice but to extend its guarantee to the Granite bondholders. The consensus is that the Jersey-based offshore structure was used as a securitisation vehicle for mortgages issued by Northern Rock. It is suspected that Granite served as an equivalent of a price transfer channel for the bank, a means by which it could transfer profits earned in the UK to Jersey’s near-zero tax regime. In February 2008, an anonymous source close to Granite admitted that ‘the obligations on Northern Rock as an originator of mortgages continue to exist … It is a financial reality’ (cited in Accounting Web 2008). According to this source, in the event of Northern Rock not supplying Granite with mortgages, it would have to repay the £49bn owed to its investors. In the worst-case scenario, therefore, British taxpayers were to pay twice for Northern Rock: first to nationalise it, and then to honour the bank’s obligations to Granite, which in turn, may be owned by Northern Rock. In the winter of 2008 some MPs raised questions about the precise links between Northern Rock and Granite, but no clear

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answers have been forthcoming. In the meantime, the unfolding financial malaise shifted political concerns to the UK’s increasingly shaky financial system. The confusion created by Granite’s structure is indicative of the larger-scale problem that the use of SPVs, often ‘orphaned’ from their parent through the artificial use of charitable trusts to break nominal control, can create. Yet such structures are commonplace throughout the offshore world and have been widely used for the securitisation of sub-prime mortgages. Curiously, Northern Rock was a relatively ‘clean’ case compared to many; yet when it failed, it exposed the great uncertainty as to how to deal with the resulting situation on the part of almost every regulator who approached the scene. This ambiguity lingered even after Northern Rock had been nationalised and received additional rescue funds from the public. While the government may have settled the issue at Northern Rock, despite the unresolved nature of its relationship with Granite, the existence of so many orphaned SPVs, holding billion upon billion of debts, yet legally separated from their parents, has unnerved banks and investors, contributing in turn to paralysis in wholesale financial markets. In this instance, the fall of Northern Rock is also emblematic of the wider impact of the regulatory background to the credit crunch. Specifically, the way the bank’s failure was handled by the tripartite structure of financial governance in the UK highlights

56 fina nci al alchemy in crisis several fundamental problems that financial regulators encounter in the age of thriving financial innovation. Gordon Brown. In 1997.and macro-approaches to financial regulation and became ‘a result of the Bank’s efforts to ensure that oversight of the financial system did not fall between the gaps in the new institutional structure of supervision’ (Ryback 2006: 7). the separation of the function of information-gathering and processing and the organisational resource capacity simply does not work: ‘the main problem with the arrangement is that it puts the information about individual banks in a different agency (FSA) from the agency with the liquid financial resources to provide short-term assistance to a troubled bank (BoE)’ (Buiter 2008: 17–18). formalised a division of labour between the Treasury. In Northern Rock’s case. then Chancellor of the Exchequer. the FSA for prudential supervision of financial institutions and market segments. failed to compile an accurate picture of the financial . As Willem Buiter argues. First. the information-gathering body. This division of labour was supposed to make the overall maintenance of financial stability more efficient by facilitating a clear distinction between the micro. the arrangement failed in a number of ways. and the Treasury for the overall institutional structure of financial regulation and the legislation which governs it. the Bank of England is responsible for monetary policy and systemic financial stability. the Bank of England and the newly established Financial Services Authority (FSA). According to this ‘tripartite’ arrangement. the FSA.

000 staff working at the FSA. Second. The Bank of England and its Governor have been criticised for acting too slowly or simply being out of touch with the developments in the markets and the risks involved in the securitisation process. Of the 3. The supervisory reviews of the bank’s books were only conducted every three years. The Treasury has been . the FSA’s implementation of the few rules on liquidity risk also raised concerns. It transpires that the FSA had neither the knowledge nor the resources to oversee and make sense of the growing complexity of securitised portfolios of individual banks. and of Northern Rock in particular.T he Tale of norT he r n ro cK 57 health of the bank. other parties to the tripartite arrangement are blamed for the Northern Rock fiasco as well. The fact that Northern Rock – which held approximately 20 per cent of the mortgage market – raised three-quarters of its funds through short-term borrowings did not alert the supervisors. In the midst of the unravelling crisis (July 2007). which was clearly not adequate to form an accurate picture of risk exposures in an environment where most risks are ‘marked to market’ and are therefore extremely volatile. only three were reportedly dealing with Northern Rock. Probing questions about the bank’s finance model (relying on wholesale markets for funds) and its liquidity position were never asked. Northern Rock was allowed to pay out large dividends to its shareholders.5 Third. which drained much-needed cash from a bank tightly dependent on the ailing sub-prime market in the US.

Fourth. During 2007. in the summer of 2009 the Financial Times would reveal that a special simulation test conducted by the Bank of England in 2004 had detected a strong likelihood that Northern Rock and other UK banks would go into crisis. was paid $1. Most scandalously of all. The Northern Rock crisis has raised many issues about how private financial gains and socialised losses are addressed by political leaders. the bank’s senior management were . the tripartite arrangement as a whole failed in the task of passing information from the FSA to the Treasury. a month later. is one of the many uncomfortable puzzles of the credit crunch. as is maintained in this book. he cashed in shares worth more than £2 million. On 14 August 2007. Northern Rock’s former CEO. the Treasury did nothing to prevent the collapse (Moulton 2008). When he resigned.5 million bonus. by taking the initiative in the Northern Rock case.36 million. the Treasury was told that Northern Rock might run out of money. the bank did just that. on 14 September 2007. In the midst of the collapse. imposing a political solution to nationalise the bank (Lascelles 2007). Applegarth reportedly was paid a $1. (In 2006.58 financial alchemy in crisis faulted for overriding the terms of the agreement and. In the period between those dates. Adam Applegarth. Why nothing was done in the years that followed and why the bank was encouraged to continue with its aggressive and dubious financial strategy remains.

The secrecy and lack of transparency offered by offshore financial centres facilitate outright scams. quasi-legal Ponzi schemes or regulatory avoidance techniques. market segment or even a financial model. the crisis is the outcome of a political and legal regime which has facilitated the privatisation of gains from financial risks at the cost of socialising their losses – in other words. and prominent. The UK government was prepared to accept the arrangement. The scheme that Northern Rock set up with its Jersey SPV illustrates one of the problems the financial markets face.) But apart from this. sub-prime lending and hence the current crisis are not the outcome of one malfunctioning institution. Merrill Lynch and UBS. sweeping under the carpet the complex legal situation . preventing public authorities from adjudicating in cases when private financial manipulation leads to systemic risks and public losses (Palan 2003). the tale of Northern Rock raises concerns about how many other companies might be benefiting from similar schemes through the use of structured finance and complex investment pyramids. Citigroup. JP Morgan and Morgan Stanley. underwriters were Barclays Capital. Lead underwriters on the Granite programme were Lehman Brothers.000 in compensation pay. Rather.T he Tale of norT he r n ro cK 59 offered £100. vehicle of financial innovation. a regime that has made the pyramid (or Ponzi) principle a legitimate. The list which links the names of the world’s largest investment banks with an obscure offshore financial scheme suggests that bad debts.

it was a flawed understanding of the effects of financial innovations on the liquidity. Specifically. banks and other financial intermediaries have no recourse but to rely on each other’s goodwill. the crisis was brought about by the multifaceted illusion of liquidity that. Ambiguity of this sort may be ignored in good times.60 fina nci al alchemy in crisis it found itself in. and hence stability. In contemporary finance. namely. why so many dubious debts were regarded as safe investment vehicles for so long. plays a crucial role in perpetrating mistrust – and for good reasons. The web of offshore entities. of the economic system that precipitated the global meltdown. but in times of crisis it proves extremely damaging. where at least half of all international lending is conducted through offshore jurisdictions and such ambiguous arrangements. raises another concern about the systemic role of financial innovation today. The fall of Northern Rock. Private investors are not as forgiving. as the following chapters show. As is argued in the following chapters. In other words. while temporarily . a Ponzi investment principle. with its use of an obscure finance scheme and. knowing full well that most if not all of their counterparties holding accounts and SPVs offshore are beyond the scrutiny of any regulatory authority. one answer to this puzzle (and some others) of the credit crunch centres on the contentious notion of liquidity in finance today. orphaned and legally separated yet holding massive amounts of debts. essentially.

it is worth examining how the crisis has been understood so far and what questions about the global credit crunch remain unanswered. in the end proved to be a dangerous and destructive myth.T he Tale of norT he r n ro cK 61 profitable. But before we turn to this part of the story. .

Ex-post explanations were put forward once the crisis started to engulf world markets. credit crunch theories can be divided into ex-ante and ex-post explanations. broadly there are two ways to differentiate and classify the rapidly evolving theorisations of the credit crunch: on the basis of time and on their theoretical grounding. The ex-ante theories. are those that warned about the possibility of such a collapse – and eventually predicted it – before the events of 2007 engulfed world markets. Focusing mainly on the latter. as the term suggests. Ex-Ante and Ex-Post Visions of the credit crunch At first cut. to high-profile policy discussions commissioned by official bodies and academic analyses. 62 . These range from popular commentary.3 how the crIsIs has Been understood The continuing economic malaise has produced a whole industry of credit crunch analytics. this chapter aims to systematise the spectrum of emerging views on the nature and implications of the financial meltdown. blogs on crisis-related issues and journalistic investigations. Whilst readings of the crisis do overlap.

conflicts of interest and profound structural dislocations). and deeper scholarly analyses of the credit system that detected profound abnormalities and tensions accumulating in the economies of ‘advanced’ Anglo-Saxon capitalism. as well as globalising trends across markets. and to what extent one can talk about a distinctly ‘new’ type of political economy in the twenty-first century (as defined by revolutions in technology. an important element shaping the different opinions is the role that consumption and debt have come to play in the countries of Anglo-Saxon capitalism. polities and cultures). the ex-ante theories originated both in a simple ‘gut-feeling’ understanding of what was happening in the financial markets.hoW T he crisis has B een un de r s Too d 63 Within this rather broad classification. Whereas more pessimistic predictions of the imminent collapse of US debt-driven consumption . The ex-post theories can in turn be classified into those that view the credit crunch as a cyclical event and those that see it as a structural crisis. communications and finance. Specifically. Here. as opposed to ‘capitalism as usual’ (a system marked by periodic crises. the distinction focuses on what is ‘normal’ and what is ‘abnormal’ in the structure and functioning of the economic system. Apart from the timing. the basic difference between these two schools of thought is their reading of the place of finance in the evolution of capitalism more broadly. the sheer sense that the Anglo-Saxon economies were overheating and asset and financial bubbles would soon burst.

four years of falling credit spreads. who preferred to remain anonymous: We were paid to think about the downsides but it was hard to see where the problems would come from. The Global Credit Crunch as an Exogenous Shock Within this ex-post group of analyses. efficient and diversified. In most cases. the dominant mood in the markets during 2002–7 is probably best expressed in the admission of a risk manager of a global bank. political leaders and observers totally by surprise. Ultimately.64 financial alchemy in crisis emphasised the destructive role of unprecedented levels of debt in the US and the global economy. many ex-post theories of the credit crunch interpret the rise of debt and consumption as sustainable and constructive features of the new type of economy. they were simply dismissed or. penalised. market regulators. one interpretation of the crisis stands out: the reading of the global credit crunch as a ‘surprise’ event – a shock that took most financiers. worse. during the credit boom such ideas were at best taken as purely hypothetical and remote possibilities. Instead. making the economy more flexible. low interest rates. And although in the wake of the crisis many market traders have confessed that they understood full well that the bubble could not continue to expand indefinitely. virtually no defaults in our loan portfolio . the deregulation of the financial system has popularised access to credit and finance. as argued from these perspectives.

this logic seems rather odd. we went through this in the eighties and early nineties.’ (in Gimson 2008) Moreover. eventually come to an end. taking the real economy into recession. In hindsight. it doesn’t matter if i’m running up the money on my credit cards because next year i’m going to earn more. the crisis should have been a relatively minor event in finance. they comment that complacency and collective reliance on fashionable techniques of trade and risk valuation have taken the markets into the crisis. everyone borrowing up to their eyeballs. crisis or painful recession.hoW Th e crisis has B e en un de r s To o d 65 and historically low volatility levels: it was the most benign risk environment we had seen in 20 years. All booms. (The Economist. even if risk managers did acknowledge that the history of finance offers unsettling lessons about bubbles and crises. typically with a crash. reflecting a price correction in one isolated sector of the global economy – the US sub-prime mortgage sector (Dymski 2009). the air of general optimism translated into pervasive short-termism and lack of basic foresight and accountability among market players: … things go in cycles. In this sense. according to his colleague at Barings. The fact that house prices and the . The fact that such a ‘correction’ spilled over into a global financial meltdown came as a shock that ruptured the workings of most financial systems around the world. 7 august 2008) As a result. We said then: ‘Well hell. whether small or large. and that some events in the markets in 2006 had implied that the credit boom might unravel. anyone who believes things are going to go on up forever is a fool.

as we shall see in Chapter 4). Yet there are also reasons why long-term historical regularities and warning signs were ignored or dismissed. the unprecedented rise of the financial sector to a dominant position in the economy. Williams et al.66 financi al alchemy in crisis financial sector’s profits grew exponentially in a decade to historically unprecedented levels in all Anglo-Saxon economies should have alerted many people (as in fact it did. Blackburn 2006. They concern a peculiar anthropology. as a culmination. yet often having minimal understanding of the ways the economic system works as a whole. Langley 2008. brand or logo capitalism. 2002). To begin with. Seabrooke 2006. Having embarked on a career in finance or banking in the past 10–20 years. the changed character of work and. the rise of the digital economy. finance and credit are only one facet – albeit a defining one – of the general short-termism of contemporary society as a whole. the financial system itself has come to be defined by the paradigm and practice of scientific finance (Greenspan 2001. Second. typically with excellent and highly specialised training in mathematics and physics. The many other dimensions of such short-termism include changing patterns of production. Montgomerie 2009). demography and the political economy of today’s financial industry. this process has been viewed as the financialisation of everyday life (Martin 2003. The major engine of financial innovation today is in the hands of a class of young and narrowly educated geeks. 2008. Academically. these professionals have no .

as one insurance broker noted: We did the south sea Bubble at school. The fact that this wonderful system could unravel so quickly and with such disastrous consequences came as a shock – a nasty one – to many of them. While most of them would be familiar with the story of the 1929 Crash.hoW T he crisis has B een un de r s Too d 67 memory of earlier recessions or even structural financial crises. as far as this new generation was concerned. (in Gimson 2008) During the boom years of 2002–7. and many might remember the collapse of Barings in 1995 or the 1998 LTCM fiasco. therefore. Indeed. their role was to make the sophisticated and complex financial markets work more efficiently. . the ‘shock’ vision of the global crisis has also been common in courtrooms and on news screens. by applying scientific approaches to managing risk and various quantitative methods of valuing the balance of risks and rewards for a particular company or class of assets. Criticised for his direct role in creating the bubble of easy credit during the 1990s/early 2000s. they would tend to interpret these as dark episodes in the ‘older’ type of capitalism (and hence irrelevant to the ‘new economy’ of the twenty-first century) or as isolated collapses of companies that miscalculated in their investment strategies and thus do not represent any of the main trends in finance. so we know how it works … it was clear that the property bubble was going to burst but it would have been nice if it had deflated slowly rather than popped. Interestingly.

bluntly. Dozens of the largest financial institutions in the world have lost over $300 billion to date on the same investments’ (Kelly 2008). 17 October 2008). (Brown. the risks unleashed and accentuated by the . What we had no idea. Lord Turner. The British prime minister. regulators and policymakers also tend to emphasise the extraordinary character of the crisis and the fact that it took most people by surprise. a newly appointed boss of the FSA. noted: ‘In April of this year everybody knew that something pretty big had happened to the world’s financial system. But sometimes the reality is that defining moments of history come suddenly and without warning … an economic hurricane has swept the world.68 financi al alchemy in crisis Alan Greenspan called the crisis a ‘once-in-a-century phenomenon’ (Greenspan 2008b). one of the Bear Stearns executives charged with a nine-count indictment of conspiracy and securities and wire fraud. creating a crisis of credit and of confidence. however. Defending Ralf Cioffi. was how extreme it was going to be …’ (Financial Times. 4 march 2009) Outside the courtroom. his lawyer argued: ‘the credit crisis took everyone by surprise. Gordon Brown. Indeed. including the Fed and the Treasury. In October 2008. followed the same line: We tend to think of the sweep of destiny as stretching across many months and years before culminating in decisive moments we call history. Baffled and incapacitated by the scope of the meltdown. it simply does not make sense to view the crisis as a surprise or shock.

the reliance of banks in many countries on revenues from dealing with the household sector. (White 2006: 5–6) So what should one make of ‘shock’ explanations of the credit crunch? On the one hand. Enron.hoW T he crisis has B een un de r s Too d 69 securitisation process. 1994–5. had been noted repeatedly by many commentators long before the boom started to unravel in the summer of 2007. more broadly. Parmalat. event. 1987. none of the financial crises of the past 30 years was understood . and increases the likelihood of operational problems. When it did experience breakdowns (in 1982. According to the philosophy of self-regulating and self-correcting markets. already heavily indebted. etc. 1997–8 and 2000). Either way. could in the future prove a source of financial vulnerability … [T]hese exposures might also have increased over time in response to successive episodes of monetary easing and associated credit expansion. To take just one example. they were easily dismissed as problems specific to the financial structure of the emerging market economies. – as isolated episodes reflecting troubles in individual firms. certainly a once-in-a-career. as well as the fragility of the US mortgage market and the economy as a whole. William White of BIS observed in 2006: … the opacity and complexity of the financial system today shrouds in secrecy who finally bears the risks. it is understandable why many market practitioners and politicians view the global crisis as a once-in-a-lifetime. or – in the case of the crises of the LTCM. the global financial system seemed to have worked smoothly and efficiently for several decades.

as the term suggests. Greenspan. The sheer scale of the global meltdown certainly came as a shock to all of those who thought that financial capitalism had reached new. Thus the ‘shock’ theory of the crisis has some superficial plausibility. explains nothing in terms of its real causes. In this light. both intellectually and politically. and involves an element of a shock.70 f inanci al alchemy in crisis to require a global response. these explanations are simply unhelpful: stressing its immediate effects. believes that it is impossible to draw any lessons about the financial system in the future: ‘In the current crisis. as in past crises. it is telling that the thesis about the ‘shock’ of . we can learn much. ‘advanced’ capitalism – until. Yet characterising the global crisis as an extraordinary episode. essentially because it did not reflect systemic flaws in the financial systems of the core. while recognising the crisis as potentially ‘the worst since World War II’. for instance. the gloomy autumn of 2007. that is. reflects a lack of anticipation and foresight. or a once-in-a-lifetime event. On the other hand. Moreover. 16 March 2008). the ‘exogenous shock’ interpretations of the crisis are problematic. But we cannot hope to anticipate the specifics of future crises with any degree of confidence’ (Greenspan. Every crisis. while emphasising the scale of the disaster. these theories make it impossible to draw any long-term lessons about the nature of the crisis in its historical context. sustainable and historically unprecedented levels of development and growth. and policy in the future will be informed by these lessons.

structural Theories of the credit crunch The Crisis of Anglo-Saxon Capitalism Theories that come under this heading aim to inquire into the long-term causes of the financial meltdown. social. they tend to see the credit crunch as a crisis of Anglo-Saxon capitalism more generally: while it is in finance that the crisis has been most apparent. these views can be classified as structural or cyclical explanations of the global meltdown. At the same time. but largely predictable result of the operation of a type of economy that had replaced the Keynesian welfare state of the . economic. As such. Broadly. in reality the meltdown is more pervasive. the emergent theories of the credit crunch have incorporated deeper scholarly inquiries into the nature of finance today. cultural and ideological foundations of market-based capitalism.hoW T h e crisis has B e en un de r s To o d 71 the global meltdown has become one of the dominant theories of the credit crunch in policymaking circles in both the UK and US. overlapping the political. The ‘exogenous shock’ readings of the global meltdown therefore appear opportune to those who are reluctant to question the underlying belief in the selfcorrecting forces of the market and interpret all major disruptions – however frequent – as extraordinary events. Thus emphasising the historical origins of the current crisis. structural theorists view it as a specific.

Turner 2008. the growth of debt-financed consumption and business activity has been more pronounced in the UK.5bn.1bn to $14. higher than in any other major industrialised economy. is the key structural cause of the meltdown.374. Gamble 2009. In 2007. Wade 2008. and its role in the overall economic organisation. and total private sector debt had risen from 133.5 trillion in debt. leaving the country more vulnerable to the effects of the credit crunch. Pettifor 2003.72 f inanci al alchemy in crisis 1950s–1960s with a neoliberal model of capitalism. The ratio of debt . personal debt jumped from $5.). both private and corporate. individuals in the UK held over £1.5 per cent of GDP to 227. debt-financed consumption.547. Shiller 2008. 2002. the consumer-driven pattern of recovery from previous crises and a general hedonistic basis of socioeconomic relationships that have come to define the culture of American-style capitalism (Altvater 1997. And according to Turner (2008). The debt-driven culture has produced its own category of ‘new poor’ – the middle classes – who now account for the bulk of personal debt (Pettifor 2003). Tily 2007. have been growing much faster than incomes and wages in the Anglo-Saxon economies. minimal savings. Debt. etc. In the US over the course of the decade. deregulated capital markets.4 per cent during the first ten years of the New Labour government. The levels of borrowings. The financial meltdown of 2007–9 is thus only a reflection of many other deep-seated crisis tendencies brewing in the structure of this model – a crisis brought about by a combination of short-term policy targets.

or what Greenspan called ‘active credit management’ (in Morris 2008: 61). it is interesting that another group of structural theories of the credit crunch takes . an explosion of leveraged buyouts and other financial excesses. as an inevitable result of the Anglo-Saxon mode of capitalist organisation. Emphasising the role of key features of such a model.4 per cent to a post-1945 record of 139 per cent (Turner 2008: 26–7). sparked by the fiasco of the sub-prime industry in the US. Many historically-oriented and systemic visions see the crisis. these economies have been affected by the credit meltdown not through their own role in the credit super-bubble but through the externalisation of the crisis from the US financial system to the global level. These in turn were unleashed by a regime of historically cheap and easy credit which was made possible in the era of low consumer price inflation and aggressive competition among financial institutions for new profits. they also point out that economies that have followed a different trajectory – such as the ‘welfare’ capitalism of continental European states or the Asian developmental economies – have escaped the excesses of financial speculation and debt-dependent growth. In the long run.hoW T he crisis has B een un de r s To o d 73 to disposable income went up from 93. therefore. therefore. In this instance. This vast growth of debt was evolving into what George Soros (2008) has called a ‘super-bubble’ – a concoction of a housing bubble. and thus unravelled. both the credit super-bubble and debt-financed consumerism were unsustainable. Essentially.

with the funds coming from a combination of reduced fiscal deficits and increased domestic . not least by the economist Ben Bernanke. The abnormality has been noted by many. Essentially. who in 2005 explained the huge increase of US current account deficit by ‘a remarkable reversal in the flows of credit to developing and emerging-market economies. effectively blaming the crisis on the role of emerging markets – mainly East Asian exporters – in skewing the balance in the world macro-economy. International Imbalances: Naughty Asian Exporters This school of thought views the credit crunch as a result of a structural discrepancy at the international level. so the argument goes. Trying to rebuild their economies in the wake of the 1990s crises. He then elaborated on why the Asian countries and other raw material exporters chose to transfer their savings to the mature markets.74 financial alchemy in crisis a diametrically opposite view. the governments of these countries have acted as financial intermediaries. the crisis is the unwitting outcome of an abnormal state of affairs in world financial flows. channeling domestic saving away from local uses and into international capital markets. a related strategy has focused on reducing the burden of external debt by attempting to pay down those obligations. a shift that has transformed those economies from borrowers on international capital markets to large net lenders’ (Bernanke 2005).

hoW T he crisis has B een un de r s Too d 75 debt issuance. and to diffuse it efficiently through the advanced system of financial intermediation to those who were assumed to be best placed to bear it: . Japan and some of the other major industrial nations. This glut boosted US equity values during the stock market boom and helped to increase US home values during the more recent period as a consequence.) 6 4 2 0 –2 –4 –6 –8 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 6 4 2 0 –2 –4 –6 –8 Emerging Asia United States 1995 1997 1999 2001 2003 2005 Figure 3. Within the US. Overall. reducing US national savings and contributing to the nation’s rising current account deficit. Bernanke argued. this strategy also pushed emergingmarket economies toward current account surpluses.1 current account imbalances as a Percentage of GdP (1975 Q1–2006 Q4) source: Bracke and fidora 2008. this shift by developing nations. together with the high saving propensities of Germany. widening homeownership was supported and facilitated by securitisation – the ability of financiers to price the risk in mortgages and other loans. (ibid. of necessity. resulted in a ‘global savings glut’.

reflecting the surprisingly strong performance of the world economy and still abundant liquidity’ (BIS 2006: 98). 1 The bank commented that ‘conditions in the major financial markets remained calm and accommodative for much of 2005 and early 2006. The mortgagebacked security helped create a national and even an international market for mortgages … This led to securitisation of a variety of other consumer loan products.76 financial alchemy in crisis The development of a broad-based secondary market for mortgage loans also greatly expanded consumer access to credit. it was argued. By reducing the risk of making long-term. (Greenspan 2005) At the time. Dollar reserves. the new financial relationship between the emerging markets and advanced capitalist economies became so paramount to world economic stability that it was even named a ‘Bretton Woods 2 system’. reflected ‘the exceptional depth and liquidity of the US financial markets. the secondary market helped stimulate widespread competition in the mortgage business. which makes it attractive for . in turn. a similar understanding of the global liquidity glut was of fered by the BIS. such as auto and credit card loans. fixed-rate loans and ensuring liquidity for mortgage lenders. the US could run massive trade deficits without seeing the dollar fall against the currencies of the ‘periphery’ because the latter were anxious to accumulate dollars and maintain their position in the American market. However ‘abnormal’ though. Within this unique arrangement.

7 –23.5 –40.9 –87.1 137.3 –30.3 45.3 –120.6 –23.0 148.4 138.7 65.3 8.9 17.8 –23.2 –30.2 –530.2 –342.0 3.3 –10.8 5.3 .2 –2.0 –8.1 10.2 Middle East and Africa 5.5 –15.1 –6.4 4.6 0.4 21.4 39.8 3.5 Statistical discrepancy Source: Bernanke 2005.1 –20.4 17.7 47.hoW T he crisis has Be en un de r s To o d 77 Table 3.9 –14.2 88.1 Global current account Balances.4 12.5 205.8 7.5 20.8 7.9 Eastern Europe and former Soviet Union –13.8 –13. 1996 and 2003 (billions of us dollars) Countries Industrial United States Japan Euro Area France Germany Italy Spain Other Australia Canada Switzerland United Kingdom Developing Asia China Hong Kong Korea Taiwan Thailand Latin America Argentina Brazil Mexico 1996 2003 46.5 55.9 4.1 42.4 –39.6 25.0 11. 41.5 24.2 –2.9 29.


financi al alchemy in crisis

other countries to hold assets in this form’ (Eichengreen 2007: 2–4). In the meantime, the Asian exporting countries were criticised for keeping their debt markets underdeveloped and shallow: ‘Large Asian holdings of U.S. debt are usually attributed to the region’s penchant for undervalued home currencies, which lead to chronic trade surpluses and a buildup of foreign reserves.’ Such excess liquidity, or savings glut, according to observers, was stunting their growth.2 The explanation was found to be in the nature of market openness and competition: according to market commentators, Asian savings tend to sit in savings accounts, creating vast pools of liquidity that enable banks to offer mortgages and loans at rates with which the originators of securitised loans cannot compete. Analysts at the time concluded that ‘a liquidity glut is mitigating against Asia’s capacity to generate an adequate supply of financial assets that will allow it to keep its savings at home’ (Mukherjee 2007). As the securitisation boom imploded, proponents of the ‘liquidity glut’ were quick to identify the root cause of the credit crunch. It was not so much the debt embedded in the structure of the economies, but the global savings glut coming from the Asian exporters. Barry Eichengreen, for instance, while recognising the role of the ideology of deregulation and self-governed finance, commented that the crisis was produced by ‘the change in the global financial landscape [that] is the rise of China and the emerging-market savings glut that flooded U.S. markets with cheap funds’ (Eichengreen

hoW Th e crisis has B e en un de r s To o d


2009: 2). At about the same time, Hank Paulson, outgoing US Treasury Secretary, diagnosed the causes of the crisis in his own way:
superabundant savings from fast-growing emerging nations … put downward pressure on risks and yield spreads everywhere … This laid the seeds of the credit bubble that extends far beyond the us sub-prime mortgage market and now has burst with devastating consequences … (Paulson, in Guha 2009)

As can be seen, the credit crunch has long-term causes, those specific to the countries of Anglo-Saxon capitalism and those reflecting the international scene, as reflected in the ‘global liquidity glut’ theses. Politically, these diagnoses may be quite uncomfortable. While the emphasis on the role of debt-driven consumption places the blame for the crisis on the political institutions and ideology of market-led capitalism, theories based on the argument about international imbalances effectively tell the story of the crisis as precipitated by naughty Asian exporters, thus absolving the agents and institutions of finance in supposedly advanced economies of their share of responsibility for the global meltdown. Arguments between the two camps will surely linger in the wake of the global meltdown. What is important to note is that while reflecting the broader historical and geopolitical context of the credit crunch, these views rarely delve into the trends that defined the specific character of the 2002–7 financial bubble. In order to understand such trends and their role in the crisis, we turn next to the cyclical explanations of the credit crunch.


f inancial alchemy in crisis

cyclical Theories of the crisis
The End of the 2002–7 Credit Boom Chronologically, the global credit crunch came as the end of the preceding housing and credit boom centred on the North Atlantic economies. This ‘boom-and-bust’ sequence led to a common reading of the crisis that has its origins in the business cycle theory of finance and economy. At its core, the theory derives from the Austrian school of political economy and is based on the assumption that in the long run any economic system necessarily goes through periods of boom and bust, expansion and contraction. Crises therefore are cyclical – or transient – events, marking the natural ‘bottoming out’ points of economic activity between the two major phases of the cycle – expansion (boom) and contraction (bust). In this view, any crisis is caused by, and reflects, the dynamics specific to the expansionary period in question, as opposed to being the outcome of a more inherent – structural – disruption to the political-economic system as whole. This vision, therefore, makes crises appear natural, normalising events in the course of the economic cycle. In the context of the global credit crunch, the business cycle approach to crisis is built on the argument that the crisis originates in a problem specific to the 2002–7 expansion of the credit system. At its heart lies the problem of pricing risk. According to cyclical explanations, the underlying cause of the continuing malaise is the markets’ increasing tendency

hoW T he crisis has B een un de r s To o d


to under-price financial risks during the boom years of 2002–7. Thus the booming housing market, low inflationary monetary policy, constant competitive drive among banks and financial houses for commissions and aggressive techniques of investment, underpinned by expectations of unbroken increases in housing values, have blunted the financial sector’s ability to value risks and rewards accurately. This in turn pushed investors into more risky assets and techniques of trade:
… although the sub-prime debacle triggered the crisis, the developments in the u.s. mortgage market were only one aspect of a much larger and more encompassing credit boom … aspects of this broader credit boom included widespread declines in underwriting standards, breakdowns in lending oversight by investors and rating agencies, increased reliance on complex and opaque credit instruments that proved fragile under stress, and unusually low compensation for risk-taking. (Bernanke, 13 January 2009)

Many factors contributed to the problem of mispricing risk. These include permissive monetary policy, a conflict of interest in credit rating agencies, some more technical problems with models and techniques of pricing risks commonly used by financial institutions, such as value-at-risk (VAR) models, as well as a lack of effective regulatory oversight over the markets:
regulation, or the alleged lack thereof, was indirectly to blame for the crisis through providing the illusion of control and involving banks and the fsa in endless detailed matters that distracted them from the big picture. furthermore, regulation of conventional financial services drove banks into unknown areas, notably the use of financial

therefore. (ambler 2008: 8) Generally. cyclical views of the credit crunch accommodate another crucial aspect of financial volatility: the human factor. Rather.82 f inanci al alchemy in crisis packages. Altogether. the cyclical theory stands in stark contrast to those views which emphasise that the sheer magnitude of the crisis calls for an overhaul of the entire edifice of finance. including the paradigm of financial regulation and governance. importantly. the cyclical theory of the credit crunch holds that the credit boom of 2002–7 and it subsequent bust in 2007–9 did not reflect structural or systemic flaws in the financial system as such. it is argued. Incompetence and Exuberance Within the range of cyclical theories of the crisis. the crisis was caused by a combination of factors – policy-related. This socially motivated policy has relaxed lending criteria in the financial industry and pushed financial institutions into risky and opaque areas. one strand of interpretation stands out in particular. The Human Factor: Greed. securitisation and complex derivatives. Also. . the crisis was the result of long-run efforts by Anglo-Saxon governments to encourage low-income people to become homeowners. behavioural and market-specific – that together diverted the markets away from a correct strategy and attitude to pricing risks. As such. which ultimately proved unsafe.

The focus of these theories tends to be twofold: first. as well as a lack of transparency or. it can be called the ‘greed. The ‘expertise gap’ thesis relates to the dilemma of asymmetric information that financial agents and market regulators tend to encounter. which became the defining feature of the most recent bout of securitisation. supervisors and policymakers). simply. The two problems. while intertwined. opacity of financial practice. and second. The ‘skewed incentive structure’ argument captures managerial and institutional problems associated with the changes in banking and financial systems generally. These include the erosion of incentives for financial dealers to be prudent when taking on risks and the lack of proper incentives (such as pay) for regulators to attract and retain personnel sufficiently competent to keep up with the latest innovations in the financial markets. place greater emphasis on some of the implications of the process of financial innovation and competition. while viewing the crisis as the inevitable end of the preceding credit boom. incompetence and exuberance’ school.hoW Th e crisis has B e en un de r s To o d 83 Broadly. . it is the problem of the knowledge or expertise gap associated with the process of financial innovation. What makes these analyses distinct is that their advocates. it is the so-called skewed structure of incentives affecting both the agents of financial innovation (market actors) and those who are tasked with overseeing the process (financial regulators. stress different aspects of financial transformation.

and typically more conservative.84 fina ncial alchemy in crisis With increasingly fierce competition in the markets generally and growing specialisation within financial firms themselves. They’ve been lending out money on securities that are worthless.. we went through this in the eighties and early nineties. ‘scientific’ finance the traditional. There was always someone overseeing someone to see things didn’t go too far. have no sense of responsibility.’ Now..’ In the 1940s. inexperienced traders for adopting aggressive practices from the US. they entered straight from university and were allowed to take extraordinary risks: ‘They’ve been doing it for years but it’s been hidden …’ A 43-year-old fiduciary risk manager at Barings agreed: ‘Everyone borrowing up to their eyeballs. it doesn’t matter if I’m running up the money on my credit cards because next year I’m going to earn more”’ (in Gimson 2008). blamed young. bank manager became an anachronism – hence the list of faults attributed to the geeky culture of Americanised finance centres on the issue of unaccountability and greed. when he started. In the sea of new. The problem of unaccountability and lack of ethical standards in finance goes beyond financial dealers and . recruits were regulated: ‘They had experience. One anonymous 78-year-old accountant. years of it. he said. it was the younger generation of employees – and institutions more broadly – who came to shape the face of global finance. who spent 60 years working in the City. ‘The trouble today is that the people . We said then: “Well hell. before they got to a position of responsibility.

The tendency of the private market to bypass any set of regulations that circumvent its profit-making potential is well known and has been noted among others by economic and financial historians (Kindleberger 1978).hoW T he crisis has Be en un de r s To o d 85 institutions. the rise of institutional investors and the development of the ‘shadow banking system’. now increasingly oriented towards taking and passing on risks. In the wake of the global crisis. rather than taking on and managing the risks themselves. where the two institutions responsible for financial stability – the Bank of England and the FSA – have been exposed for their lack of vision. their sluggish reactions to the unfolding crisis and simply not being up to the task or . Some of the most staggering examples come from the UK. as well as on the role of managerial practice and business conduct within the financial industry itself. It also has important implications for various segments of financial practice and control. it describes the institutional transformations of banking and finance that have paralleled the erosion of the function of traditional banking. and the corresponding transformations within financial institutions themselves. on the other. proper insight into the state of the financial sector. On the one hand. the failure of regulatory and supervisory bodies to read market developments accurately has come to light on many occasions. As such. it captures the inherent conflict between financial market developments and the reach of the regulatory oversight. these schools of thought place greater emphasis on the role of policymakers and regulators in creating the crisis.

this policy. David Blanchflower. many commentators (e. First. Amery 2008) have pointed out that the main problem of the pre-crisis regulatory system was the classic case of moral hazard. and increasingly risky. But criticisms of the official policy stance are manifold and go beyond those directed at individuals. Third. thus prompting financial institutions to invent new. there are those critics who argue that it was not the lack of regulation but rather the plethora of financial . Nor did it try to anticipate the kind of shock that the collapse of Lehmans in September 2008 would deliver to the British financial system (in Hutton 2009). a member of the Monetary Policy Committee at the Bank of England. ways to manage and redistribute the debt to third and fourth parties. freely admits that the regulator did not understand the risks banks and building societies which had grown so reliant on the money markets for their funding were taking.g. Chris Rexworthy. according to many analysts. Anecdotes about the breathtaking incompetence of regulators and supervisors abound. the credit crunch was the direct result of a long-standing political aim of the Anglo-Saxon governments to encourage wider homeownership and access to credit. Second.86 financi al alchemy in crisis ‘asleep at the wheel’. admitted that he considered resigning in August 2008 at the point when the UK economy was sliding into recession. placed a large chunk of bad debt in the hands of people who are least able to hold it. driven by social motives. a former director of the FSA. but the Bank produced an inflation report that did not mention the word. As is being argued.

those responsible for the grossly irresponsible credit derivatives trading and the ensuing risk exposure were not people who had been quantitatively trained. where senior managers often had no idea about the composition.hoW T h e crisis has B e en un de r s To o d 87 norms and regulations that encouraged financiers to seek ways of bypassing the official regulatory system and exploit regulatory arbitrage: ‘The over-regulation of traditional financial services shifted enterprise towards the complex financial engineering of packages unknown to. and not understood by the FSA or UK Treasury’ (Ambler 2008). unseen by. far too often. purpose or even the name of the products their company was trading in. As Willem Buiter (2008) writes. and other attention-deficit-promoting activities ranking high. this problem was apparent . outside the traditional set of requirements imposed by regulations) and that they generated positive earnings. (carmona and sircar 2009) Fourth. critics argue that it was the inadequate implementation of financial policy as much as its flawed theoretical assumptions that precipitated the crisis. Interestingly. in this instance financial engineers themselves were keen to focus blame on the decision-making processes within banks and financial companies: as we have learned [in 2008]. There also emerged a peculiar state of affairs within financial companies themselves. they rose to their positions on other criteria. sales. with deal-chasing ability. They were mostly concerned that the company’s trading techniques provided legitimate means of raising funds off balance sheet (i.e.

On the other hand. In the Euro area. which led to a paucity of information about the financial circumstances of individual banks and other systemically important financial institutions. On the one hand.). the Bank of England (the lender of last resort) claims not to have had any individual institution-specific information and never considered market liquidity. near-banks and financial markets. it fell victim to regulatory capture by Wall Street (ibid. In the US. as the crisis continued. therefore. the crisis was aggravated by the chaotic and extremely convoluted regulatory structure for banks. the central bank did not play a supervisory and regulatory role for the banking system. while the Treasury was simply too slow to act. more and more critical voices have observed that lack of due oversight and diligence reflects a much . The UK financial systems have suffered from a flawed tripartite arrangement between the bodies responsible for financial stability.3 And while the Fed did have better access to institution-specific information. the meltdown has underscored the extent to which the technical and mathematical sophistication of modern financial techniques has outpaced the options available to financial regulators. A product of the many vices of the age of ‘scientific finance’.88 f ina nci al alchemy in crisis in all major geographical corners of the credit crunch. The FSA (the market regulator) focused almost exclusively on capital adequacy and solvency. cyclical visions of the credit crunch emphasise that the crisis reflected a classic problem of the knowledge gap between policymakers and the financial markets. likewise.

but convinced others that the boom would continue indefinitely? What was it that the financial markets invented and traded so aggressively? And. for instance. Altogether. the emergent schools of thought on the global meltdown. Yet while analysing the many tentacles of the highly complex crisis. operation and governance of the financial system today. politics. they leave a host of concerns about the crisis unaddressed. individually and collectively. wasn’t the securitisation bubble one giant fraudulent scheme? In what follows. the paradigm of soft-touch (or light-touch) regulation advocated by the political regimes on both sides of the Atlantic for the past three decades.hoW T he crisis has B een un de r s Too d 89 bigger trend in Anglo-Saxon financial capitalism – namely. considering the many grey zones of finance today and the sheer obscurity that finance had reached. What. made some people anticipate the crisis almost to the letter. raise many important questions about the structure. this book addresses these questions. .

and their children. of course. and the credit crunch has its share of both. the crisis impinged on the ordinary person in the street: the majority of people in crisis-hit countries have had little contact with the brave new world of financial engineering. Most painfully. demographic 90 . The meltdown has exposed the ineptness of many people – in high places and elsewhere.000 for every citizen. The IMF also estimated that the present value of the fiscal cost of an ageing population is.4 soMe uncoMfortaBle Puzzles of the credIt crunch Any financial crisis has its villains and fools. on average. If unchecked. Data released in the summer 2009 suggest that the public debt of the ten leading rich countries will rise from 78 per cent of GDP in 2007 to 114 per cent by 2014. Yet it is they. Their governments will then owe about $50. it has revealed that greed can be very blinding. ten times that of the financial meltdown. who have rescued private financial firms through massive injections of taxpayers’ money into individual banks and financial markets. it has shown that those supposedly tasked with financial supervision and stability often have very little idea of what financial institutions actually do.

analysts and brokers. including traders in big investment banks. Indeed. despite occasional corrections to the markets. But the crisis has also posed somewhat smaller. baffled by the scale of the unfolding turmoil. the West has been enjoying a decade of unprecedented prosperity. yet important. therefore. are destined to pay for the vagaries of the credit boom. . They centre on the ethics of financial industry and the question of social justice in financial capitalism. remain unanswered. As the markets imploded. many market players. eroding the values of many companies and individuals. questions about today’s finance which. These are just some of the long-term concerns raised by the burst of the credit bubble. Generations of taxpayers.uncomf orTaB l e P uzzles of Th e cre di T c r u n c h 91 pressures will increase the combined public debt of the wealthy economies to 200 per cent of GDP by 2030 (The Economist. and banking crises were widely assumed to have been the ills of the immature capitalism of the nineteenth century and not a problem of today’s financialised. 11 June 2009). have admitted that nobody anticipated that a devastating collapse could take place in the twenty-first century. globalised economy. so far. dismissed: The Warning signs and the Whistleblowers The first puzzle is the timing and the apparent unpredictability of the meltdown.

In fact. fired. At the level of individual companies. Moore had said that this was very risky because borrowers would have difficulty repaying (though not because funding could dry up). But in 2004 and 2005. neither HBOS nor the FSA believed that it was appropriate to assess the riskiness of its rate of growth . as in any major financial scandal. The bank reached the brink owing to an extremely aggressive financial strategy during 2000–8 and what turned out to be the very ill-advised acquisition of a Dutch bank. ABM Amro. To date. the UK’s best known case is the Royal Bank of Scotland (RBS). unfortunately.1 it emerged that the then chief executive of HBOS had fired Paul Moore. in some cases. the global credit crunch has its own whistleblowers. HBOS was lending too much by relying on wholesale financial markets. as we learned in the wake of the crisis. In other words. Just like Northern Rock. warnings about the possibility of a structural financial collapse had been voiced at different levels of financial and economic analysis. It was the freezing up of these markets that pushed the bank into insolvency. these whistleblowers were routinely ignored or. an internal risk compliance manager. many people knew and warned that the end was imminent. they were not heard even though.92 f ina nci al alchemy in crisis Yet in light of the arguments outlined in Chapter 3. who had warned management about the excessive risks in its loan portfolios. this simply does not make sense. As two member banks of the group – RBS and HBOS – came close to bankruptcy and public money was put to their rescue.

Part of its remit was to examine ‘proposals to reduce administrative burdens of regulation’. thanked him for his good service. Kennedy 2009). The group included more than a dozen bankers and City grandees. In a subsequent development. the Chancellor of the Exchequer. The scandal surrounding the fiasco of HBOS-RBS was further fuelled by the revelation that Sir Fred Goodwin. on an annual pension of £693. the UK authorities had been informed about potential trouble at Northern Rock as early as 2004 (Cohen and Giles 2009).uncomforTaB le Pu zzles of T he cre di T c r u n c h 93 on the grounds that funds from wholesale sources could dry up (Peston. Another embarrassing revelation came in the summer of 2009. Alistair Darling. three months after quitting RBS. was obliged to resign in February 2009 following allegations that in his previous job as chief executive of HBOS he had fired the whistleblower and dismissed warnings about excessive risk (Kennedy 2009). 11 February 2009.000. Northern Rock and HBOS were at the centre of a 2004 ‘war game’ regulators held to test how banks would cope with sudden turmoil in the mortgage market and the withdrawal of money from foreign banks on which Northern Rock’s business model relied. In a letter. former chief executive of the fallen RBS. James Crosby. served on the official committee that advises the UK Treasury on financial stability until well into the credit crunch (Hope 2009). newly appointed deputy chairman of the FSA. Sir Fred was not asked to stand down until 28 January 2009. According to the Financial Times. .

the risk simulation planning. spokespeople for the FSA and the Bank of England said that the aim of the exercise was to identify weak regulatory practices rather than predict individual bank failure. Madoff Securities had $1. including $711m in marketable . The warnings included the fact that Madoff’s books were audited by a three-person accounting firm. and in any case banks following that strategy were profitable and growing. hedge fund investment adviser Aksia LLC warned clients not to invest with Madoff after learning of ‘red flags’ at his company. According to a number of people well versed in the subject. According to the accounts. In late 2006. then the UK’s largest mortgage lender. It was felt that it was too harsh to say Northern Rock’s business model was excessively risky. even though the exercise revealed the banks’ vulnerability.3bn in assets. though the Bank did warn of the growth in wholesale deposits repeatedly in its financial stability reports. In the US we learn that Bernard Madoff’s Ponzi scheme came as a surprise to his clients.94 f inanci al alchemy in crisis As the Financial Times reported. Subsequently. highlighted the systemic risks posed by Northern Rock’s business model and its potential domino effect on HBOS. the regulators concluded they could not force the lenders to change their practices. the Bank of England and the Treasury. conducted by the FSA. 2 which in late 2006 affirmed that the financial statements of Madoff’s securities firm were ‘in conformity with accounting principles generally accepted in the United States’. though not to the auditors.

Such a ratio of debt to equity made Madoff’s company a classic pyramid scheme (Bloomberg News. famously described derivatives as ‘financial weapons of mass destruction’. Members’ equity. himself a successful market player. an academic and market practitioner advising many policymaking bodies. They lost considerable amounts during the dotcom bubble and on companies with crooked accounting. the firm’s net worth. were likely to suffer from systemic collapse: large banks with their sophisticated internal risk systems have been caught up in every market cycle. warnings about the crisis were formulated more systematically. Surviving the Soft Depression of the . published an article in the Financial Times warning that the Basle II accord would be inadequate to prevent a systemic banking failure and that the banks. 13 December 2008). Warren Buffet. was $604m. typically herding in the markets. Economic historians and those working in the heterodox tradition of economics and political economy had been writing about unsustainable levels of debt in the North Atlantic markets for years. In the summer of 2009 he was sentenced to 150 years’ imprisonment for financial fraud. In the winter of 2008. They may be about to do so again on their syndication of collateralised debt obligations – the next bubble to burst. In circles closer to academic commentary. Let us take as an example Financial Reckoning Day.uncomforTaB l e P uzzles of Th e cre di T c r u n c h 95 securities and $67m in US debt. Madoff confessed that his fund was indeed a Ponzi pyramid. (Persaud 2002) In the same year. In 2002 Avinash Persaud.

consumption cannot go down much further. However. The book’s authors. foreigners will not continue to finance america’s excess consumption … and fiat paper money will not continue to outperform the real thing – gold – forever. This is not a cyclical change. More interestingly. concluded their study of the new. in the run-up to the credit meltdown. consumers cannot continue to go deeper into debt. drawing on Hyman Minsky’s work. for it can no longer hope to spend and borrow its way to prosperity. noted the dangers of overoptimistic risk assessments in the markets. the dominant tone in the official understanding of financial development remained puzzlingly optimistic. published in 2003. the BIS pondered: . several research publications by official financial institutions like the BIS. There is also a whole current of academic work in political economy and related disciplines that had been warning about the unsustainability of the credit boom and dangers of over-inflated asset markets and mispriced risks. but a structural one that will take a long time’ (ibid. for instance.: 256).96 f ina nci al alchemy in crisis 21st Century. Ponzi-style era of consumer borrowing and credit excesses in the US with a rather pessimistic prognosis: american consumer capitalism is doomed … The trends that could not last forever seem to be coming to an end. In 2006. (Bonner with Wiggin 2003: 276) They continued: ‘America will have to find a new economic model.

The credit and financial boom. could withstand a variety of shocks. the success of New Labour was founded on the greater availability of credit to the population. This leaves room for a complementary explanation: these phenomena might be linked to there having been such abundant global liquidity over such a long period. unfortunately.uncomf orTaB l e Puzzles of T he cre diT c r u n c h 97 What grounds are there for believing that ‘imbalances’ pose a threat to the optimistic view looking forward? it is not hard to identify a large number of significant and sustained deviations from historical norms in important macroeconomic variables. In the UK during 2002–7. even if these did arise. (2006: 141) Why was it. the flourishing . recourse to such ‘fundamentals’ does not seem adequate to explain either the extent or the duration of the unusual circumstances currently being observed. no one wants to be the one who stops the music. The sceptics and whistleblowers were too few to mention. however. has been essential to the longevity of political regimes on both sides of the Atlantic. then. concerns about disruptive reversions to more ‘normal’ values have to be qualified to the extent that such deviations can be explained and justified as being of a lasting nature. strengthened by the forces of globalisation and financial integration. Another reason is political. supposedly heralding a new era of prosperity. while the prevailing mood in the markets and the attitude in policy circles and in everyday life reinforced the notion that the world economy as a whole. that no one seems to have been prepared for the possibility of the financial meltdown on a global scale? One answer is quite simple: when the party is so good.

. economic growth was strong. regulatory restraint. economy continued for the fifth consecutive year in 2006. but we must continue to pursue pro-growth policies such as those designed to keep tax relief in place. With the Labour Party’s position and appeal fatally damaged by the deeply unpopular war in Iraq. (2007: 23) . it was observed in the Economic Report of the President that: The expansion of the u.s. slow the rate of health care inflation.98 f ina nci al alchemy in crisis position of London as a financial centre and the new nature of economic growth which. Indeed. and opening foreign markets to u. in 2007. the economic argument remained one of the few things supporting Labour’s success with voters. the signs of growing economic fragility were missed or simply ignored (Galbraith 2006). In the US. goods and services . the economy was never a priority for President Bush and his administration.s. on the other hand.4 percent during the four quarters of 2006. restrain government spending. with real gross domestic product (GdP) growing at 3.. economy and pro-growth policies such as tax relief. enhance national energy security.s. meant ‘the end of the boom-and-bust’ character of the inflation-prone economic cycle with which the Conservative Party was associated. overlooking evidence of the deterioration in the housing market and the growing risks of the debt-driven financial expansion. As a result. This strong economic growth comes in the face of numerous headwinds and resulted from the inherent strengths of the u. as Gordon Brown liked to repeat. The administration forecast calls for the economic expansion to continue in 2007. and expand free and fair trade.

the City dominated the economy and emerged as a unique global financial centre. tended to service domestic economies. In the UK. financial and business services accounted for 45 per cent of UK corporate tax income.000+ p. for instance. Many scholars maintain that the debt-driven expansion was the only way to maintain the living standards of the majority of the population at a time when wealth was being concentrated in the hands of the very few. during the decade of credit frenzy.) pay 25 per cent of all income tax. London’s model historically had been much more global. the inflation-adjusted income of the highest-paid fifth of US earners has risen by 60 per cent since 1970. At the peak of the credit boom. while it has fallen by more than 10 per cent for the rest. It appears that the Wal-Mart Walton family is wealthier than the bottom third of the US population put together – about 100 million people. according to 2006 data.uncomforTa Bl e Puzzles of T he cre diT c r u n c h 99 So one answer to the question ‘why did politicians choose not to acknowledge the growing pyramid of debt or the risks mushrooming in the financial systems?’ is simple: debt was useful. which made it a peculiarly .a. Under New Labour. reliance on finance-led growth produced its own political dynamic.3 Domestically. At the same time. According to Société Générale. The financial sector’s high earners (earning £100. the financial sector provided 40 per cent of jobs in London (Caulkin 2006). Gini coefficients (a measure of income inequality) were rising steadily (Funnel 2009). In both the US and the UK. while its rivals in New York and Tokyo.

trade in money has often been described as a Ponzi game. Is it fair to argue that the whole architecture of the global financial system is centred on the idea of ripping others off? History tells us that all economic bubbles. Gowan 1999). ineptness and cynicism that thrive at different levels of the political economy. the credit crunch has been described as the crisis of ‘Ponzi’ finance. tend to be a magnet for rogue dealers and outright crooks. Murphy and Chavagneux 2010). a giant casino or a global game of fictitious capital (Strange 1997. But aside from the longer-term contradictions of the mode of economic growth in the advanced capitalist economies and issues of political short-sightedness. Ponzi capitalism: a crisis of fraud? From its very start.4 Are we to understand. offshore financial space where financial innovations flourished (Burn 1999. Palan. from the tulip mania in Holland in the seventeenth century to the dot. then. But Ponzi schemes. that the whole financial system has become one giant Ponzi scheme? Ever since finance was liberalised. the credit crunch has unveiled another highly sensitive area of finance today: the very thin line that appears to separate outright fraud from what is commonly taken to be a venture of financial innovation. Carlo Ponzi.100 f inancial alchemy in crisis unregulated. who seize the . Palan 2003. are driven by deliberate deceit. as the allusion to the original fraudster.com boom of the late 1990s. implies.

scams and pyramid schemes as legitimate investments. the principle of a pyramid scheme applied to the dynamics of the sub-prime mortgage industry in the US – the epicentre of the crisis. captures a more general tendency among financial firms to avoid true disclosure of risks and hide bad debts by using the tools of financial innovation. The securitisation boom of 2002–7 proved to be no exception. such as Bernard Madoff and Allen Stanford.uncomforTaB le Pu zzles of T he cred i T c r u n c h 101 opportunity to make a lot of money by deceiving the public by promising high returns from a new. but also. venture. As the crisis unfolded. First. . corruption and financial machinations hit the headlines. it transpires. more and more cases of fraud. There are at least three levels at which the notions of Ponzi finance and thus fraud are relevant in the analysis of the global credit crunch. the notion of Ponzi finance. Third. Ponzi pyramids were exposed as the particularly nasty practice of some high-profile financiers. during the securitisation boom. Sophisticated financial means of trading and packaging highly obscure financial instruments employed in securitisation and re-securitisation deals were instrumental in concealing not only bad lending and business practice. Second. reflecting the element of deceit and fraud. they view the credit boom of 2002–7 and the process of securitisation as one massive industry of deceit and fraud. commentators often talk about the global credit crunch as the collapse of a gigantic Ponzi scheme. fictitious. Observing these cases. In essence.

Minsky (1982. Many believe that the epicentre of the continuing credit crunch – the sub-prime mortgage industry in the US – was a giant Ponzi pyramid (Fish and Steil 2007. Several facts about the structure of sub-prime lending substantiate this assertion. turn into more risky speculative finance. in which an economic agent can pay debts and interest only by borrowing even more. 1986) used the notion of ‘Ponzi finance’ to describe a state of acute financial fragility. Kregel 2008. Ponzi finance is the ultimate phase in the evolution of a financial cycle. . Ee and Xiong 2008. where even interest payments have to be financed by new debt. At the same time. The three types of finance mark the transitions starting with a conservative financial strategy and working towards an economic agent taking ever greater risks. where cash flows only cover interest payments. the Ponzi principle implies that fraud and deception are key motives. Broadly speaking. this progression describes the spiral of financial innovation and the progressive underestimation of risk by financial agents. therefore.102 f inanci al alchemy in crisis Ponzi Finance and ‘Sub-Crime’ In his financial instability hypothesis. which develops after hedge finance. ‘Ponzi’ is a method of financing old debt with new debt. where both interest and principal are repayable. In Minsky’s original taxonomy. Dorn 2008. Wray 2008). particularly during periods of economic optimism. For Minsky. and then into the Ponzi state.

Any Ponzi scheme can thrive only as long as it attracts new participants. the interest rates on their loans rose. IndyMac. one of the first large US mortgage houses to crumble in the global meltdown. they can tumble too. was not . constituted a web of new markets for exotic financial products. it sold $80bn such loans to other companies (Black 2009). the practice of providing people who have uncertain credit histories. once the bottom tier of properties was inflated through the creation of massive demand. Housing markets.uncomforTaB l e Puzzles of T he cred iT c r u n c h 10 3 First. sub-prime lending was justified by the belief that the rising value of property would be sufficient to repay the loans and. along with the actual terms of the sub-prime loans. however. the entire US housing market entered a bubble phase. For instance. no prospects of a higher income and often no jobs with a 100 per cent (or sometimes higher) mortgage was itself a very large-scale deception. Yet from the very start it was clear that many of those sub-prime borrowers would be unable to pay their mortgages if. through a complex chain of financial innovations. specialised in making what are known as ‘liars’ loans’. According to Jan Kregel (2008). In the US. as in any Ponzi scheme. or rather when. are notoriously cyclical. what is most worrying is that this was happening far beyond the sub-prime mortgage business: liars’ loans were securitised and. In 2006 alone. this belief proved to be self-fulfilling. This possibility. and house prices can not only stop rising. As Black argues.

by the benign and ill-informed view of the financial and monetary authorities of the risks posed . The reasons why the sub-prime industry flourished for so long go beyond economics. This suggests that the Ponzi pyramid of sub-prime finance. it also transpired that many lenders. In retrospect. and the related securitisation boom. were deliberately diverting clients to more expensive sub-prime products. enticed by commission fees. the terms of borrowing and the conditions for repayment appear to have been the key block in the Ponzi pyramid of sub-prime loans. knowingly inducing borrowers to accept loan terms they will not be able to meet (Wray 2008: 51). low interest rates were available in many other regions – notably in continental Europe and Japan – which managed to avoid the proliferation of similar Ponzi schemes on the back of their own sub-prime sector. Ponzi-type methods employed by lending institutions included large pre-payment penalties.5 In the aftermath of the crisis. On the other hand.104 financi al alchemy in crisis mentioned by the scores of financial advisers who sold the products to their clients. Australia and New Zealand) due to historically low interest rates in the 1990s and 2000s which offered ample opportunities for borrowers. even when the applicant could have qualified for a ‘prime’ loan. was facilitated by the political climate in the Anglo-Saxon economies and. low ‘teaser’ rates that were later reset at much higher rates. sub-prime lending flourished in the US (and to a lesser extent in other Anglo-Saxon countries such as the UK. On the one hand. correspondingly.

The Ponzi Business of Securitisation To date. As of June 2008. the housing and securitisation boom was in fact celebrated by many officials on both sides of the Atlantic. credit rating agencies. In the summer of 2008. two major cases of pure Ponzi pyramids have come to light. 406 defendants were charged in 144 cases across the US. It is in the wake of the sub-prime fiasco that clear evidence of mortgage fraud hit the headlines. As noted above.6 According to the Federal authorities. The majority of the large corporate cases involved accounting fraud. Journalists following the investigations likened the instances of sub-prime fraud to the Enron and WorldCom scandals. such as Bear Stearns in the US. accounting firms and hedge funds – as part of a wide-sweeping probe into mortgage fraud. FBI investigators were homing in on 19 ‘large corporations’ – including investment banks. insider trading and failures to disclose – with criminal intent – the proper evaluation of securitised loans and derivatives. fraud was a ‘contributing factor’ to the overall credit crisis (Kirchgaessner and Weitzman 2008). The first was put together by Bernard .uncomforTa B le Pu zzles of T he cred i T c r u n c h 10 5 by the expanding credit bubble. Cases range from small-time manipulation of accounting books by brokers and the practice of ‘predatory lending’ to more high-profile cases involving big banks. which brings us to the next terrain of Ponzi finance: the business of securitisation itself.

his hedge fund was a Ponzi pyramid. a laborious and well-choreographed effort to produce accounting books every month and report to clients was nothing more than a confidence trick. For several years he had been running what was known as a super-profitable hedge fund. In truth. he encouraged investors by suggesting they pour their cash into his funds incrementally. Banco Santander. In the summer of 2009. thorough accountants did smell a rat in . as noted above. in reality. Although justice seems to have been done as the 70-year-old is likely to spend the rest of his life in prison. HSBC. once a Ponzi-style activity is suspected it is relatively easy to uncover the truth. Madoff admitted to his sons that. Madoff was sentenced to 150 years in prison for fraud. By turning some investors away. As it would emerge later. According to many financial supervisors. In the winter of 2008–9. a New York-based financier. Madoff was building the steadily increasing flow of money he needed to keep the scheme going (Financial Times. 20 February 2009). he reassured his clients that they were benefiting from a specialised inside track. Essentially. as well as well-established banks like BNP Paribas. rather than demanding money up front. RBS and other financial institutions. questions mount about how many people knew about the nature of Madoff’s business and why his scheme was not exposed earlier. And although. with a wide portfolio of clients who included thousands of individual investors and pensioners.106 financi al alchemy in crisis Madoff.

Stanford ran institutions that are alleged to have misled investors about their exposure to risky illiquid assets (Financial Times. Regulators allege that Stanford’s pyramid operated primarily through Stanford International. continues to deny any Ponzi element in his business (Ishmael 2009). nobody in a senior position in the US regulatory system seems to have suspected the massive pyramid scheme. Stanford. The second now notorious case of a Ponzi scheme involves Sir Allen Stanford. Officials appointed to liquidate the offshore bank at the heart of the purported scam warned that it could take up to five years to locate funds lost by investors in Stanford’s Ponzi scheme (Chung 2009). Madoff and Stanford dominated their companies and used peculiarly inconspicuous auditing firms to check them. who knows how many more billions of dollars would have disappeared into fictitious books. In both cases. What is most astonishing is that there were real warning signs about both men. which sold about $8bn of certificates of deposit to investors by promising improbable and unsubstantiated high interest rates. another well-known financier. an Antigua-based bank. In both cases. Accused of an $8bn fraud.uncomforTaB l e P uzzles of Th e cred i T c r u n c h 10 7 Madoff’s books. If Madoff himself had not confessed. His company went into liquidation after it became apparent that many investors were seeking to withdraw funds from the bank when its cash reserves were insufficient. analysts grew suspicious of the returns the two financiers were offering. Yet while they continued . unlike Madoff. 20 February 2009).

large and small investors alike invested with Paul Greenwood and Stephen Walsh. They are just the latest in a stream of alleged Ponzi pyramids. they represent a much wider trend of fraudulent financial practices which had been concealed by the credit boom and securitisation industry. Both schemes came to light only because their architects were unable to continue their financial manipulations in the frozen financial markets and their clients started to demand their money back. Although the SEC investigated both companies. The sheer number of schemes under investigation and their geographic spread – from Alaska to Florida and with a whole raft of overseas investors . the case against Stanford was brought only after a Venezuela-based analyst made his criticisms public. It is thus unclear for how long the pyramids would have continued had the international credit markets not seized up. Madoff came clean voluntarily (Chung 2009). whereas as we have seen. for at least 13 years. they evaded any serious scrutiny (ibid. at least twelve complaints involving Ponzi schemes and similar scams have been filed (Chung and Masters 2009). In the wake of the sub-prime crisis. In the end. in the belief that an ‘enhanced equity index’ strategy was superprofitable. What is worrying is that although these two cases are certainly the most well known. For instance.). two New York-based money managers. the most it did was fine them for relatively minor transgressions. But according to prosecutors and regulators the money simply filled the two men’s personal piggy banks.108 financial alchemy in crisis to post astronomic returns.

After all. regulators were hampered by political pressure to leave hedge funds alone on the one hand. when Ponzi’s original postage scam flourished. the last time the US saw anything like this was during the 1920s.’ At the same time. The Ponzi web has spread beyond America’s shores. In Italy. As many critics argue. Milan has lost millions on a derivatives deal. including the regulatory framework in which it flourished. Deutsche Bank and Hypo Real Estate – came under investigation for what prosecutors believe may have been fraudulent or ‘illicit’ profits amounting to €100 million.000 registered investment advisers on the other (Chung and Masters 2009). as many as 700 local authorities may have lost money on similar deals (ibid. the institutional foundations of the securitisation industry. ‘the beauty of these recent cases is that very little money ever went out. and a lack of resources to inspect more than 11. In Germany. According to historians. It is very likely that in the aftermath of the crisis more such revelations will surface. JP Morgan Chase. securitisation has . It was all on paper.). have helped entrench fraud as a legitimate practice of financial innovation. But what does one make of all this? It is contentious to allege that the securitisation industry was in fact one giant Ponzi scheme.uncomforTaB l e P uzzles of Th e cred i T c r u n c h 109 – dwarf what was uncovered in any recent recession. In the spring of 2009 four big banks – UBS. According to one former SEC official. The growth of hedge funds and offshore finance made secrecy and high returns seem more common (Picciotto 2009).

by creating a market for these assets and transforming them into liquid assets. to a variety of options on their mortgages. thus spreading and diversifying the risks. rather than just one bank. having gained access. for instance. flexibility and thus economic stability. the process of securitisation widened their ownership structure as several parties. diversity. then. Theoretically at least. coupled with widespread expectations that more fraud schemes are bound to be exposed as the recession .110 financial alchemy in crisis existed for decades and its economic purpose had been to attract previously unpriced (because unmarketable) assets into market circulation. to the high-profile scams mentioned above. In principle. Consumers and producers in many segments of the world market benefited from securitisation. Indeed. securitisation has as its aim facilitating wider economic turnover. could own or claim a portion of a loan portfolio. they set up their businesses with the sole purpose of reaping personal profits by deceiving their clients. On the other hand. even in radical academic circles. the number of fraud schemes that have surfaced to date – from the case of a rogue trader Jerome Kerviel whose scheme cost Société Générale almost €5bn. so far conceptualising the credit crunch as one massive crisis of financial fraud has not gained much popularity. Ponzi and Madoff are convicted crooks. To claim that the major part of the international financial sector operated under the logic of a massive Ponzi pyramid is highly controversial and requires some substantiation.

Third – and much more worryingly – when warnings about the true nature of these schemes were voiced. continue to flourish in the US? And why did politicians of various calibres continue to celebrate the advance of the ‘new economy’ and the ‘new paradigm’ of credit risk management? There are many answers to these questions. politicians. for the most part they were ignored. First.uncomforTa B le Pu zzles of T he cre diT c r u n c h 11 1 continues – does suggest that something went terribly wrong with the business of securitisation. as the political connections of both Madoff and Stanford imply. lawyers. it transpires that the proliferation of scientifically calculated but opaque financial techniques in the self-regulated financial markets has made it easier for individuals and institutions to conceal fraud and deception under the wide umbrella of financial innovation. How is it. that outright fraud. Second. regulators and. whose very name implied something very rotten. bankers. it appears that the many parties to this process included financiers (large and small). The credit boom of 2002–7 and the whirlpool of new financial techniques and products made these schemes almost impossible to detect. predatory lending and obscure financial schemes bordering on fraud have been sustained for so long? Why were the warnings about the mounting risks of securitisation and the growing fragility of the financial system unnoticed? How did the sub-prime loan industry. then. as the booming industry of credit crunch studies suggests. Notwithstanding various explanations of the long-term .

this illusion has complex socio-political.112 financial alchemy in crisis causes and short-term triggers of the global meltdown. thus contributing to greater and wider prosperity. They are the products. they also enhance the liquidity and welfare of the economic system as a whole. economic and theoretical origins. of one great illusion that has become an axiom of financial innovation over recent decades: the misconceived idea that. by innovating in credit instruments and techniques. both direct and indirect. Put more simply. financial markets not only optimise the risks. As explained in the next chapter. . this book suggests that most of the riddles brought up by the credit crisis have a common origin. it is the naïve belief that the financial market today creates wealth and spreads it through the economic system.

in turn. emerged as a combination of historical. it would have played an important yet relatively minor role in sustaining the 2002–7 boom had there not been a broader international politicaleconomic environment that supported. This environment. the global meltdown is a crisis centred on the US sub-prime mortgage industry.5 2002–7: the three PIllars of the lIquIdIty IllusIon Even in purely financial terms. The following pages identify three interconnected forces that. facilitated and encouraged a particular market-based approach to managing risks in finance. Even so. analytical. This chapter unpacks the role that ideas. liquid markets and economic prosperity. liquidity and the Paradigm of self-regulating credit In narrow terms. having reified the myth of efficient finance. political and institutional developments. in its broader 113 . behaviour and the institutional organisation of financial regulation played in constructing and sustaining the illusion of liquidity. helped disguise the deepening fragility of the North Atlantic economies. the sub-prime lending industry was a time-bomb waiting to explode (Wray 2008).

and defined by the notion that every eventuality can be priced. but also. by the search for greater liquidity. securitised and transferred to others in the market (Shiller 2008). Yet precisely what this greater liquidity implies remained a somewhat fuzzy notion. crucially.114 f inanci al alchemy in crisis international dimension. liquidity is about desire for and ownership and transferability of one’s claims on wealth (Berle and Pederson 1934). As in any other area of economic activity. Liquidity is the absolute essence of all market exchanges and is paramount to the functioning of any financial system. In the era of highly financialised capitalism. as the preceding . efficient finance which has constituted mainstream thinking on finance and financial regulation for the past decades. It is important to realise in this instance that securitisation itself has become a functional form of the paradigm of self-regulating. The key reason lies in the ideology of perfect markets and the theory of market-completing financial innovation. On the one hand. innovation in finance has always been driven by the desire for quicker and greater profits. dominated by sophisticated trading techniques and products. it is a crisis of securitisation. liquidity of financial markets has often been assumed. it is argued. Some scholars even suggest that liquidity is synonymous with the wider meaning of capitalism itself: ultimately. The way liquidity has been understood in this framework is representative of many other important assumptions underlying the paradigm of self-correcting financial markets. yet not necessarily warranted.

most financial innovations have for a long time been perceived to be liquidity-enhancing: by pooling a greater variety of assets in the market exchange. Theoretically. new financial instruments. On the other hand. rely on the liquidity of the underlying assets. from Minsky onwards. The process of inventing. financial engineers and traders have expanded the reach of the financial markets. valuing and introducing new credit instruments. by pricing them and then transferring them to new.T he T hree Pi llars of T he li Qu idi T y i l l u s i o n 11 5 chapters have noted. critics of the financial orthodoxy. Securitisation has had its own controversial effects on the idea and functioning of liquidity in the markets. thereby increasing market turnover and. On the other hand. markets and institutions has been driven by the search for greater liquidity across the global financial markets. securitisation has been understood to be . for instance – the latest wave of financial engineering – both relies on and enhances liquidity. the funding of a large number of market participants involved in the securitisation process depends crucially on market liquidity being permanently sustained’ (Banque de France 2008: 11). have argued that the relationship between new financial products and the liquidity of the economic system as a whole is far less straightforward. willing and able owners. liquidity. in popular terminology. Securitisation. while adding to a sense of greater liquidity in the markets. At the same time. It ‘enhances the liquidity of underlying receivables by transforming them into tradable securities.

banks reacted to the new regulations by accelerating debt origination on the basis of the capacity to move assets off balance sheet by selling them. In simple terms. one can design several securities (tranches) with different risk-reward profiles which appeal to different investors. Unsurprisingly. the Basle requirements made it unprofitable for banks to hold safe and liquid assets on their balance sheets (Wigan 2009). Historically. . Generally. By doing so. This idea did not emerge out of the blue.116 f inancial alchemy in crisis a technique to create securities by reshuffling the cash flows produced by a diversified pool of assets with some common characteristics. (cifuentes 2008) Advocates of the technique argue that the key economic functions of securitisation have been to provide an alternative form of financing for companies with predictable cash flows and to help lending institutions manage the credit exposure more efficiently.). securitisation was believed to increase liquidity across the financial system and the economy as a whole (ibid. In practical terms. therefore. securitisation meant that risky (but profitable) assets were moved from the banks’ balance sheets into the unregulated financial system. by creating securities out of illiquid assets. securitisation has been the banking sector’s reaction to the introduction of the Basle II accord of financial regulation. the Eurodollar market which emerged almost by accident but later become widely established). thus allowing them to make more loans. much like other important financial segments (say.

As Minsky foresaw. This shift in turn has become a major institutional transformation of the global financial system. financialised economy the ability to lengthen the debt chain leads to increasing illiquidity in the financial system as a whole: ‘to the extent that either the most liquid assets leave the banking system for the portfolios of other financial institutions or the debts of the newly grown and developed financial institutions enter the portfolios of banks. 2008). it was transmitted through its impact on liquidity. Regulations intended to strengthen the balance sheets of banks by weighting their assets on the basis of their riskiness and thus rewarding the holding of safe assets actually drove risky assets off the balance sheet. ultimately destructive repercussions for the stability of the financial system as a whole. according to Victoria Chick. the liquidity of the banking system declines’ (Minsky 1982: 174). securitisation reflects the way risk has been modelled. in a deregulated. but on such a scale as to change the whole manner in which banks operate (Chick 2008). At the heart of this process lay the transformation of the US banking system (Kregel 2007. As a result of the introduction of the Basle rules. Chiefly. securitisation was undertaken not just as a small part of bank operations when banks needed liquidity. In this regard. valued and traded by banks and financial houses since liberalisation reforms were introduced in the 1980s . As noted above.T he Th ree Pi llars of T h e liQ u idi Ty i l l u s i o n 117 This trend has had its own. the experience of the first Basle accord illustrates the law of unintended consequences.

bonuses and profits. in which the bank is no longer an institution whose principal purpose is to take deposits and grant loans. Instead. between 2004 and 2006 earnings from . managing those assets in off balance sheet affiliate structures such as special investment vehicles (SIVs).118 financial alchemy in crisis in the US and elsewhere. it is a competitive financier seeking to maximise fee and commission income from originating assets. Lenders have become progressively indifferent to risk and obsessed by reward (Credit Magazine 2008). and thus spread moral hazard around the financial system. According to one estimate. simply because the interest and principal on the loans will be repaid not to the bank itself. not as principals (Wade 2008: 32–3). Thus. according to Robert Wade. now known as the ‘originate and distribute’ (ORD) model. and servicing them. In recent years. The incentive to be a prudent lender has been replaced by an overarching drive to maximise commissions. underwriting the primary distribution of securities collateralised with those assets. the gap between a bank’s capital and its managers has widened. banks and hedge funds became careless because they were acting as intermediaries.1 These reforms led to the introduction of a new type of banking. the banker today has no motivation to conduct proper credit evaluation. The adoption of the ORD model has underpinned a phenomenal rise in commission fees and income from banks’ capital market-related activities. Crucially from the point of view of financial fragility. but to the final buyers of the collateralised assets.

cited in Langley 2009). this trend has been commonly viewed as an indication of a more efficient financial system and foundation for economic stability. In the wake of the global meltdown. it promises to ‘improve systemic stability if risk is held by those with the greatest capacity to absorb losses’ (Bank of England 2006. Middle East and Africa. The concern with creating new markets for their products prompted financial institutions – both in the official. over 80 per cent for Europe. from $55bn in 2004 to $90bn in 2006.T he Th ree P i llars of T h e liQ u idi Ty i l l u s i o n 119 trading in derivatives and capital market-related activities at the top ten global investment banks rose by almost two-thirds. The resulting series of financial innovations created a sense. noted that while the ORD model ‘does not alter the financial sector’s aggregate credit exposure to the non-financial sector’. Politically. it seems naïve and short-sighted to draw a straightforward. the Bank of England. linear link between securitisation and systemic stability. of abundant liquidity in the sub-primerelated financial markets and of financial wealth being created and spread. and just over 40 per cent for Asia Pacific).2 Reflecting these changes. profits from sales and trading operations had not only been growing. In 2006. visible banking sector and in the so-called shadow banking system – to embark on a spate of financial engineering which was unprecedented in its scope and sophistication. but also assuming a greater share of the investment banks’ revenues (over 90 per cent for the Americas. for instance. At . though not a guarantee.

120 f inanci al alchemy in crisis the peak of the credit boom. As Paul Langley writes. (langley 2009) With regard to how liquidity has been approached within the regulatory architecture. With the assumption of an infinitely liquid market there was no need to install a systemic provision to guarantee its liquidity. the mainstream political discourse that paralleled the expanding credit boom invariably represented the markets as efficient … and liquid. or more accurately the illusion of. however. there was little to suggest that markets for assets named ‘liquid’ would be any different from the norm. such representations of finance meant that a ‘liquid’ market became an object that investors increasingly regarded as a given fact. since the sub-prime industry seemed to exemplify what was possible in an era of liquid finance. the solution was sought in private risk management tools (Wigan 2009). Here again it is the idea of. the central parameters of international financial governance were founded on regulatory developments in the private sector: when the first Basle accord proved ineffective. a particular emphasis in the Basle II accord proved fatal in the lead-up to the global credit crunch. Specifically. external to them. As a result. the accord established a system of regulatory principles that delegated to the individual institutions themselves the management of their portfolio of risks. The key concern for . things were much murkier. Basle II has been built on the assumption that a well-functioning financial market is always liquid. liquidity that disguised many fallacies – both conceptual and political – at the time.

g. liquidity as a ‘state of mind’ The popularisation of finance has had its own impact on the way liquidity is understood. Through the alchemy of financial engineering. rather that the content of those transactions (e. the idea of ‘liquidity’ has come to describe the liquidity of the market. this assumption itself is a . It is this reliance on private regulatory techniques and risk-optimising tools that has produced the other two pillars of the 2002–7 liquidity myth: the Ponzi mode of finance and an authority structure for validating the products of financial innovation. in popular terms liquidity has increasingly come to describe the volume and speed of financial transactions. although seemingly only an analytical fallacy. while the market as a whole – founded on financial innovation and competition – was made liquid. Put simply. Playing with debt – Together. Warburton 2000). As contended in this book. has meant that the very idea of liquidity has become progressively detached from its older associations with the liquidity of assets and proximity to instruments of payment.Th e T h ree P i llars of T h e liQ u idiT y i l l u s i o n 121 policymakers at the time was market efficiency and the efficiency of individual banks (Davies 2009). Paralleling the rise and spread of financial markets. The advance of financial engineering. or market turnover. the banks were assumed to optimise their own risk strategies. in both practical and analytical terms.

made possible when a crowd of knowledgeable buyers meets a crowd of knowledgeable sellers. market liquidity is about prevailing price trends and the ability to execute transactions reasonably swiftly. or market liquidity in a more narrow sense. Believing that market turnover is infinitely sustainable and hence synonymous with liquidity is a dangerous illusion. Therefore. unfounded conceptual assumptions and beliefs constitute only one side of the liquidity illusion. According to Carruthers and Stinchcombe (1999). market fluidity. At the same time. And building a whole system of theories and regulatory principles on these two assumptions borders on something much more serious. perceptions. But market activity is always a social process and thus constitutes a complex interactive process of information flows. in the realm of the financial markets three basic mechanisms underpin the creation of liquidity: 1. Assuming that anything can be bought and sold in the financial market is simply wrong. The other important element of the illusion in the run-up to the global credit crunch lies in the dynamics of market liquidity itself. Continuity of trade. In narrow technical terms. . and it is important to understand how social and behavioural factors shape liquidity. attitudes and expectations.122 f inanci al alchemy in crisis key reason why many destabilising trends and risks in the credit bubble had been overlooked. is a social construction.

offering them to a host of seemingly willing buyers. more typically. 3. as the authors argue in their original study. This standardisation in turn. market-makers and sellers all have to hold a deep conviction that the ‘equivalent’ commodities in a large flow of financial instruments really are all the same. is a collective and cognitive achievement: buyers.T he T hree Pi llars of T he li Qu idi T y i l l u s i o n 12 3 2. for a small margin.: 353–4). on an over-the-counter (OTC) basis. As the boom expanded. either on organised market platforms or. spawning theories about . seemed to ensure that these products contain accurate information about their underlying risks and values. The existence of market-makers who. are willing to risk transferring large quantities and thus maintaining a continuous price. comprises the spatial. Homogenisation and standardisation of commodities. the belief in and reliance on the capacity of securitisation to optimise risks became ever greater. For a while during the credit boom this conviction appeared to function well. Financial geeks were extending the range of financial products and services. The magic of securitisation. intertemporal. in turn. Standardisation of products and financial techniques is absolutely central to sustaining market liquidity (ibid. manufacturing standard products or by creating legal instruments with equal claims on an income stream. therefore. by grading natural products. Market liquidity. cognitive and social processes of valuing risks.

liquidity was no longer about the available pool of money or even credit more generally. until quite late in the period under review. market liquidity was increasingly taken to be synonymous with the shared appetite for financial trading – or put bluntly. for instance. only in recent months … has the downside to these new practices become more apparent. mortgage credit has become available on easier terms to borrowers almost everywhere. peculiar impact on the construction of liquidity.124 financi al alchemy in crisis ‘abundant market liquidity’ and a ‘global liquidity glut’. and changes in attitude altered what people wanted to do. In June 2007. speculation. According to one market player. examples of new practices abound. But institutional developments within the financial sector also contributed to both the perception and the reality of the greater availability of credit: changes in regulation and technology altered what could be done. (Bis 2007: 7–8) Optimism during the global credit boom had its own. both mortgage and consumer credit became available to many who previously would not have had access at all. not least in the area of credit to households. indeed. it is ‘the result of the appetite of investors to underwrite risk and the appetite . Stripped of its relation to the underlying assets. this was generally considered to be a healthy development supporting owner-occupied housing. Rather. the BIS observed: the prevailing view that the world was awash with liquidity – that is. thanks both to deregulation in many countries and to the global extension of the mortgage scoring techniques pioneered in the united states. credit was both cheap and commonly available with weaker conditionality than had previously been the case. in the united states and a number of other countries.

Th e T h ree P i llars of T h e liQ u idiT y i l l u s i o n 125 of savers to provide leverage to investors who want to underwrite risk. a tendency . As the techniques of securitisation became ever more complex and opaque. While one side of liquidity is about finding a willing buyer and exercising one’s ability to transfer claims. it was increasingly difficult to shift them in the markets. But here is one of the many paradoxes of liquidity. proved to be dangerous. Confidence in turn depends on a level of transparency in the markets and knowledge about the new securities being traded. so central to the sense of market liquidity. the greater the liquidity. As Gillian Tett (2008) notes. the idea that collective reliance on financial innovation and sophistication automatically creates ‘the market’ proved to be an illusion. The greater the risk appetite. Standardising these securities and making them transferable in the market. as noted above. this twofold function became ever more difficult to maintain at a systemic level. more and more of these newly minted securities were left on banks’ balance sheets. was absolutely pivotal both to sustaining the investment boom and to preserving the notion of a liquid market. First of all. From the point of view of markets as social institutions. crucially. Tett argues. Most people understand this as ‘market confidence’. the new derivative products had become so obscure that it could take days for computer programs to value them. In fact. a liquidity boom can only be sustained as long as a collective belief in the tradability of assets persists. and vice versa’ (McCulley 2008: 1). the other side is the ability to sell. Standardisation.

ultimately. With the spread of financial innovation this crucial component of heterogeneity of the market context gradually eroded during 2002–7. as Persaud and Nugée (2006) explain. Second. that contributed to the misinterpretation of market liquidity trends and. liquidity. market exchange is essentially about the double coincidence of two diametrically opposed desires: a transaction will only take place if a seller finds a willing and able buyer. It is the erosion of this diversity. standardisation has given rise to its own dangerous dynamic in the market. precipitated the liquidity crunch. Yet. but also on the diversity of opinions and positions of the market-makers.126 financi al alchemy in crisis that was overlooked by most financial supervisors and regulators at the time. other buzzwords include ‘herding’ . Knowledge about markets and products. constitute an important aspect of market turnover. and the actions of buyers and sellers taken together. the standardisation of techniques and products. its fluidity and thus. liquidity is contingent not only on the standardisation of products and market trends. After all. In this sense. As the ensuing crisis showed. The success of credit derivatives markets and the profits they offered attracted many investors who used broadly similar market positions and pricing models. in common terms. Financial commentators call this problem the ‘concentration level’. this proved to be fatal to the idea of a liquid financial system. trading practices and pricing methods is essential for ensuring a certain level of transparency in the market.

while during a boom similar attitudes and shared positions create a sense of greater vibrancy and liquidity in the market. proved the point. the major risk posed by the growing homogeneity of market behaviour is that when distress strikes the market. the conventional trends of a bubble and Minsky’s Ponzi finance prevail: the undervaluation of risks. especially liquidity risk. hordes of investors were left holding similar positions in a falling market (Madigan 2008).T he T hree Pi llars of Th e liQ u idi T y i l l u s i o n 12 7 and ‘crowded trades’. similar investor positions are unable to diffuse the shock. in many cases. warnings were voiced about the dangers of what looked like herding in the derivatives markets. they magnify it. herding and the concentration of risks . As the first waves of the crisis combined with a spate of downgrades and uncertainty over valuations. it is noteworthy that while speculation. Whatever the term chosen. At the same time. the aggressive expansion of new borrowings. and. Therefore. the use of quasi-legal investment techniques and outright swindles. in stressful periods and crises these common practices erode more values than a more diversified market would allow. During the later years of the credit boom. One of the most telling signs was that credit spreads had been tightening virtually uninterrupted from 2003 to early 2007 as investors piled into the collateralised debt obligations (CDOs) market. The global credit crunch. much like any other systemic financial collapse. In this herd-driven process of financial innovation. There were simply too many speculators operating in one market segment. Instead.

offshore facilities helped conceal the risks of the transactions. Lehman Brothers. As with Northern Rock. securitised them. such as synthetic financial structures. as the preceding chapters have shown.2m derivatives contracts with a total notional value of $6 trillion. all of whom were looking to minimise their exposure to Lehmans. It held over $1.2 trillion of open positions spread across almost every market counterparty. it eroded the transparency of the markets. importantly. both in relation to supervisory bodies and also. The post-crisis investigation of the fallen bank revealed that globally. Lehmans. like many other banks. then moved the resulting assets overseas. Also crucially.128 financi al alchemy in crisis tend to be generic features of any financial crisis. at the level of counterparties – those at the other end of a transaction. at the time of collapse. the credit boom of 2000–7 had been defined by a specific element within the underlying regulatory paradigm: the sophistication of new products. ‘sliced and diced’ them with other MBSs. blurring the valuation basis of the original . often registered in unregulated spaces of offshore finance and associated primarily with the strategy of financial deregulation. Lehmans is estimated to have held 1. it has blurred the line between financial innovation and financial fraud. accumulated mortgage-backed assets (MBAs) in one country. The tale of the biggest casualty of the credit meltdown so far. reiterates the scale of the problem of obscure debt and financial manipulation. As the spiral of financial innovation progressed.

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security (Thomson 2009: 9–11). This not only triggered a liquidity crunch at the bank, but also made bankruptcy procedures very difficult to instigate. Instructively in this instance, in May 2007 Bernanke warned: ‘substantial market risk may be associated with holdings of illiquid instruments – tranches of bespoke collateralised debt obligations illustrate this well. A pattern of crowded trades may lead to market illiquidity, sometimes in surprising locations, when risk aversion heightens’ (in Madigan 2008). And while it is the banking sector that has suffered the bulk of losses and remains the focus of attention in the wake of the credit crunch, some observers doubt whether commercial banks have increased their leverage too much. According to Willem Buiter, most of the increased leverage in the financial sector took place outside the commercial banks – in investment banks, hedge funds, private equity firms and a whole range of new financial institutions relying on the new securitisation-based financial instruments (Buiter 2008). Other analysts and regulators confirm that it is the spread of the hedge fund industry and, in particular, its involvement in the securitisation industry that aggravated the problem of risk concentration and market illiquidity. This process has been twofold. First, the expansion of the hedge fund sector led to more investors chasing the same opportunities. When this happens, profits start to decline. Declining profits in turn encourage investors to increase leverage, so that a Minsky-type Ponzi pyramid emerges. Second, hedge


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funds appear to have been using increasingly similar trading strategies, thus eroding the diversity of the market. According to the ECB, since 2001 hedge fund returns have become less widely dispersed, indicating that their positioning was becoming increasingly similar. In 2005, the ECB stated that ‘under stressed conditions, hedge funds, because they simply cannot afford to wait when leveraged positions begin to lose money, would probably be among the first to rush for the exit’ (in Madigan 2008). It is also telling that not only did regulators note the potential dangers of risk concentration and crowding, but risk managers themselves admitted that problems in the credit sector were not really unexpected. In 2007, Madelyn Antoncic, New York-based chief risk officer at Lehman Brothers, admitted that there was too much complacency in the markets at the height of the boom: ‘People didn’t realise that one of the main factors that contributed to this period’s recent stress was the crowded trade and the lack of liquidity for a particular trade once everyone gets out of the same strategy, especially when the trading models are the same’ (ibid.). The liquidity of the new financial system, therefore, was a somewhat artificial construction, created by the rarely questioned theorems of self-regulating, efficient and optimising market strategies and the collective behaviour of investors, or simply, herding: the sustainability of market turnover depended crucially on the collective actions and expectations of financial players.

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In the end, both pillars of the so-called liquidity boom proved illusory. The idea of risk-optimising financial engineering has turned out to be flawed at its core: it proved impossible to eliminate risk from the financial system since, in Buiter’s (2008) words, the world of finance does not have a hole in it through which risks simply fly away. The creation and maintenance of liquid markets by financial practices, or what scholars call the ‘performativity’ of various calculative practices, also proved to be a fiction: the crowd of buyers and sellers can shuffle debts around for a while, yet insofar as the assets themselves were never truly liquid, these actions could only be sustained temporarily. And it is here that we encounter the third pillar of the liquidity illusion of 2002–7: the role of a singular structure of private authority in the financial markets which was pivotal to creating and sustaining the illusion of a liquid financial system during 2002–7: the credit rating institutions.

The alchemists: Turning Bad debts into ‘money’
No matter how exuberant, canny or short-sighted financial strategists might be, illusions of prosperity, including the liquidity illusion, can only be sustained while there is some credibility to newly invented instruments. Following Carruthers and Stinchombe (1999), one can understand this issue in terms of a liquidity-maker’s presence in the market. At the heart of the function of a liquidity-maker lies the dilemma


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of transferring very specific, idiosyncratic knowledge about a given product into standardised and more transparent, common knowledge that would render underlying products knowable, valuable and tradable. In a national economic system, for instance, the state typically performs this function when issuing its own currency. In the private sphere of the securities markets there are other institutional arrangements designed to serve this role. According to Carruthers and Stinchombe, in postwar America, by pooling together large numbers of home mortgages and guaranteeing the income stream from them, Fannie Mae made them into more liquid securities, first, by making the task of discerning their market price easier and, second, by reducing the amount of information needed to understand their value. As Carruthers and Stinchcombe explain, instead of compiling information about each individual home and borrower on a case-by-case basis, a lender need only use aggregate information about means and variances in the pool of mortgages. By pooling mortgages the function of Fannie Mae was to increase market liquidity by transforming a future flow of payments to the issuing bank into a financial instrument to sell on the secondary mortgage market by using a short-run guaranteed price for mortgages that banks originate (ibid.: 359). More recently, in the ‘new economy’ of the late 1990s it was financial analysts, accounting and audit firms that, by endorsing the financial reports of dot. com companies – real and fictitious – created market

corporations whose executives have been convicted of serious financial fraud. The method of market-to-market accounting allowed the company instantly to book future earnings it forecast on energy deals. the company seems to have relied on old-fashioned cooking of the books: by treating routine expenses as capital investments. with the corollary of bolstering Enron’s potential return on investment and . The basic idea was to represent losses as profits. The two most notorious scandals of that particular bubble were WorldCom and Enron. involving special purpose entities (SPEs) and financial manipulations. Overall. masking of risk and overvaluation of assets. the accounting violations at Enron included revenue overstatement. Enron recorded as revenue the total amount of its energy trades rather than just the profits made on each trade – the standard practice at brokerage firms. somehow failed to see what they were doing (Kadlec 2002).Th e T h re e P illars of T h e liQ u idiT y i l l u s i o n 133 liquidity for the shares of those companies.3 Enron employed a much more elaborate scheme of financial innovation. In the case of WorldCom. cost understatement. The combined effect was to overstate earnings per share. Arthur Andersen. Enron’s financial engineers also structured several of its partnerships to make the parent company appear to be generating cash from operations rather than from its financial activities (Guttman 2003: 208). WorldCom’s auditor. Using its exemption from brokerage regulations and oversight by the Commodities Futures Trading Commission.

the financial frauds. accounting representations set the competitive conditions for others to match if they were to survive in the marketplace (Tinker and Carter 2003: 580–1. and individual accounting firms like Arthur Andersen for lack of due diligence. the Financial Standards Accounting Board. and the general culture and political ideology of efficient markets (Lowenstein 2004). however. a giant Ponzi scheme. dominated by the five largest accounting firms in the US. During the boom. Importantly. both of whom have since been imprisoned for fraud. Yet both facts and the controversial role of financial innovation suggest that the speculative drive of the dot.com bubble and the competition for markets set a general trend across the new economy: while appearing temporarily profitable and highly liquid. For the financial industry. The inevitable implosion of the dot. in reality. the dot. analysts note that this trend was supported by the standards of the private regulatory body.com euphoria made things much less clear-cut. Vivendi and many other firms for cooking the books and deceiving their shareholders. WorldCom.com boom was. Guttman 2003.com bubble must have been painful to the CEOs at Enron and WorldCom. or helped disguise (Grey 2003). In both these high-profile cases the companies’ auditors chose to overlook. It is tempting to blame individual executives at Enron.com crash . Lowenstein 2004). In essence. the dot. Yet the dot. Enron was a typical Ponzi scheme.134 f inancial alchemy in crisis diminishing the firm’s cost of capital (Tinker and Carter 2003).

In the age of ‘scientific’ finance and securitisation. During 2002–7. John Moody extended the practice to rating securities. much as in the bubbles of the 1980s and late 1990s. bundles of toxic debts. or something. and make the complex structures of IOUs ‘worth – or seem to be worth – more than the sum of its parts’. The first mercantile ratings guide was established in 1841 in the wake of the financial crisis of 1837 in order to rate merchants’ ability to meet their financial obligations. in the words of Timothy Sinclair (2005). was needed to act as market-maker on a large scale and sustain collective belief in the liquidity of what were. starting with US railroad bonds (Cantor and Packer 1994). in . when information is key to managing risks and structures of knowledge are essential for market turnover and. in essence. The rather feeble regulatory reforms that were introduced in the wake of the Enron scandal did nothing to stop the escalation of the new profitable niche – residential mortgage markets and the wider securitisation. That something was the credit rating agency (Lowenstein 2008). Credit rating agencies (CRAs) have been with us for a long time. became the ‘new masters of capital’. In 1909. But it is with the rise of today’s self-regulating finance that CRAs have assumed a new niche of private authority in the markets and. Today’s CRAs are the products of their time. in order to turn sub-prime loans into liquid securities someone.T he Th re e Pillars of T h e liQ u idi Ty i l l u s i o n 135 seems to have been no more than a blip in the larger trend of speculation and expansion.

Institutional investors. and the like have been required to buy investment-grade securities as rated by one of the nationally recognised rating agencies. by and large. it suffered no penalty (Wade 2008: 30–1). such as pension funds. At the same time. Some argue that. the easier it is to sell the asset to a final buyer. however. market liquidity. As Sinclair explains. As capital markets have displaced bank lending. insurance companies. trusts. Opinions do diverge. ratings agencies have acquired unprecedented power. The functioning of the market and the tradability (synonymous for many with liquidity) of mortgage-based securities fundamentally depended on the ratings they acquired. the rating agency in question bore no responsibility for its rating: if it made a mistake.136 f inancial alchemy in crisis some readings. And they were paid for their ratings by the banks. ratings have increasingly become the norm of the price mechanism of the market (ibid. as to precisely what aspect of their operation was so detrimental to the financial economy. crucially. The role CRAs played in turning toxic securities into tradable assets and subsequently in making the bubble implode4 is one of the least disputed aspects of the global meltdown. the liberalisation of the financial markets and the general transformation of finance into the business of risk optimisation have increased the importance of investigation. The higher the credit rating of a security. and as the valuation mechanisms and trust implicit in the older system of bank intermediation have broken down. . analytical mechanisms and calculative practices in finance.).

predicting valuations of future risks based on narrow historical records – that were flawed (Boorer 2008). ratings-based rules precipitated the crisis by creating perverse incentives for arrangers. issuers and ratings agencies to create complex financial instruments that received higher ratings than they deserved. Still others argue that the core problem with CRAs is structural: as private companies. In principle. the real problem lies with the rules and regulations that govern them. they face a conflict of interest between their objective to make profits and their role as independent risk assessors (Wade 2008). the AAA ratings of these instruments were granted not because of the underlying information. Notwithstanding the nuances of this continuing debate. therefore. Partnoy (2008) argues. the financial Frankensteins that the CRAs’ mathematical models said were low-risk.T he Th re e Pillars of Th e liQ u idi T y i l l u s i o n 1 37 CRAs performed well. the rating business has shifted from providing information to selling ‘regulatory licences’ – or keys to ‘unlocking financial markets’. but it is the methodological assumptions of the models they used – for instance. but because these higher ratings permitted investors to buy something triple A-rated which paid 20 times the spread of other triple A-rated instruments. As Partnoy (2008) insists. they cannot serve as an effective assessor of value for the financial market. Others note that the CRAs themselves are not the villains. Being regulated under the Basle accord. the crisis made it clear that CRAs have . In the case of Constant Proportion Debt Obligations.


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aggravated the securitisation bubble by creating the illusion of liquidity in the markets and wider political-economic systems. Functionally, as noted above, they have been trapped by the basic conflict of interest between being private, profit-seeking companies and their function of providing an independent assessment of risks to the market. This trap has affected their performance in three ways. First, each rating agency had an incentive to overrate the products in order to attract more deals. Second, CRAs run a parallel line of business, giving advice on how to structure financial products. Just as in the case of financial analysts and crooked accounting firms in the 1990s dot.com boom, the CRAs’ advice was skewed by the hope that the products on which they advised would also come to them for rating, giving them a double stream of revenue and a double incentive to overrate. The third conflict, the most egregious of all according to Wade, also parallels the privately defined regulatory context of the dot.com boom. Under US securities law, ratings agencies were not obliged to undertake their own due diligence about the risk characteristics of the products they were rating. Legally, they were entitled to take the information provided by the seller more or less at face value. This, Wade (2008: 33) argues, gave the seller an even stronger incentive to deceive. Another crucial aspect of the CRAs’ role in precipitating the meltdown concerns the methods they relied on when rating the newly minted securities. Here, again in intriguing parallel to the ‘new economy’ boom,

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13 9

a complex process of financial innovation has been at work: first, formal separation of ownership, driven by regulatory avoidance, manipulation of legal ownership of assets and creative accounting; and second, the technique of layering securitisation structures. Credit rating agencies have been pivotal to both. From the very beginning of the securitisation boom, a central objective in ensuring the marketability of securitised debt has been to enable the rating agencies to grade the credit risk of the assets in isolation from the credit risk of the entity that originated the assets. Rating agencies demanded legal opinion that the securitised assets represented a so-called ‘true sale’ and were outside the estate of the originator in the event the originator went bankrupt (Baron 2000: 87). Such separation was essential for the approval stamp that the risk was redistributed and removed from the originator’s books. This role was played by scores of offshore SPVs, which were set up specifically as sham operations to isolate the originators from the product they sold. Once the assets had been isolated from the insolvency risk of the originator, no further credit risk analysis was required from the purchaser. Risk analysis, however, was required from credit rating agencies, and it is here that they failed most miserably. According to Lowenstein (2008), in the euphoria of 2006, a Moody’s analyst had, on average, a day to process the credit data from the bank. The analyst was not evaluating the mortgages but rather the bonds issued by the SPV. The SPV would purchase


financi al alchemy in crisis

the mortgages. Thereafter, monthly payments from the homeowners would go to the SPV. The SPV would finance itself by selling bonds. The question for Moody’s was whether the inflow of mortgage payments would cover the outgoing payments to bondholders. For the bank, the key to the deal was obtaining an AAA rating, without which the deal would not be profitable. The secret to turning a sub-prime loan into a triple-A asset lay in the innovative technique of layering various types of assets according to their seniority. The highest-rated bonds would have priority on the cash received from mortgage holders until they were paid in full, followed by the next tier of bonds, then the next, and so on. The bonds at the bottom of the pile – the ‘equity’ tranche – got the highest interest rate, but would absorb the first losses in the event of defaults (IMF 2007b; Lowenstein 2008). Thus in another worrying parallel to the financial fraud of the dot.com era, the private agencies of the self-regulating market were now heavily implicated in facilitating dubious financial practices and outright fraud. The similarities between the ‘true sale’ idea of using SPVs in the securitisation process and the legal manipulation through the use of special purpose entities (SPEs) in the dot.com era are hard to ignore. In the case of Enron, for instance, SPEs – most infamous among them was something called Raptor – provided hedging insurance to Enron for any losses the latter might suffer from its volatile investments. To achieve this, Raptor needed to be a legal entity independent and separate

T he T hree Pi llars of T he li Qu idi T y i l l u s i o n

14 1

from Enron (Tinker and Carter 2003: 579). Being in full compliance with Generally Accepted Accounting Principles (GAAP) requirements as to its independence, Raptor was in a position to offer Enron a hedge contract on any of the latter’s investments, whereby Raptor guaranteed Enron that it would absorb any loss in value should the value of Enron’s asset portfolio decline. No recompense for the hedge was needed, as Raptor would be allowed to reap any profits in the (unlikely) event that the investment appreciated in value. Mirroring the experience of the Granite fund and Northern Rock discussed in Chapter 2, the scheme unravelled when Enron’s own stock declined in value amidst rumours about the firm’s economic viability. Raptor was first hit through its balance sheet. In order to compensate for the losses on its books, Raptor, along with several other SPEs, was consolidated into Enron’s accounts, registering an immediate loss in excess of $500m (ibid.: 580). Eventually, the firm sank. So we can see that the securitisation boom of 2002–7 was built on one great illusion – liquidity. Financial agents and engineers, relying on the techniques of scientific finance, ‘created’ the markets for what were essentially bundles of toxic debt. The regulatory paradigm supported this practice in two major ways. Analytically, the regulatory principles of most financial supervisory bodies assumed the markets to be always liquid, prioritising not only the risk of market or systemic illiquidity, but also individual and specific risks that financial institutions might face while

and partly by advocating the social welfare gains of new. partly by capitalising on the contribution of the financial sector to the economy. Politicians reaped the benefits. as a result. ‘democratised’ finance. arguing that this new approach to managing risks enhances market liquidity and the financial robustness of the economy. a whole set of regulatory norms produced the specific pillars of the illusion of liquidity during 2002–7: the markets’ view that liquidity is synonymous with confidence and thus is self-fulfilling. Like most illusions.142 financial alchemy in crisis operating in such a system. the global financial architecture reflected the idea of liquidityenhancing financial innovation. the illusion of liquidity eventually came to a destructive end. and the financial trade based on credit ratings. in turn. however. Mainstream finance theory. Institutionally. . has guided this trend.

economic and political – became an axiom of modern finance. Scholars and analysts had long pointed out the flaws in such reasoning.6 after the Meltdown: rewrItInG the rules of GloBal fInance? Essentially. by the structure of financial regulation founded within the private realm of finance. the global credit crunch became the crisis of the latest bout of financial alchemy. As the credit boom of 2002–7 illustrated. crucially. The dangerous illusion of wealth which became an article of faith during 2002–7 was centred on the idea of infinite market liquidity and the notion that through continuous innovation in new financial techniques and instruments. the social institutions of the financial markets today and. yet the idea of ultimate benefits brought by private financial innovation – social. It has been argued in earlier chapters that the great illusion of liquidity that lies at the heart of the credit crunch 143 . the illusion of liquidity was supported by the political and theoretical edifice of global financial governance. financial institutions and traders enhance the liquidity – and thus the stability – of the financial system as a whole.

governments validated the experiments of private financiers by offering state-backed. Essentially. with this move. Hence the efforts of the regulators centred on opening up the markets. to restore confidence (understood as liquidity) in the financial markets. cutting interest rates and trying to make the financial institutions lend to each other. The amounts set the tone for how the crisis would be handled for the year ahead. quite a lot: the policy response to the global meltdown has evolved through three distinct stages. unblocking credit lines through monetary injections that were quite unprecedented in their scale. Effectively. The Three stages of the Policy response Ad hoc Crisis Management (10 August 2007–9 October 2008) In the first days of the unfolding turmoil. several central banks agreed to offer their guarantees in exchange for toxic assets from financial institutions. As the crisis progressed. often coordinated internationally. high-powered . the first phase was about pumping money into the frozen markets and was defined by the efforts of the national monetary authorities. the answer is.144 f inanci al alchemy in crisis was built on these three pillars of modern finance. central banks rushed to put out the fire with massive injections of cash. Now that the global credit meltdown has passed its second anniversary. one question naturally arises: What has been done? At first glance.

allowing little time for deep analysis or musings about the actual causes or lessons to be learnt from the crisis. however. the ad hoc measures proved to be insufficient. Not only does it go against the golden rule of monetary theory and the principle of a lender-of-last-resort action.1 it is also unclear what will happen to the billions of dollars of toxic debts now being held by the banks. Panics require urgent.af T er T he me lT doW n 14 5 liquidity to individual institutions which could no longer shift their junk paper in the markets. In the midst of the panic that paralysed the global markets in the late summer of 2007. the immediacy of political reaction was understandable. the world entered the second phase of crisis management: . whether governmentsupported or not. decisive action. Neither the exorbitant size of cash injections nor the central banks’ attempts at transatlantic regulatory coordination helped quell the turmoil. This decision remains one of the most controversial policies of the global credit meltdown. Yet as the crisis intensified and transformed into deeper problems in the national and international credit systems. National Recapitalisation Schemes (9 October 2008–2009) Following the government takeover of Fannie Mae and Freddie Mac and the collapse of Lehman Brothers.2 Even this radical response to the crisis brought feeble results.

The British solution to the problem of de facto insolvent banks was drafted over the first weekend of October 2008. via the Office of Financial Stability (OFS).146 f inancial alchemy in crisis national recapitalisation programmes. an additional $787bn fiscal stimulus was launched. The conditions attached to the use of taxpayers’ money included curbs on executive pay. a similar scheme was launched. The so-called Brown-Darling £500bn bailout aimed to transform the way these institutions are run by using public funds. where since April 2008 the Fed had been expanding its lending facilities (and its balance sheet). governments in the US and Europe followed the example set by the UK in launching recapitalisation or bailout plans for the troubled banks. . authority to buy or insure up to £700bn of illiquid assets from private financial institutions (Wigan 2010 forthcoming). The government’s goal was to restore the credit circulation not only within the financial system but also in the ‘real’ economy. a special term asset-backed securities loan facility (Talf) gave investment groups access to cheap leverage so that they could buy securitised bonds. The UK rescue plan therefore contained a vital element of conditionality within the new liquidity provisions to the banking system. suspending payment of dividends to shareholders and maintaining lending to small businesses and homebuyers at 2007 levels. A Troubled Assets Relief Programme (TARP) gave the Treasury. With the election of Barack Obama as president in November 2008. In parallel. In the US. In a quite extraordinary turn against the principle of the free market.

Oxfam (2009) estimates that governments have pumped $8. the rescue plan for AIG is of particular significance. the UK government is now the majority shareholder in both RBS and Lloyds TSB. starting with Northern Rock.42 trillion – made up of capital injections. In November 2008.3 In total. he notes. The bailout plans met with little success. several big banks in the US and the UK have come – either partly or totally – under state ownership. The reaction from the financial markets was half-hearted: although market indices stopped falling uncontrollably. Cavanagh and Redman 2008). In the US. the mood in the world of finance was far from optimistic. since the funding plan effectively recognised that the insurance giant had transformed itself into a de facto investment bank through its subsidiary. subsidised loans and debt guarantees – into the failed financial institutions. Overall. The banks in turn. the US and European bailouts taken together were 41 times more than their commitment to development aid and 313 times more than the funding pledged to climate change control (Handerson. toxic asset purchases. although publicly shamed by various governmental committees for their experiments during . the majority of the failed institutions had to agree – extremely reluctantly – to become part of the scheme in which their share of toxic securities was acquired by the state in exchange for public control. since the latter’s acquisition of the stricken HBOS. As Wigan (2010 forthcoming) writes.afT e r T h e me lTd oWn 147 As a result of these bailouts. Financial Products AIG.

Its inception can be dated to 15 November 2008. The G20 summit. Lending levels remained low. fuelling public and media fury. when world leaders gathered in Washington. even claiming that ‘they are not charity’ cases.148 financi al alchemy in crisis 2002–7. it did mark the beginning of a series of efforts at the global level to reform world finance. In the meantime. To date. The Obama administration has been behind a radical plan for financial reform announced in June 2009. Although the summit did not bring any tangible results. It did not help when it emerged that executives in the key financial institutions. were slow and reluctant to accept state help. was a central forum in . such as AIG and Goldman Sachs in the US and RBS-HBOS in the UK. albeit rather too hastily. two key events have spurred progress on these efforts: the election of Barack Obama and the G20 London summit in April 2009. the world financial crisis descended into a global recession. DC for a summit that was dubbed ‘Bretton Woods 2’. and the chain of bankruptcies expanded into the real economy. other than public commitments to bolster the global financial system and rethink existing approaches to financial governance. which reconvened in September 2009. have received vast amounts in bonus payments. International Financial Reform (15 November 2008–?) The deterioration of economic conditions worldwide has moved crisis management into its third phase: an international regulatory response.

from localised injection of money to national bailout schemes and. Indeed. Put in somewhat crude terms. therefore. and simply impossible to foresee which version. it can be understood as a reflection of the . And while it is difficult to predict which form the world financial architecture will assume. The crisis and Geopolitics: a new special relationship? The first visible crack in the seemingly global reaction to the crisis is geopolitical. as it seems likely that both political and analytical differences will affect the course of action. So. it is clear that these differences are determining the path of financial reform. all three stages of the policy response to the meltdown have been marked by divisions and conflict. the chapter delves into some of the key rifts that have surfaced to date. both analytical and geopolitical. if any. plans for a new architecture of global finance are still being negotiated. at various levels. in the evolution of the policy reaction to the crisis. finally.af T er T he me lT doWn 14 9 which pre-existing differences of opinion and politics had to be renegotiated in order to produce a plan for financial reform which all could agree to. to coordination at the international level. As this book goes to press (winter 2009). In what follows. this book concludes its analysis of the global meltdown by charting the key lines of the debate that appear to be informing the new vision for global finance. Instead. is likely to be implemented as policy action. it is difficult to comment on the proposals that are being debated.

has been opposed to the idea of preventing market progress by administrative or political interference since the 1970s. for its part. most notably France and Germany. The United States As noted above. The US. in the US until the nationalisation of Freddie Mac and Fannie Mae and the collapse of Lehman Brothers. these political differences have centred on the way politicians at different levels of the decision-making hierarchy chose to interpret the nature of the crisis and its major lessons. Originally. the UK has built its economic strength on the power of the City of London as the world centre for financial innovation. Whereas the EU has traditionally been more in favour of closer regulation of the financial industry. within the EU itself. the official reflection on the . In the age of financial capitalism. where there is a sharp divide between the UK and other EU members. the political response to the credit crunch was simply an attempt to restore confidence by pumping liquidity into the markets. Here. Both sides of the conflict centre on how national (and supranational) authorities view the process of financial liberalisation.150 financial alchemy in crisis long-running differences between the Anglo-Saxon and continental models of capitalism. one important conceptual detail of the US bailout plan stands out. the line cuts in two ways: between London and Wall Street on the one hand and Brussels on the other. In the context of the global credit crunch.

The version of the reform proposal launched by the Obama administration in early summer 2009 takes things much further. 3. Specifically. new requirements for regulation of the financial products that previously were traded in unregulated exchanges. protects consumers and investors. The plan aims to build ‘a new foundation’ for financial regulation and supervision that is simpler and more effectively enforced. including the establishment of several new institutions that would undertake the task at the federal level. Stronger regulatory potential by the government. was designed to address individual market and business failures rather than question the core principles of the functioning of the financial system. Steel and Nason 2008). the blueprint. extending the scope of regulation to non-banks .afT e r T h e me lTd oWn 1 51 lessons from the crisis. or ‘objectives-based’ plan. in particular. rewards innovation and is able to adapt and evolve in line with changes in the financial markets (US Treasury 2009: 2). Oversight and close supervision of financial firms. The proposal targets financial regulation at four key levels: 1. Comprehensive supervision of the financial markets. installing. stressed that innovation and market competition remain the priority for the US economy. as articulated by the US Treasury Secretary in the March 2008 blueprint for a new system of regulation (Paulson. 2.

In its call for a system-wide overhaul of financial supervision. calling for more regulatory bodies and extended powers in the US network of financial regulators.5 Moreover. 4. nationally and internationally. At the same time. Although full of good intentions.152 financi al alchemy in crisis and adding to the apparatus of existing financial supervisory authorities at the Federal level. The plan also commits the US to taking a lead in strengthening international financial reform. Obama’s vision for a new financial system stands in stark contrast to a much more muted and light approach of the blueprint drafted by Paulson’s team in spring 2008. the proposal is thin on concrete initiatives and fails to address many important issues. and as many analysts continue to reiterate.4 At first glance. it is a long-needed and welcome step towards public acknowledgement that financial excesses have disastrous consequences for society and the state. there is a risk that the reform will only complicate the already cumbersome structure of financial governance in the US. a more . and that existing market-friendly standards of governance have been unable to address them. lack of clarity associated with the division of powers and responsibilities between the monetary authorities and financial supervisors has been a major factor in aggravating the crisis. by raising international regulatory standards and levels of coordination. In this respect. critics have pointed out that the apparent comprehensiveness of the plan is illusory. As noted above.

To complicate matters. the plan has yet to gain congressional approval and it is unclear which version. A more complicated domestic regulatory framework would also undermine the effectiveness of any international coordination in terms of cross-border supervision. the EU followed the US in acknowledging the need for international policy coordination.afT e r Th e me lTd oWn 153 effective mechanism of crisis resolution would need to be much more transparent and simple. though not decisively so. of the proposals is likely to make it to the final policy act. they centre on the differences between American and European officials in drawing lessons about the risks and benefits of financial innovation and liberalisation. which has been a key problem in the global meltdown (Crook 2009). Therefore. between the US and Europe gradually surfaced. On the face of it. the Obama administration’s proposals for a better governed financial system have left many questions about the credit crisis unanswered. . Fundamentally. the EU’s initial regulatory response to the crisis echoed the themes of the US March 2008 blueprint. Yet. notwithstanding its radical tone. Europe Things in Europe have been somewhat different. if any. significant divisions. rather than complex. In spring 2008. not least because the risk of a cross-border banking crisis was deemed high. both conceptual and policyrelated.

in Europe arguments have centred on the split between the UK and continental Europe. upgrading valuation standards. As proposals for regulatory reforms matured from initial discussions to the level of procedural planning and implementation. and reviewing the role and use of credit rating agencies in the financial markets. Over the course of 2008–9.154 f inanci al alchemy in crisis The European ‘roadmap’ for a new regulatory structure is built on four conceptual areas: improving qualitative information and transparency for investors. the Financial Times reported that ‘fears are rising in the City [of London] that strict new European regulation could hit the financial services . While the voice of American delegations in these summits has been muted due to the political changes in the US. these distinctions became ever more apparent. Specific regulatory norms proposed by the EU include higher and tighter capital and liquidity requirements for all banks operating in Europe. strengthening prudential frameworks and risk management in financial institutions. In June 2008. the EU’s stronger preference for tighter financial regulation and calls for a pan-European committee of financial supervisors have been the major stumbling blocks to discussion in the November 2008 and April 2009 summits. including the European divisions of US banks. These measures would make it more expensive to package and sell obscure products such as mortgage-backed securities (MBSs) in Europe and thus erect a barrier in the way of the further evolution of securitisation.

should be at the EU level. is in the detail. A European institution setting minimum standards would fetter the competitive drive to deregulate between countries. Specific European proposals that trouble Britain include: • The proposal. set out in an EC paper. as they say.af T er T he me lT doWn 15 5 sector as a weakened Prime Minister confronts the leaders of France and Germany buoyed by their success in the European elections’ (Masters and Barber 2009: 3). • The idea that an EU ‘systemic risk council’ (a new supervisory body) would be chaired by the president of the ECB. • The proposal that EU supervisors be empowered to demand that national governments bail out banks. All these proposals have unnerved . such as credit ratings agencies and central clearing houses. Financial institutions would also have to meet increased minimum capital requirements and limits on borrowing. Such a body would also be able to bully reluctant regulators elsewhere in the EU into demonstrating that their banks hold sufficient risk capital (Financial Times. The EU directive would also require many hedge funds and private equity firms to register with regulators and disclose more about themselves and their investments. 11 June 2009). • The proposal that supervision of entities with a pan-European reach. But the devil. for tighter regulation of hedge funds and private equity.

the efforts will be too vague and hesitant. The plans for a new financial architecture are also riddled with opacities and conflicts at a deeper. as well as the poor record of previous efforts to design a global financial architecture. the real danger is that despite the severity of the crisis and ostensible determination of a number of policymakers to rewrite the rules of global finance. the post-credit crunch financial system may not be so different from its predecessor. conceptual level.156 f inanci al alchemy in crisis the City. But the problems with the crisis response unfortunately do not stop here. Lord Myners. therefore. technical and political. Considering the politics of financial regulation on both sides of the Atlantic. conceptual dilemmas and Traps In terms of its theoretical underpinnings. the post-crisis regulatory fallout can broadly be divided into two . In July 2009. At the level of global geopolitics. amidst reports that delegates from the City of London Corporation had been sent to Washington to seek American support in drafting a resistance to the EU initiative. claimed that the plans to regulate the hedge fund industry are motivated by political gains and are ‘bordering on a weak form of protectionism’ (Jones 2009). As some commentators and politicians began talking about the ‘green shoots of recovery’ in the second half of 2009. there are serious stumbling blocks. en route to a new architecture of financial governance. Financial Services Secretary to the UK Treasury.

is a search for comprehensive. democratised finance and financial innovation has brought to society. Their emphasis in challenging the basic paradigm of finance today could be called the ‘traditionalist’ approach to financial reform. I believe that the Fed still has powerful tools at its disposal to fight the financial crisis and the economic downturn …’ (Bernanke 2009). systemic solutions to the crisis. The first. Stressing the benefits that the era of new. This school of thought diagnoses the credit crunch as a cyclical event and strives to find policy solutions to the crisis within the existing range of tools available to governments and markets. or the structure and principles of the economic organisation as a whole: ‘[T]he global economy will recover. The resulting reform agenda. . quite radical range of views is framed by disillusionment with the performance of the financial industry over the past few decades more broadly. but the timing and strength of the recovery are highly uncertain .. these theories tend to be built on structural explanations of the crisis. these proposals call for a better. diagnosing it as a major breakdown in the very foundations of Anglo-Saxon capitalist organisation. Rarely do these views question the logic of existing economic and policy frameworks. more up-to-date and competent approach to financial regulation and governance. The second.afT e r T h e me lTd oWn 157 distinct paradigms of finance.. therefore. more mainstream set of opinions and plans come under the rubric of ‘making financial innovation work’. In essence.

trading. The Traditionalist School: Return to Prudence and Old Values you have forgotten the basics of what finance and banking are for. private financiers. Intellectually. the ‘traditionalists’ frequently draw their insights from history and non-economic academic disciplines and they often appeal to a wider audience. who started his career in the 1950s at a desk in a provincial bank. specialists in academic finance theory. are couched in the specialised financial language of today and are formulated by a range of financial practitioners. The audience – comprising mostly young finance geeks – was clearly not impressed. at the expense of all of us. are dominated by expert forums. it is time to return to some old-fashioned banking. you have carried your institutions into abyss.158 financial alchemy in crisis A notable distinction between the two groups lies in their intellectual origins. The banker. valuation and supervision techniques. The latter approaches. the second is mostly built on the idea of improving the current practice of investment. on occasion. observers and. was asked only one question from the audience at the end of his address: ‘So has . in your financial experiments. on the contrary. While the first school of thought is informed by considerations of the place of finance and money in society. These were the key words of a plenary address given by a senior bank executive to a credit risk summit held in London in October 2008.

This anecdote captures the essence of the ‘traditionalist’ school on the lessons of the credit crunch. it emerged that the bank in question is the only British bank that has got through the credit crunch with minimal losses. underpinned by the desire for quick profits and market-making opportunities. corrupt and unaccountable financial industry. have gone too far. It accommodates the many angry voices of civil society groups. supported by unanimous understanding in the markets that things will be fine ‘as long as the music is playing’. encouraged herding. the views of some politicians and a few financiers – most prominently Warren Buffet and George Soros. the advocates of this group call for a rethink of the very structure and purpose of the financial system today. they argue. The markets’ appetite for apparent efficiency. Therefore. As the traditionalists argue. but ultimately came at the high cost of the public good of financial stability. amidst calls to overhaul this dangerous and obscure financial industry. but rather on the whole culture that has bred irresponsible. ‘liquidity’. the anti-greed . flexibility and profits has not only bred pervasive unaccountability on behalf of individual traders. senior managers and analysts. and made aggressive greed the code of practice in the financial industry.af T er T he me lT doWn 15 9 your bank avoided all the losses then?’ Later. Blaming the crisis not merely on specific investment and speculation techniques. exuberance and short-termism. Innovation and speculation. the use of common analytical and trading techniques. has made finance a very brittle system.

long-term profits even though they happen to be lower than your rivals’ in any given year’. one that is more prudent and long-term in its orientation.’ says an executive of a medium-size bank commenting on the role of the culture of big-bank aggressive competition in the crisis.) Crucially. the world needs to make a clear distinction between socially useful banking (retail and commercial) and the more parasitic. the vision of a better capitalist system of finance tends to be charted either along Keynesian lines of the regulatory state or.160 financi al alchemy in crisis and ‘pro-prudence’ regulatory camp calls for the return of old-fashioned. ‘We see ourselves as retailers. (ibid. a new financial order. the traditionalists argue. boring banking and conservative finance – in terms of both size and aspirations: ‘The market will reward you for safe. Accordingly. would also require restoring the state to the centre of power vis-à-vis the City and Wall Street and warrant severe punishment for the convicted fraudsters who have made their fortunes in the bubble. Specifically. hierarchies of power and coordination rather than horizontal . speculative investment banking. based on a culture of thrift rather than spending. as an executive of a medium-sized lender argued (in Guerrera 2009). to ensure a better financial system in the future. our goal is not to maximise earnings in any given year but to have a profitable business for centuries. at some extreme. by drawing on the virtues of a more ‘Asian’ type of capitalism. at the expense of us all. We have a very conservative business model not by luck but by design.

Predictably. toxic products. in the meantime. on the other hand.6 Within hours of being published. Barclays Capital. the plan came under fire from two sides: bankers accused it of being politically motivated and even incompetent. and maintain that without the massive investments poured into the industry by competitive lenders. for instance. etc. especially in Anglo-Saxon capitalism. Indeed. the UK itself was vehemently resisting EU pressure for a pan-European system of tighter financial supervision and regulation.af T er T he me lT doWn 161 networks. paternalistic loyalty rather than aggressive competition and flexibility. Meanwhile. while analysts and critics argued that the plan is far too anaemic and not radical enough in challenging the culture of greed and unaccountability. the UK authorities drafted a White Paper proposing changes to the existing system of bank regulation. It works by . representatives of big financial firms defend the culture of competition and innovation. On the one hand. in July 2009. The financial markets. such as ATM machines and internet banking. The technique enables clients to reduce the amount of capital they must hold. are typically caught between electoral priorities and pressures from the financial industry. such proposals prove to be far too threatening for the financial industry and hence too sensitive for political authorities. consumers and the real economy would have been deprived of now mundane services. for example. are keen to find ways to recycle their old. has designed new tools of ‘smart securitisation’. Politicians. as noted above.

According to Francesco Papadia. much wider group of post-crisis reflections encompasses policy discussion at various levels and is unfolding along with the dialogue with private financial actors. and the obscurity of finance. Highlighted by the G20 statement on financial architecture in April 2009 as well as several high-profile . doesn’t it? Making Financial Innovation Work The second. ‘securitisations have become ridiculously complex. director-general of market operations at the ECB. have made the system as a whole less transparent and more obscure. With some variation. plain-vanilla deals’ (in Tett and van Duyn 2009). such a vehicle would require a lower level of capital to be held against it (Tett and van Duyn 2009). what defines these views is their critical examination of some of the new financial practices and products that became the defining features of the latest round of securitisation and ‘re-securitisation’. To these ends. that needs to be addressed by the new regulatory paradigm in the post-crisis environment. With a decent rating. not only widening the gap between the regulators and financiers. These practices.162 financi al alchemy in crisis pooling their assets with those of other clients into a securitisation vehicle large enough to be rated by a credit rating agency. it is argued. It is this gap. but also creating opacity within the financial markets. various improvements to the current self-regulating financial system are being proposed. Structures should become simpler. Sounds familiar.

This proposal concerns financiers themselves: CEOs should not receive excessive pay and bonuses.afT e r T h e me lTd oWn 163 reviews of the lessons of the global credit crunch. thereby making financial trades more transparent and hence accountable. (These controls are mainly advocated by the EU. whereas regulatory structures like the FSA should offer better pay to their personnel in order to attract and retain employees who actually understand what they are charged with regulating. Measures being proposed include: • A ‘Basle III’ accord on capital and liquidity norms that would be counter-cyclical and require financial firms to hold more liquid assets.) • The need to set up organised and centralised trading platforms for products that were traded off market until recently (like OTC derivatives). • The need to license and control credit rating agencies that have disgraced themselves by assigning AAA ratings to toxic and illiquid securities. • National plans to re-empower and strengthen the mandates of existing monetary and financial . they are based on the idea of rebalancing private gains and social losses. and on regulating what is being understood as ‘systemic risk’ in finance. • The need to change the structure of incentives. especially when these are funded by the taxpayer.

therefore. the process at the core of the crisis – the ability of financial engineers to transform obscure debts into ‘liquid’ assets – is not being questioned. This illusion led politicians. regulators and home buyers to believe that global capitalism had entered a new era of resilience and prosperity based on deregulated credit. though these ideas remain riddled with political conflicts.164 f inancial alchemy in crisis institutions.) Again. • The need to set up some sort of system of international coordination to detect the warning signs of financial trouble ahead which would respond efficiently to the emerging crisis. ‘scientific’ risk management and financial sophistication. the major lesson of the global credit crunch has been the fact that the meltdown came as a result of a long tradition of financial innovation and the belief that financial engineering creates money and wealth. as mentioned above. that in the current discussions of the future of finance. it is difficult to predict which version of the proposals will be incorporated into concrete policy. the credit boom of 2002–7 was based on a pervasive illusion of liquidity that blinded financiers into taking on multi-billion dollar parcels of debt. there are also proposals to set up a pan-European body with a similar agenda. (The most recent negotiations have charged the IMF with this task. It is particularly disappointing. In essence. The G20 plan for strengthening the . In terms of the analysis of the crisis presented in this book.

that . in general. support competition and dynamism.af Te r T he me lT doW n 16 5 global financial system. 2009: 10) Generally. are even more confident of the ultimately beneficial role of financial innovation: our preference is for light-touch regulation (with one exception on housing loan-to-value ratios …). the mainstream solution to the global crisis is based on the cyclical theory of financial crisis and on the belief that the market mechanism. as stressed in the G20 communiqué: ‘Regulators and supervisors must protect consumers and investors. The authors of the Geneva report. support market discipline. with appropriate assistance from the state. Indeed. interferes with the appropriate allocation of capital. restrictive control of financial intermediation stifles innovation and. reduce the scope for regulatory arbitrage. therefore. is disappointingly reminiscent of its rather impotent predecessor: the brief attempt to erect a New International Financial Architecture (NIFA) in the wake of the late 1990s crises. avoid adverse impacts on other countries. one of the high-profile policy reports on the crisis. can re-balance itself in the event of failure. indeed crucial. (Brunnermeier et al. especially if government starts to intervene with direct controls over bank lending. The regulatory and policy adjustments necessary for stabilisation and recovery in turn should not compromise the abiding principles of free competition: ‘It is important. for instance. and keep pace with innovation in the marketplace’ (G20 2009: paragraph 14).

risk-taking is a healthy and positive part of economic activity. As a result. As a result. without killing the underlying drive for financial innovation. and adjustments to. Moreover. The logic underpinning these proposals is that. the structure of markets and regulation not inhibit our most reliable and effective safeguards against cumulative economic failure: market flexibility and open competition’ (Greenspan 2008a). At the same time. competition and liberalisation of markets. but for reasons specific to 2002–7. the emerging debate over an appropriate regulatory response concerns the fine-tuning of existing principles of financial policy and governance. A better approach to financial regulation in the future should therefore compensate for these flaws. no one within the emergent mainstream of post-crisis policy debate is seriously challenging the idea that private financial innovation and complexity have become such a destabilising factor that it has moved many segments of the financial system – the regulation of liquidity being one of them – beyond the reach of regulators. importantly. appearances notwithstanding. .166 f inanci al alchemy in crisis any reforms in. confidence itself is not synonymous with liquidity. as a principle. privatised finance. it has been mispriced and misallocated. Thus the key lesson that cyclical interpretations of the crisis draw from the global crisis is the idea that the real problem of the global credit crunch is its sheer magnitude. few seem to understand that. without undermining the key benefits of innovative.

the nature of assets being created and traded. restoring market liquidity without questioning the essence of financial trade today. and stringent. has led the financial system into the gigantic hole it finds itself in today. NIFA was briefly in vogue from . Indeed.afT e r T h e me lT d oWn 167 however. every crisis – economic and financial – almost invariably rekindled the calls for a ‘new Bretton Woods’ system. In this instance. while more recently. very few of the ideas being put forward are essentially new. and the very meaning of what ‘liquidity’ is. the paradigm of market-driven progress has not been seriously challenged and. attempts to re-regulate finance can aim to be. the injustices of globalising markets fuelled anti-globalisation movements across the world. history is a useful indicator of how effective. few heed their warnings once the financial cycle and market ‘liquidity’ are restored. Since the late 1970s. Despite the waves of financial disasters and growing tensions within the economies of advanced capitalism. has firmly shaped the ‘constitution of global capitalism’ (Gill 2002. the past few decades of the evolution of financial architecture suggest that despite the radical tones and ostensibly far reach of some of the post-credit crunch proposals for reform. Moreover. the wave of financial crises of the late 1990s has given rise to what has been dubbed a New International Financial Architecture (NIFA). It is thus likely to lead us into another one in the not-too-distant future. Even if critics like Minsky appear to be taken seriously during crises. up to now. Vestergaard 2009).

macro-prudential regulation risks becoming to finance what ‘good governance’ has become to politics: instinctively. Apart from a plethora of forums and committees set up in the wake of the 1997–9 crises (the G20 forum. . Financial Stability Forum. financialised capitalism.). Ambitious yet vague on concrete detail. etc. NIFA remained pro-market-centred and aimed to facilitate financial innovation. liberalisation and competition further. policymakers tend to search for the same weapon. various Basle-centred groups. it targets qualitative parameters of financial risk – the macro-prudential approach is in a fact a big elephant in a very dark room. Recent history also suggests that in another important parallel to earlier attempts to deal with the legacy of the financial crises. With regard to its focus. now fashionably called a macro-prudential approach to financial governance. Apparently radical in its tone – unlike conventional quantitative. microeconomic indicators of financial stability. NIFA targeted mainly the emerging markets – places notorious for their financial and economic woes – and hence completely overlooked the possibility that a devastating financial malaise might engulf the economies of highly sophisticated.168 f inanci al alchemy in crisis 1999 until the 9/11 attacks diverted the attention of policymakers from finance-related problems to other areas. The bodies and committees that were set up under the NIFA umbrella remained poorly coordinated and impotent in terms of their juridical status. everyone senses it should be a good thing.

measure or control it. derives from the assumption that. at the core of the macro-prudential approach is the idea of better management of ‘systemic risk’ in finance. as John Plender (2009) argues. the crisis might have been averted. has moved economies far . But macro-prudential regulation – whatever form it might eventually take (and there are serious doubts as to how feasible.af T er T he me lT doWn 16 9 but no one knows precisely how best to define. there is currently very little understanding. however. crucially. There are several reasons for saying this. national-based statistics and the assumptions of monetarism. current proposals are) – is not a panacea which will necessarily save us from financial instability and crises. First. Under closer scrutiny. Yet again. Second. as to what ‘systemic’ risk might be and. contagious and quite dangerous for the system. macroeconomic governance has been based on obsolete. how it evolves (Davies 2009). The world of finance. It certainly has not. this argument appears quite naïve: for a while now. the macro-prudential approach. aside from an intuitive understanding that ‘systemic risk’ is widespread. One positive thing about calls for a closer macroprudential focus is that they are based on the apparently serious realisation that the micro-prudential institutionby-institution supervision undertaken by the FSA has not been sufficient. had macroeconomic analysis played a larger role in governing finance during the bubble. least so at the international level. politically and economically.

while Obama’s radical programme to re-regulate finance still needs more concrete detail on the parameters of national regulatory framework and crucially. The City of London is becoming increasingly uneasy about EU-based initiatives for a stronger and wider system of financial regulation. the global meltdown. To incorporate qualitative indicators of risk in the framework of governance is a good idea. policymakers did not pursue it seriously and the idea remained purely academic. and finally. the IMF published proposals for a new macro-prudential approach. Third. very little has changed. and several prominent scholars. is a crisis of economics as a profession as much as it is the crisis of finance. as the argument of this book has implied. the foundations of financial reform continue to prioritise the benefits of financial competition and innovation. congressional approval. including John Eatwell and Charles Goodhart. in the excitement about post-credit crunch reform people tend to forget that the idea of macro-prudential regulation has a long history. Yet lacking a current crisis. Despite appearances. After all. making macroeconomic targeting and even analysis somewhat old-fashioned in an age of obscure financial engineering.7 In the wake of the 1990s crises. History in turn . but how best to implement it today remains a very open question. analysed in detail the pros and cons of a new paradigm.170 f inanci al alchemy in crisis beyond national boundaries. As the political rifts underlying the post-credit crunch reforms outlined above suggest.

more accurately. ultimately inefficient in preventing another global crisis in the future. the pressure from the financial industry and the anaemic nature of the reform proposals noted above render the plan incomplete. slow and. the momentum for a comprehensive financial reform is fading away. On the one hand. This is what happened to the 1988 Brady Report. financial reform. While some less controversial and technical proposals for re-regulation may eventually materialise. policymakers as laggards and. . and even various Basle-centred initiatives for international financial cooperation in the late 1990s. it is revelations of this type – diagnosing the crisis as caused by individual failures rather than a systemic tendency – that will end up being the summary of the legacy of the global meltdown. the global credit crunch is the closest the world – or.afT e r T h e me lTd oWn 171 suggests that. is likely to bear little fruit: the global meltdown simply was not painful enough. aside from installing new jargon in the world of finance. including the pillar of macro-prudential regulation. As the recession lessens and the conflicts within the post-crisis policy debate deepen. It has exposed financiers as villains. On the other hand. to the 1999 US Priorities for a Global Financial System. That is probably the most tragic paradox of the current crisis. hence. ‘advanced capitalism’ – has come to collapse since the Depression of the 1930s. made banking a dirty word. briefly.

the credit crunch was brought about by the strategy of financial deregulation. in early October 2008. what is most extraordinary about the global meltdown is that in the history of financial capitalism it has been a rather mundane event. it came at the end of an unsustainable economic boom and a bear market. Like most of the crises of the past two decades. the global payment system was on the verge of total breakdown. 172 . or ‘boom-and-bust’ pattern of growth. competition for quick and easy profits and lack of oversight of – or.conclusIon: a very Mundane crIsIs The global financial meltdown wrought havoc in the countries of ‘advanced’ capitalism. full of enthusiasm about the extraordinary sophistication of finance in handling risk and widely celebrated political victory over economic cycles. The recession that has subsequently engulfed international markets is the closest the world has come to a global depression since the 1930s. more accurately. it was preceded by optimistic. following the sinking of Lehman Brothers. And yet aside from its geography. the international financial system teetered on the brink of a collapse. Critically. Like other crises. Like any other crisis. ‘expert’ opinions about a ‘new economy’. after a year of credit paralysis. In September 2008.

strengthen economic stability. debt structures and the myth of prosperity. financial engineers enhance the liquidity of the financial system and. the availability of easy leverage. this book has argued that at the heart of the crisis has been the great illusion that the financial markets actually create liquidity and wealth and thus enhance social and economic well-being and stimulate growth. today’s financial alchemy and. the credit crunch has been driven by the interplay of market psychology. despite the severity of the crisis. As the preceding chapters have shown. therefore. Contrary to mainstream views that the credit crunch was caused by the problem of risk valuation.conclusion: a Ve ry munda n e c r i s i s 173 insight into – the nature of ‘investment’ today. the concept of liquidity encapsulates crucial socio-economic and . the peculiar and complex relationship between three factors – herd behaviour on the part of financiers. is still with us. the illusion. crucially. The global meltdown revealed ‘liquidity’ as a dangerous beast of modern finance. Although ostensibly nothing more than a technical term. murky speculative practices and the outright frauds of some financiers and bankers. the paradigm of modern finance – has created the most dangerous of all myths: the liquidity illusion that precipitated the crisis. the global credit crunch showed that the fashionable enterprise of ‘financial innovation’ only helped disguise the buoyant trade in toxic products. Like every other bubble. Built on the theory that by creating a market for a new financial product or technique. And just like every other financial crisis.

as Minsky and many of his intellectual successors warned. the Ponzi pyramid of bad quality. The sophisticated. Predicated on the confusion between market confidence and systemic liquidity. specifically. long banished to the sidelines. transparent and advanced financial systems of the West and.174 f inancial alchemy in crisis political dynamics of the modern financial system. The global meltdown. The global meltdown has been anticipated and even foreseen. not in kind but in it geographical spread. then. the widespread belief in the infinite and abundant liquidity of the global market has fuelled the latest bout of securitisation. their pessimistic messages were seen as sour grapes on the part of the financial markets and were unpopular politically. illiquid loans was bound to collapse. In the midst of the economic boom. . According to financial orthodoxy. In the end. is unique. Sceptical voices were mostly heard from the heterodox schools of economics and political economy. and did just that. all of these trends and processes can easily be traced back to any of the outbreaks of financial volatility and crisis during the past few decades. not only by scholars of financial history and capitalism. but also by market analysts and participants. crises normally affect emerging economies or perhaps individual companies who mismanage their financial affairs. Sadly. those opinions were heresy vis-à-vis the dominant ‘religion’ of efficient finance theory. Yet the debt that was the foundation of the securitisation industry could only be shuffled around temporarily. The trouble is. and the notion of wealth-enhancing financial engineering.

the shock seems to be both shallow and short-lived. The mechanism that produces such a tendency centres on the myth of liquidity-creating and wealth-enhancing financial innovation. Some of the post-crisis moves towards a new architecture of global financial governance do touch on various problems exposed by the credit crunch. as references to both the Great Depression and its classic analysts – Keynes. to shake the orthodox view of financial innovation. along with Keynes and Irving Fisher. There are some proposals that aim to eliminate and control . efficient and democratic. Minsky and Galbraith – suggest. Unfortunately. It has been unable. Those who argued that financial fragility is inherent in the economies based on self-regulating capital markets were dismissed as sceptics whose theories lacked a robust technical foundation.conclusion: a V ery munda n e c r i s i s 175 of Anglo-Saxon capitalism had been assumed to be robust. In this respect. At the same time. one odd outcome of the global meltdown is that Minsky. He argued that while financial innovation marks any period of economic optimism and tranquillity. however. It has erupted as an historical shock to the world of advanced capitalism. this rehabilitation is only partial. it also inevitably drives the system towards the brink of a crisis. The global credit meltdown has shown this idea to be a dangerous and costly myth. seems to have been rehabilitated by the economic and financial mainstream. Minsky’s most profound message concerned the role of financial innovation in socio-economic stability. however. That is perhaps the greatest paradox of the global financial meltdown.

recur. At the same time. of the rules of global finance. and even challenge the place of offshore financial centres and tax havens. . the notion of ultimately beneficial financial innovation seems to be too sensitive – or perhaps too complex – to be confronted openly. It also means that such a crisis can. Watch out for comments about ‘abundant liquidity’ and new frontiers of financial innovation and engineering. it was the ability of today’s financial alchemists to build a giant Ponzi pyramid of debt and conceal it with the great illusion of liquidity and wealth that is the real cause of the global financial meltdown. or even a profound rethink. After all. and is likely to. unaccountability and lack of transparency. All this suggests that despite the emergent buzz of reform. the global credit meltdown has been neither deep nor painful enough to initiate a radical overhaul.176 f inancial alchemy in crisis greed.

3. for instance. The Bank of England. IKB had to be rescued with a $3. the ECB. noted in October 2008 that liquidity regulation ‘can play an important role in requiring banks to build larger defences against crystallisation of rollover risk’ (2008: 39). 6. compared to 2. 2. According to the Mortgage Bankers Association. in 2007 HSBC was the world’s seventh largest bank in terms of shareholders’ equity (data from Euromoney).6 per cent in 2000. Occasional studies of liquidity have been published by other central banks in the wake of the crisis. 5. 4. Most notably. According to Inside Mortgage Finance. chapter 1 1. In 2004.notes introduction 1. It filed for Chapter 11 bankruptcy on 6 August 2007. 2. the BIS. Keynes likened finance to a beauty contest run by a newspaper. Forbes ranked HSBC as the seventh largest company in the world. FSF and the IMF. 177 . but according to what others might consider to be ‘beautiful’.5bn rescue package put together by a group of public and private sector banks on 1 August 2007. Voters evaluated contestants not on the basis of any objective criteria. in 2006 13.5 per cent of mortgages originating in the US were sub-prime. ResMae Mortgage filed for bankruptcy and Nova Star Financial reported a loss that analysts had not foreseen.

8. China held $376bn of long-term US agency debt. A few months later. On 13 December 2007. who actually authorised the AIG bailout. Goldman Sachs. 9. while the bulk of China’s holdings of US debt is in the hands of the government. China controls more than $1 trillion of US debt. 10. In the autumn of 2007. was the ‘home’ institution of Hank Paulson. then US Treasury Secretary. It was credit derivatives.178 f inanci al alchemy in crisis 7. According to 2008 data. reacting to falling market indices and more and more bad news coming from individual companies. 14 July 2008). the largest recipient of the AIG debt. China’s biggest banks own large chunks of agency debt. (a type of insurance intended to protect buyers should their investments turn sour). 11. According to official US data. the AIG bailout would balloon to around $150bn. A year earlier. that sunk AIG when the sub-prime market turned sour. seven central banks around the world continued to slash interest rates and provide additional emerging liquidity support to the markets. analysts put the total exposure of the six biggest Chinese banks at $30bn (data from Bloomberg News). such as Goldman Sachs. the Federal Reserve led an internationally coordinated monetary injection which involved swap facilities and a multi-billion support package between five leading central banks (BBC 2009). Bear Sterns had been worth £18bn. The second largest holder is Russia. In July 2008. is more likely to be about $1 trillion. Commentators note an odd coincidence here. The actual amount. or a fifth of outstanding agency debt (Bloomberg News. Analysts estimated that. the key beneficiaries of the Fed rescue. according to Brad Setser. in the past had repeatedly claimed that derivatives were valuable risk -management tools which did not need . Also. Interestingly. 12. including the Treasuries. the two states hold at least $925bn in US agency debt. including bonds sold by Freddie Mac and Fannie Mae. JP Morgan and Merrill Lynch.

n oT es 17 9 13. Sale and repurchase agreements. 3.2 per cent year-on-year in January. Ireland and Luxembourg. At the end of 2008.6 per cent and Japan down 30. repo transactions allow banks to post unwanted securitised bonds as collateral to borrow funds from central banks (Tett and van Duyn 2009). it has also emerged that European banks have incurred higher losses than their US counterparts. including Singapore. In the wake of the credit crunch. COBRA (Cabinet Office Briefing Rooms) is the UK government’s crisis response committee which deals with national crises such as pandemics and floods. Until the liquidity squeeze of autumn 2008. saying that losses were out of the question (Williams Walsh 2009). Germany’s industrial output was down 19. 16. AIG officials also dismissed those who questioned its derivatives operation. Latvia and Ukraine suffered the most. In the EU. We are grateful to Victoria Chick for highlighting this key detail. clearly attract these SPVs due . which may be controversial. to be regulated. Switzerland. the IMF predicted that the total expected losses by banks and other financial institutions were in the range of $2. 15. world manufactured output and world trade in manufactures shrank dramatically. Interestingly. 2. In March 2009. Among the emerging markets affected. the rest. the value of equity has fallen by €6 trillion.2 trillion (IMF 2009: 2).8 per cent (in Wolf 2009). or more than 50 per cent from the peak reached in summer 2007 (Papademos 2009). Yet the banking systems in Eastern Europe – mostly controlled by European banking giants – are at a major risk of collapse. South Korea down 25. chapter 2 1. Granite had no employees whatsoever. 14. The figures include the Netherlands. threatening in turn the stability of European banking generally.

chapter 3 1. 18 February 2008. only 1 per cent of housing loans were securitised. Insurance. Other depositary institutions are supervised at the Federal level by the Office of Thrift Supervision and the National Credit Union Administration. Channel 4. 5. The European market is 12 times as large. is not supervised at the Federal level at all (Buiter 2008). ‘How the Banks Bet Your Money’. This compared with 68 per cent in the US.25 trillion. the Federal Reserve Board and the Office of the Comptroller of the Currency.180 financial alchemy in crisis to their very low tax regimes and because they offer a high degree of opacity and secrecy. According to the BIS. Financial markets are supervised by the SEC or by the Commodity Futures Trading Commission. which played a key role in the crisis through the credit risk insurance industry. at the Federal level commercial banks are supervised by the Federal Deposit Insurance Corporation. 4. India and South Korea. Based on interviews and analysis by Jon Moulton. Renamed the Financial Stability Board in the wake of the global credit crunch. According to the BIS. 2. Investment banks fall under the Securities and Exchange Commission (SEC). by early 2006 the combined holdings of China and other large emerging markets had increased to an estimated $1. Dispatches. The data for the state of the markets for securitised debt also suggested that the financial systems in the Asian economies were ‘too shallow’. in Hong Kong. from just over $800bn at end of 2004 (2006: 103–4). while in Japan and Malaysia the ratio was between 5 and 6 per cent. As Buiter explains. 3. the Asian sovereign bond market (valued at $830bn) was less than a tenth the size of its US and Japanese counterparts. . As of April 2007.

but was ultimately caught and died in poverty. borrowers were persuaded to take a mortgage without being told that they would be unable to pay it off early or change the terms. Employed in analytical terms by Minsky. up 9 per cent from 2003 (Caulkin 2006. 1 in foreign equity.n oT e s 181 chapter 4 1. 2. and has been the leading hub of financial innovation globally. It was the fastest-growing hedge fund market. cross-border bank lending and as a secondary market for international bonds. financial services incurred £19bn in trade surplus. The 144 cases. Madoff Investment Securities LLC used Friehling & Horowitz. the scandals of pyramid schemes run by Madoff and Stanford made the notion ever more widespread. they were ensnared in the sub-prime net (Kregel 2008). As a result of the bailout. In 2006. an auditor operating out of a 13 × 18 foot location in a business park in New York City’s northern suburbs. derivatives and foreign exchange trading. the City of London was global No. which involved roughly $1bn (£510m) in losses. 6. 5. who made millions of dollars by fleecing Americans during the 1920s economic boom. the term actually commemorates the life of a scandalous crook. and that their interest repayments after the initial ‘teaser’ periods would be up to 6 per cent (600 basis points) higher than the market average: in other words. Bernard L. 68 per cent of the bank is currently owned by the state. IFSL 2007). . from estate agents and appraisers to underwriters. lenders and lawyers. 4. targeted anyone involved in fraudulent mortgage loans. Often. Carlo Ponzi. 3. developers. In 2004. In the context of the credit crunch.

Observers agree that the institutions are mainly motivated by the desire to ‘get out from under US government thumb’ (Reuters 2009). oversight of global financial markets. According to the classic doctrine of Walter Bagehot (2006 [1877]). 4. 3.1bn. The accountancy firm Arthur Andersen. US Bancorp and BB&T repaid billions of dollars ($10bn. several financial institutions started repaying the taxpayer funds. which was paid $4. $6.182 financi al alchemy in crisis chapter 5 1. 17 May 2007. supervision of internationally active financial firms. claims that WorldCom’s finance chief Scott Sullivan never handed over the material Andersen asked for (Kadlec 2002). respectively) in June 2009. As Crook (2009) writes.6bn and $3. the ongoing financial crisis differs from the context Minsky identified. 2. Morgan Stanley. In this regard. such loose ends concern technical aspects of regulatory capital and leverage ratios for financial institutions. the lender of last resort should only offer financial help to viable but temporarily illiquid financial institutions under a range of stringent conditions and at a penalty rate.4 million a year to certify that WorldCom’s books were honest. Accepting toxic debt as central bank collateral did not give the central banks a clear ‘way out’. Data from The Economist. and crisis prevention and management. Here. By the summer of 2009. chapter 6 1. Kregel (2008) notes. 2.’ 5. By issuing ratings downgrades. At least 22 smaller banks have been allowed to repay some or all of their taxpayer money. there is vagueness about how . the plan notes that ‘We will focus on reaching international consensus on four core issues: regulatory capital standards. 3. 4.

6. 7. and new norms of consumer protection in the country.n oTe s 18 3 Fannie Mae and Freddie Mac – central to the mortgage securities bubble – will be regulated under the new rules. The paper includes tighter capital and leverage requirements. I thank Victoria Chick for highlighting this important point to me. .

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57. 125. 116. 44–8. 120–1. 124. 86. 88. 133 toxic. 144.index Accounting. 119.14 commercial (traditional) 13. 35. 119. 146. 194 Asia – 38. 146 system 2. 88 197 . 77–8. 91. 94. 178n. 95. 74–5. 132 creative accounting 47. 94 Tripartite Agreement 31. regulatory arbitrage 46. 107. 119 Banking crisis 2. see ratings agencies Arbitrage. 87. 19. 85. 147 and capital 31. 115. 78. 136. 38. 56. 21. 24. 78. offshore. 128 asset inflation 2. 3. 73. 96. 21–2. 118 shadow 15. 131. 141 Agency debt (USA). 49. 85. see also Ponzi capitalism 66 ORD model 15. 158. 14–15. 63. 118. 58. 153 Bank of England and credit crunch 21. 79. 110. 116. 11. 106. 85. 95. 133. 117. 42. 9. 49. 139–40. 139 and securitisation 9. 48. 134 Accounting standards: 135–8. 171. 180n. 34. 16. 83. 8. see also fraud. new economy. 36.2 ADB 38 Asian capitalism 160 Asset(s) Asset-backed securities (ABS) xxx. 162 Banking and liquidity. 164. 43. 161. 74 ‘Naughty Asian exporters’. 105. 81. 163 and liquidity (also liquid assets) 6. 165. 129. 35. 77. 117. 115–16.9 Agencies. 88. 177n. 29. 179n. 48. 160 investment. 167 and risk 67. 30. 139 and fraud 94–5. Ponzi. 36. 31. 117.2 and Northern Rock. 27. 141. 110. 88.

69. 74–5. 178n7. 35. 96. 47. 172 varieties of 150. 157 BIS 19. 127–8. 25. 169. 175 Ponzi. 44. 120. 137. 138. 65. 76 Bretton Woods system 9 ‘Bretton Woods-2’ 76. 167 crisis of 24. 70. see also Ponzi 100–12 Central bank(s) 29. 92. 127. 175 Capitalism 1. 68. 79. 174–5 financialised 3. 180n. 173. 18. 116–17. 69 Credit rating 142 . 172n. 136.4. 161. 177n2 Federal Reserve (the Fed) 29. 88. 30. Ben 29. 91–2. 34. 31. 42. 71–4. 64. 135.5.2 on liquidity 19. 168. 154–5. 41. 167 Bubble 3. 136 dot. 120. 130. 114. 89. 74. 91–2. 163 committees and groups 168. 178n12 City of London 150. 133. 100.4 Basle Accord 95. 148. 124. 114. 100. 171 Bernanke. 12. 170. 160. 81. 183n. 44.198   financial  alchemy  in  c risis Bankruptcy 24. 177n2. 180n. 182n2 ECB 16. 35. 66.6 Capital markets 41. 171–2. 143. 164 Credit derivatives 87. 36. 161–3. 95. 80 Capital see also recapitalisation: 1. 71–4. 76. 88. 124. 32. 145. 164. 42. 18. 139. 28. 165 Capital adequacy (also norms) 88. 155. 27. 53. 80–3. 146. 91.5 ‘super-bubble’ 73 Business cycle theory of. 181n3 Credit boom 3. 108. 156. 133–4. 99. 157. 103. 105. 89. 178n7. 63–7. 101. 135. 179n1. 157. 122. 126. 96. 162. 50. 43.com 48. 177n. 43. 49. 177n. 183n. 29. 114. 79. 44. 91. 129. 134 securitisation 20. 30. 111.1. 67. 22. 129. 178n12 Credit expansion 19. 144. 28. 172n. 63. 96. 123.2. 72. 160–1 Anglo-Saxon 63. 34. 26. 160. 148.

176. 170 theories of.11. 119. 163. 150. 167. 98. 42. 171. 44. also Eurocurrency. 86. 135. 150.com crisis. 172 of the 1990s.15 Euromarket. 126–8.9. 59. 150. 156. 82. 145. 32. 51. 6. 181n. 124. 34–5. 163 Crisis of the 1930s. 165. 140–1 European Central Bank (ECB). 33. 69. 109. 154. 162 regulation of.com bubble 48. 52–3. 95–6 Global 34. 72–5. 45. 119. 25. 36. 173–4. 140 Europe 36. 144–9 Debt 2. see central banks Financial expansion 98 . 161. 132. 55. 60. 16. 141. 178n. 131. 78–9. 182n.2 mortgage-backed. 179n. 164 EU 32. 145. eurodollar market 9. 180n.9. 104.2 toxic 7. 37. 145. 132. 116 Enron 48. 95. 105. 117.9 Debt culture 9–10. 178–9n. 135 role in the crisis 135–9. 77. 178n. 105. 178n. 29 public 90–1 US debt 33. 87. 64. 116. 178n.5 Federal Reserve (Fed). 101–2.3 Deregulation 11. 121. 164.5 Freddie Mac 33. 74.14 response to crisis 153–6. 134. 95–6. 171. 128. 77. 95. 69. 63–4. 179n. 95. 172 Depression. 161. 139. 183n. 183n. 78. 100. 102 Derivatives 10. 50. 146 Eastern Europe. 43. dot. 73. 95.12. 128. 170.9. 133–5. 35. 40. 99. 50. 62–89 structural theories 71–9 cyclical theories 80–9 policy responses to. 163.index  199 Credit rating agencies (CRAs) 22. 32. see also crisis of the 1930s. 3. 45. 175 Dot. 43. 20. 178n. 42. see central bank Fannie Mae 33. 153–4. 40. 171 Great Depression 35. 81. 138.

128. 32. 179n. 109–20 Financial liberalisation 150 Financial architecture. 90. 160. 162. 100–9. see also NIFA. 20–3. 103 Housing market(s) 2. 22. 166 Hedging 16. 52–5.1 . 148 Global savings glut see also savings and liquidity glut 78 Gold (standard) 9. 181n. 181n. 156–7.200   financial alchemy  i n crisis Financial fragility 20. 76. political economy) 3. 68. 42–3. 168. 176 Greenspan. 28. 89. 173. 130. 38. 175 and liquidity 20 and ORD model. 81. 109. 158 Geopolitics 149. 66. 118 Financial innovation 8. 84. 118. see crises Greed 41. 41 Illiquid asset 14.6 and offshore. 166. 82. 120.2 Great Depression. 83. 174 House prices 25. 13–17. 149. 15. 45. 107. 133–4. 59. 126–7. 143. 501. 28. 22. 84. 33. 105–6. 25. 47. 55. 175–6 controversy over. 155–6. 95. 165. 68. in crisis 82–9 Iceland 36.3 and liquidity 129–42 crisis lessons. 100–3. 29. 156 Global recession. 70. 152. 43–7 role in crisis. 109. 156. 103 Human factor. 43. 159–61. 150. 94–5. 140 Hedge fund(s) 15. 167 Financialisation 12. 82. 146. 111 Galbraith. 65. 118.3 Herding. 175 Geeks. financial 16. 83. 129–30. 98. 157. 175 Granite. 159 Heterodox (economics. JK 1. 164–6. 162. 142. 59. see also Northern Rock and Offshore 40. 100. 141. 96 Governance. 148. 140. 168–70. 116. 42. 89. 163 institutions 182n. 47–9 and Ponzi. 102. 37. 123. 73. finance 66. Alan 14. 56. 2. 51. 181n. 173. 34. 66 Fraud 40–2. 153. investor 95. 60. see also depression and crisis.

177n. 173. also meltdown 5. 113. also liquidity boom. 115–17. 30. 114. 174 system 20. 176 Liquidity support in crisis 30–1.1 (ch. 182n. 16–17. 128–31. 143. 10–11. 183n. 32. 170. 86. 144. 30. 34. 79. 16–17. 119. 137–9. 142. 177n.16. see financial innovation Interest rate 26–7. 166. 164. 76. 177n. 126. 97.7 .1 Keynesian welfare state 71 Kindleberger. 182n. 173. 112. 78. 135 and markets 7. 179n. 20. 115–16.15 Inflation. 143. John Maynard 3–4. also debt 6. 127 types of. 141 Illiquidity 117. 7–8. 6. 178n. 159. 76. 6) Leverage 1. 126. 145 and assets 8. 45. 175. 173. 132. 17. 126–7. 159. 161. 140. 10. 144. 29. 18.7 and subprime 103–6 Japan 39. 88.index  201 loans. 28.2 liquidity glut. 136. 90. 150. 163. 143. 173–4 and financial innovation 9–10. see also toxic debt Keynes.6 Liquidity artificial 42 concept. 24. 136. 107. 64. 154. 73. 104–5. 146. 173–6 and regulation 57. see also asset price inflation 45. 180n. 177n. Charles 85 Lender of last resort 88. 113–42 paradox of. 10–12. 104. see also savings glut 7. 141–2. 112. 8. also crunch. 167 and system 14. 140. 125 risk 19. 121. 81. 91. 34. 145. 77. 12.2. 36–7. 47. 174. 60. 57. 129 Systemic 141 IMF 26.5. 179n. 75. 98–9 Innovation. 125. 121. 12. 17–23 pillars of. 167. 129–30. 36.2 crisis. 124–5. 146. 178n. 164. 11. 179n.2 Junk (securities) 145. 176 defined. 5–6. 73. 60. 121–4.12 illusion of 4. 141. 115.

59. 30. 128. see also Minsky. 51–61 Offshore finance. 32.4 Ponzi era 96 Ponzi finance. 127. 79. 172 New International Financial Architecture (NIFA) 165. 95. 181n. 86. also Ponzi scheme 19. 92–4.4 on financial innovation 115–17 Monetarism 169 Monetary policy 2. 152. 174. 105. tulip 100 Minsky. 168 Northern Rock. 65. 34. 14.4. 145 Ponzi. 109. 134. 138. 104–5. 180n. 128. 38. 105. 57. 166 .7 Mortgages. 96. 60. 78. 44. 69. 176 Offshore. Carlo 100. 106. 181n. 128. 139. 146.1. capitalism 72 New economy 67. 101. 26. see also Ponzi 96. 102–3. 39. 141. 105. 174–5. sub-prime 2. 13. 25. 174 Ponzi. 114. 113 Residential 135 Neoliberal. 22. 55. 144–5. 127 Privatisation of financial risk 11. Hyman Ponzi capitalism 100–2. 121. 129. 102–3. see also Granite and offshore 30–2. 139 Over-the-counter (OTC) 123. 104. securitised 7. 69 Mania. 163. 28. 53–5. 100. 167.202   financi al alchemy  in  c risis Loans. 147 and Granite 40–2. 178n. see also Granite and Northern Rock 15.1 taxonomy of finance. 103. 59. 163 Panic 29. 107. 41. 182n. 20. 48. 181n. 129. 18–19. 128.2 Loans. 102 and Ponzi finance. entities 48. 17. liars’ 103 LTCM 67. 102. 42. 100–4. 134. 167. 174 Ponzi principle 59–60. Hyman 3. 127. 103. 81. 179n. 112. 176 and securitisation 106–10. 56. 134. 59. 51. 132.

86–7. 68–9. 21. 145. 18.2 macroprudential 168–71 light-touch 89. 50. 172 management of. 95. 177n. 102. 166. 147 Recession 2. 138. 165–6 and Basle 116–17. 94. 79–80. 11. 14–15. 153. 81. 11–12. see credit ratings agencies Real economy 12. 75. 32. 130. 178n. 16. 111. 114 in wake of the crisis. 81–2. 15. 24. 98–9. 131. 164 pricing of. see also liquidity glut 75. 128. 52. 59 SPV 42. 78. 13–15. 109. 85. 146. 33. 155.index  203 Rating. 179n. 40. 37. 170. 163. 172 global 2. 19. 48. 172. 65. 113. 38. 137. 121–5. 82.12 optimisation of. 13. 165–6 Risk and liquidity 10. 64. 33.2 in the political-economic system. 24. 25–6. 110. 92–3. 124. 78. 154. 155. 42–3. 105. 93–4. 65. 43–7.3 Savings. 112. 117. global glut. 146. 65. 64. 161 Real estate 14 Recapitalisation: 36. 116. 89. 121. see also NIFA. 25. 67. 118. 179n. 92–3. 135.14 underestimation (also misunderstanding) of. 65. 59.3 SIV 15. 56. 83. 171. 143. 41–2. 159 Structured finance 13. 112. 81. 82. 19–22. 96. 128–30. 173 systemic 59. 135. 165 paradigm of. 76. 150–7. governance 9. 87. 19. 137 and innovation. 9. 28. 107. 48–51. 65. 139–40. 148 Regulation. 161. 141–2. 127. 64. 124. 111–12. 8. 18. 85. 57. 84. 55. 94. 59–60. 6. 142. 37. 78 Speculation 73. 67. also valuation. 119. 120. 180n. 172. 6. 43. 148. 152. 65. 82. 113. 49. 168. 136. 177n. 118 . 138–9. 169. 133. 102. 86. 48. 133. 127. 155. 38. 86.

77. 156. 104. 124. illusion of 1.204   financial  a lchemy  i n  c risis Toxic debt. 164. 179n. 150. 99. 18. 150. 154. 71. 142 WorldCom 48. 30. 146–8. see debt True sale 139–40 United Kingdom 21. 160 Washington Mutual 35 Wealth. 22. 25. 119. 150 Wall Street 1.5n. 71–2. 97–100. 51. 75. 143. 49. 105. 133–4. 31. 112. 53–5. 114. 34. 85. 59. 38. 161. 33. 40–1. 58. 88. 34. 92–4.3 . 32. 28. 86–8. 12. 7. ch. 95. 35–7. 173–6 Welfare 13–14. 17.13 United States 2. 2. 91. 43. 112. 182. 73.

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