Financial Alchemy in Crisis
Financial Alchemy in Crisis
The Great Liquidity Illusion
10 9 8 7 6 5 4 3 2 1
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For Alexandre Gennady Palan
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.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. 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. 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. 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
2002–7: the three Pillars of the Liquidity Illusion liquidity and the paradigm of self-regulating credit Playing with debt – together.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. 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
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)
. would not have been possible without the generous assistance. Randall Germain. Gary Dymski. Bruce Carruthers. london.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. i am particularly indebted to Rory Brown. summarising my own attempts to learn from the financial meltdown. Roy Keitner. Assaf likhovski. this book. Jakob vestergaard. encouragement and patience of Roger van Zwanenberg and the editorial team at Pluto Press. i am also grateful to my students and colleagues at City University. Jan toporowski. Randall Wray. Most of all. Michael Zakim and many others for constructive comments and feedback on earlier versions of the text. Christine Desan. i thank Ronen Palan for everything. victoria Chick. Giselle Datz. Angus Cameron. and elsewhere. Duncan Wigan. Dick Bryan. Paul Davies. Kees van der Pijl. Robert Wade.
Bond. Pierce the Black Monk.
. Body. sometime in sixteenth-century europe
sometime in the twenty-first century. wherein there is no corruption. as purged as crystal. ask him to throw the Bond in the air. Alchemy makes gold from base materials. not to be outdone by their sixteenth-century brethren. Alchemical gold is made of three pure souls. ask for an AAA rating. today’s experts have become as adept as their sixteenth-century forebears in the dark arts of wealth-creation. leave for six days. and Water of the Wood. and spirit grow into a stone. add two parts credit card debt and three parts house mortgage debt. Fire of earth. this is to be cast on Mercury and it shall become most worthy gold. take one part motor car debt. soul. then sell to a bank. a man versed in mathematics. these are to lie together and then be parted. earth’s Mother (Water of earth). invented a new formula. new monks. and call the whole. When it falls to the ground. Call in the Wizard.take earth of earth. and mix well together.
Indeed. Few thought that his classic study on economic history would be applicable to a crisis of advanced twenty-first-century capitalism. once considered a buttress of the high plateau and a built-in defense against collapse were really a profound source of weakness.IntroductIon the end of a Great IllusIon
By now it was also evident that the investment trusts. as George Santayana famously wrote. it is the illunderstood process of modern financial alchemy that has become the real cause of the global credit crunch. 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. of which people only a fortnight earlier had spoken so knowledgeably and even affectionately. With remarkable celerity it removed all of the value from the common stock of a trust. The turmoil that engulfed an unsuspecting world one Tuesday in early August 2007 has paralysed the
. was now fully in reverse. (Galbraith 1955)
Sounds familiar? John Kenneth Galbraith wrote these words in 1955 in his celebrated text on the 1929 Wall Street Crash. as is argued in this book. ‘those who cannot learn from history are doomed to repeat it’.
In fact. Yet there were some who had been writing about the possibility of such a collapse for years. incidentally. on a par with. So why another book on the global credit crunch? Because despite the plethora of theories and approaches. if not of greater significance than. There is little doubt that the meltdown will be remembered as an historical watershed.2
f inancial alchemy in crisis
world of finance and. How was it. the only industry to have done well out of the credit crunch appears to be the booming business of crisis commentary and theorisations. Complex in its nature and origins. the crisis has spurred a myriad of reflections. since then. still appears to escape the vast majority of observers – observers who. others had even detailed the imminent banking crisis in the ‘advanced’ financial systems (Persaud 2002). did not foresee the crisis in the first place. 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.
. the entire global economy. even decades. 9/11 or the fall of the Berlin Wall in 1989. criticising the traditional vector of monetary policies (Toporowski 2000). Some had warned about the historically unprecedented debt burden in Anglo-Saxon countries and predicted a crisis of debt-driven consumption (Pettifor 2003). the major cause of the global financial meltdown. some had been warning against super-inflated asset and housing markets. and the reason why it was inevitable though not widely anticipated. then.
Detecting historical parallels with previous socio-economic and financial crises and warning against history repeating itself. as a rule.inT roducT i on: T h e end of a Gr e aT i l l u s i o n
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. not ‘mainstream’ economists. Joseph Stiglitz and Nouriel Roubini aside. Hyman Minsky and other scholars who form the tradition of heterodox. As a result. political economy. There
. or critical. 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. these scholars prefer critical historical inquiry into the dynamics of financialised capitalism. and their concerned voices were simply muffled amidst the general sense of a credit bonanza in 2002–7. they are rarely invited to air their views in the pages of glossy business periodicals or high-profile policy forums. they often sound like unenlightened sceptics of finance-led economic progress. Still others ventured their prognoses on the basis of intuition and gut feeling. a few economist celebrities like Paul Krugman. many of them come from the same school as John Maynard Keynes. Suspicious of purely econometric techniques and abstract models in their analyses. Intellectually.
for instance. but for centuries scholars of political economy have been arguing among themselves about how best to define the concept of ‘value’. it remains current in the wake of the credit crunch. strikingly. today’s financiers create money and wealth. social. even cultural – have shaped the preconditions for the global malaise. rational and calculative. what ‘price’ is. During the boom years of 2002–7 this fallacy. was concealed by one great myth of today’s finance: the illusion of liquidity. As will be argued below. This belief had been shared by many participants of the crisis. They have yet to reach an agreement. Specifically. it is the idea that by inventing novel credit instruments and opening up new financial markets. the global credit crunch has shown this idea to be a dangerous – and costly – fallacy. geopolitical.4
f inanci al alchemy in crisis
is no doubt that complex sets of factors – historical. Keynes famously described the financial market as a ‘beauty
. including its major casualties.
‘liquidity’ and the crisis of invented money
There is a certain oddity about the realm of finance and economics. 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. Yet as the following pages contend. apparent to many in the aftermath of the crisis. technical. Although apparently precise. strict. economic. the key cause of the global credit crunch can be traced back to one pervasive and dangerous myth. We all know.
however. the world economy may require not just a facelift. In this sense. agreed definition or framework. rather than as a clear. Everyone knows that liquidity is the lifeblood of any financial market and that it is essential for general economic activity. But it is much less clear what such a statement means. these worries turned into the fear of a global liquidity meltdown. That fear soon materialised in a very real financial and economic crisis.
. Most people. Just weeks before the crisis erupted. even those outside finance. leading policymakers were concerned with what they believed was a structural ‘liquidity glut’. would intuitively prefer to be in a position that is liquid rather than one that is illiquid.in T roducT i on: T h e end of a Gr e aT i l l u s i o n
contest’1 and the metaphor stuck – albeit we know that things in this beauty contest often turn rather ugly. 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. after the financial wreckage of 2007–9. Yet within a matter of days. 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. The irony. still less whether that is a “good” or a “bad” thing’ (Smout 2001). but a major transplant. 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.
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. Or. a market. 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. complex. portfolio. multidimensional notion. Liquidity is also about depth – of a market for a particular class of assets – and speed – with which a certain transaction can be completed.6
f inancial alchemy in crisis
The problem is conceptual. liquidity can also comprise all these things and describe several layers of economic activity at the same time – for instance. To make things more complicated still. the global financial system as a whole. as economists like to stress. the liquidity of an individual bank. 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. an institution or even an economic system as a whole. 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. Liquidity can literally vanish overnight. liquidity to sell is not always the same as liquidity to buy. a segment of the market. national economy and finally. It describes a quality – of an asset. Liquidity is a very fluid.
. illiquid debt when confidence and optimism evaporate.
as did the markets for these products: whereas in 2007 $2. in 2008 almost none were sold to private sector buyers (Tett and van Duyn 2009). importantly. or at least started as. took the trouble to learn about the nature of these instruments in depth. their competitors – were making money. There is no clear
. Not many buyers. As will be argued below. gave them fancy job titles and paid them handsomely. Most chronicles of the crisis concur that the global meltdown centred on. When the boom came to a halt. synthetic financial products were exposed for what they actually were – parcels of toxic debt – and their market liquidity evaporated.inT roducT i on: T h e end of a G r e aT i l l u s i o n
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. At the height of the 2002–7 liquidity boom. financial institutions employed armies of young MBAs. bent on persuading even the most sceptical clients to part with their cash for bundles of securitised loans. liquidity drainage from the markets. Bankers could confidently sell highly complex instruments in bulk to clients around the world. All they seemed to care about was that the market for these products appeared highly liquid and that they – and. it now transpires. The new generation of finance professionals turned out to be nothing but a highly motivated sales force. these and many other puzzles of the credit crunch centre on the problem of liquidity and its metamorphoses in the modern financial system.500bn of loans were securitised in the US.
it is conditioned by the market context. As the field of credit crunch studies expands. The financial sector has been transformed from being part of the service economy. into an industry of trading and optimising risk. In the brief age of Keynesian economic stability. the diversity of views becomes ever more apparent. the concept of liquidity has undergone its own series of mutations. Not that long ago things were somewhat simpler. ‘liquidity’ was generally assumed to describe a quality of an asset and ultimately was related to the notion of money. the state lost its monopoly over the process of credit-creation.
. And even though the concept of ‘money’ remains probably the most controversial aspect of economics and finance. In 1971. however. most students of finance at the time would concur that liquidity is a property of an asset. on what the concept of liquidity actually implies today. In parallel.8
f inancial alchemy in crisis
consensus. an intermediary between lenders and investors. As such. As a result of the financial innovations that led to this collapse. 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). the postwar system of fixed exchange rates and financial controls was dismantled. But then the real life of the financial markets complicated matters.
During the centuries of metal-based money. The idea behind this principle is economic flexibility: by securitising previously non-traded products and putting them on the market. this trend manifested itself in the global debt crisis of the 1980s (Guttman 2003: 32). and became prone to overextension of credit. has been gravitating towards the realm of the financial markets themselves. Most dramatically. the Eurocurrency market became the global engine of liquidity-creation and debt-financing. The second mutation of liquidity has been the so-called securitisation revolution. the Euromarket. both functionally and conceptually. securitisation is a technique used to create securities by reshuffling the cash flows produced by a diversified pool of assets with common characteristics. widen
. and later in the era of the Gold Standard and even the fixed exchange rates of the Bretton Woods system. the notion of liquidity. By doing so. Created by commercial banks to avoid national regulations. the banking system’s ability to extend credit. liquidity was closely associated primarily with state-generated credit money and. Theoretically. With the collapse of the Bretton Woods regime and the rise of private financial markets. the transformation of liquidity has paralleled the rise of private financial markets. A key factor in this trend was the emergence in the late 1960s of the unregulated financial space.in T roduc Ti on: T he end of a G re aT i l l u s i o n
First. financial institutions attach a price to these assets. one can design several securities (tranches) with different risk-reward profiles which appeal to different investors (Cifuentes 2008). second.
Facilitated by technological and scientific advances. and with their greater reliance on securitisation techniques in managing their portfolios. the notion of liquidity as tied to the pure credit intermediation mechanism or a state-administered monetary pool began to fade away.: 40–1). In theory. strengthen the robustness of the economy as a whole. More recent examinations of liquidity as a category of finance have moved away from associating it with notions of money or cash. while emphasising its evasive and multidimensional character (Keynes 1936). stressing instead the link between market liquidity and risk (Allen and Gale 2000). obscure loans have been transformed into securities and traded in the financial markets. therefore. Indeed. the securitisation of credit has greatly increased the variety and volume of trade in the global financial markets.10
f inancial alchemy in crisis
their ownership and hence. the earlier political-economic conceptualisations of liquidity. The business of securitisation has been assumed to bring many benefits to the economy. creating the sense of much greater liquidity of these markets and the depth of the credit pool (ibid. have viewed liquidity as necessarily a twofold concept. the securitisation of credit became a process through which often poor quality. With banks rapidly becoming major players in this global financial market. Boosted by the resolution of the debt crisis of the 1980s. as well as the spread of the derivatives markets. by expanding the web of economic transactions. The explanation for this
. securitisation is supposed to enhance liquidity and economic stability.
high-powered or state-backed money. over the past few decades. 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. Also. a market characterised by the ability to buy and sell with relative ease’ (Farlex Free Dictionary). With money itself becoming increasingly dematerialised. After all. 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). thereby institutionalising liquidity firmly as a category and instrument of the market and its pricing mechanism. analyses of finance in the macro-economy have assumed that liquidity is no longer primarily a property of assets. As a result. As one web-based financial dictionary suggests. liquidity describes ‘a high level of trading activity. The policies of financial deregulation and liberalisation reinforced this trend. it may seem odd to link liquidity to categories of cash.in TroducT i on: T h e end of a Gr e aT i l l u s i o n
change in the analytical approaches is to be found in the financial developments of the post-1971 era. Instead. but rather an indicator of the general condition and vitality of a financial market. the global financial system is based on credit and a multitude of economic transactions. Specifically. liquidity has been presumed to relate
. allowing buying and selling with minimum price disturbance.
As financialisation advanced. therefore have been progressively abstracted from the dynamics of productivity. This in turn has produced several interrelated assumptions that have shaped finance theory and policy in the run-up to the global credit crunch. Just as money itself is. centred on financial institutions’ ability to transform illiquid loans into tradable securities. and second. trade.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. real economic
. reaping profits in the process. In terms of understanding what liquidity is and how it behaves. the process of securitisation (depicted above). marked by the inherent contradiction between money as a public good and as a private commodity. liquidity has progressively lost its public good component. or what social scientists understand as financialisation. the deepening of the financial sector and the growing role of finance-based relations in shaping the nature of socio-political developments today. 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). It encapsulates two intertwined tendencies in contemporary capitalism: first. therefore. or financialisation. The expansion of the credit system and the accumulation of financial wealth. The first trend concerns the expansion of the global credit system and can be described as a process of demonetised financialisation. an important assumption correlated with this trend. both spatially and intertemporally.
In this view. Rather. 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. or placing them off the balance sheet. by selling it on to third and fourth parties.e. mainstream finance theory and practice supported and guided these trends by embedding the new credit system in a paradigm of scientific finance. riskoptimising and market-creating financial innovations have been seen as key to enhancing social welfare more generally:
. (ii) by parcelling them into specific financial vehicles (such as tranches of mortgages or structured financial products). This complex chain of financial innovation is known in mainstream finance theory as market completion. crucially.g. 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. Toporowski 2009). that role has been assigned to just one sector of the financial system – commercial banking. often institutions specialising in trading these particular products. developments in the sphere of state-backed or high-powered money. for instance. as happened with many highly risky securitisation products) (e.in T roduc Ti on: Th e end of a G re aT i l l u s i o n
growth and. by pooling a bunch of sub-prime mortgages from several mortgage lenders). In the context of the sub-prime market. Second. analytically.
by relying on scientific approaches to risk management and calculative practices.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. such as real estate. thereby optimising risks and enhancing the liquidity of the financial system as a whole (Cifuentes 2008). even to applicants able to qualify in a prime-only market. Financial innovation. Those applicants obtain a welfare gain by having more choices and flexibility.
. cited in Wigan 2009). for instance. this process – extending far beyond the sub-prime market – symbolised ‘a new paradigm of active credit management’ (cited in Morris 2008: 61). transforms previously unpriced and typically illiquid assets. securitisation. (chinloy and macdonald 2005: 163–4)
Ultimately. is believed to create new facilities for risk optimisation and thus complete the system of markets. therefore. into tradable and liquid financial securities. As the theory holds. car or student loans and sub-prime mortgages. By pricing the risks of different types of credit quality. as Alan Greenspan foresaw. According to Greenspan. ‘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. 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.
in ways almost nobody understood. and the spread of new methods of risk management and trade. 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. Yet instead of being traded. or simply left on the books.
.inT roducT i on: T h e end of a Gr e aT i l l u s i o n
Third. the expansion of the so-called shadow banking industry. Indeed. Generally. the spiral of demonetised financialisation has been underpinned by institutional and operational advances in financial innovation. as Gillian Tett writes. in 2006 and early 2007. such as structured investment vehicles (SIVs). the growing sophistication and specialisation of offshore financial centres and techniques (Palan 2003). most were sold to banks’ off-balance-sheet entities. all leading to the extraordinary growth of variety and complexity of financial products themselves. such as value-at-risk (VAR) models. no less than $450bn worth of ‘collateralised debt obligations of asset-backed securities’ (CDOs of ABSs) were created. 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. there has been a remarkable rise in the number of hedge funds. In addition to the structural shift towards the ‘originate and distribute’ (ORD) banking model. she argues. as the principle of active credit risk management would imply.
more accurately. debt – has resulted in the now mainstream notion of liquidity that is divorced from any attribute of assets per se.16
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Officials at Standard & Poor’s admit that. 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). or between search and funding liquidity (ECB 2006). the axiom that financial innovation and engineering have the capacity to liquefy any type of asset – or. At the level of financial institutions themselves. it could take a whole weekend for computers to carry out the calculations needed to assess the risks of complex CDOs (Tett 2009). This conceptualisation of liquidity in turn has produced a sequence of analytical fallacies which have
. liquidity is most commonly understood as ‘confidence’ of the markets. And although some recent analyses have drawn a distinction between market and systemic liquidity (Large 2005). Here. rather than as a quality of assets as such. able and willing to trade at a given point in time at a prevailing price level (Warsh 2007). Namely. they conceive liquidity fundamentally as a property of the market or an institution. by 2006. 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.
I believe. Amidst the ostensible rehabilitation of his name. Therefore. 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. Second is the view that general market trade and turnover are synonymous with market liquidity. Altogether. consequently. 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. it is
. This misunderstanding. The first fallacy is the assumption that it is the market-making capacity of financial intermediaries to identify.
liquidity illusion and the Global credit crunch
‘Stability is always destabilizing’. 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. Hyman Minsky famously stated in his financial instability hypothesis. originates in a hollow notion of liquidity itself and.in T roducT i on: Th e end of a G re aT i l l u s i o n
contributed to the illusion that this is the real cause of the global credit crunch. 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.
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. in terms of liquidity. But as long as the music is playing. regardless of their intellectual and policy affiliations.18
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this message that seems to attract most commentaries on the credit crunch. 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 .. financial
. most commentators on the credit crunch recognise the tendency to underestimate the risks in a bearish market or bubble. ‘good’ times breed complacency. as stated famously by Citi’s Chuck Prince in July 2007: ‘When the music stops. you’ve got to get up and dance’ (cited in Soros 2008: 84). Indeed. According to Minsky. Most observers concur that the major factor in the global credit crisis was the progressive underestimation. Indeed. things will be complicated. exuberance and optimism about one’s position in the market and lead to greater reliance on leverage and underestimation of risks. or misunderstanding. economic prosperity and optimistic forecasts that pervaded North Atlantic economies and financial markets. The trend towards the ‘originate and distribute model’ … ultimately led to a decline in lending standards. of risk by financial agents. Many American observers continue to believe that the root cause of this problem was the liquidity glut coming from the emerging markets..
it appears that only a fragmented and highly selective version of Minsky’s theory resonates in current readings of the global meltdown. 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. this phenomenon constitutes an illusion of liquidity. many emergent theories of the global credit crunch appear to have strong Minskyan undertones. this illusion can have very real – and destructive – social. fund manager or a government) has about the safety and resilience of a portfolio and/or market as a whole. most mainstream analysts of the crisis overlook the core of Minsky’s framework. essentially. While noting the risk effects of the general macroeconomic environment and investor expectations. In other words.in T roducT i on: T h e end of a G re aT i l l u s i o n
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. or a situation in which markets under-price liquidity and financial institutions underestimate liquidity risks (CGFS 2001: 2). (Brunnermeir 2009: 78)
The BIS arguably went furthest in analysing the repercussions of this collective underestimation of risks for liquidity and admitted that. economic and political consequences. as now commonplace references to a ‘Minsky moment’ in finance or the crisis of Ponzi finance suggest. As the credit crunch revealed. In this sense. Yet once we consider the contentious place of ‘liquidity’ in the crisis.
Just as the securitisation bubble was beginning to inflate. The latest round of securitisation. in fact has driven the financial system into a structurally illiquid. creating new products and opening up new markets. create additional and plentiful liquidity. Yet.20
f ina nci al alchemy in crisis
eye on the very ability of private financial intermediaries to extend the frontier of private liquidity. ‘every institutional innovation which results in both new ways to finance business and new substitutes for cash decreases the liquidity of the economy’ (1984 : 173). as financial innovations gain ground. 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
. the velocity of money increases. whose liquidity was assumed but in fact was never guaranteed. crisis-prone state. as Minsky warned. one of the big investors warned about specific liquidity risks faced by his company. propelled by the belief that clever techniques of parcelling debts. On the one hand. on the other. 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. ultimately accentuating financial fragility in the system and thus accelerating the scope for a structural financial collapse and economic crisis. What is astonishing is that some market players seemed to be aware of this danger. According to Minsky. At the level of the financial system.
The ongoing turmoil has revealed that. during more benign periods.2 However. indeed. None of the studies. in October 2008. This has been part of a longer-term decline in banks’ holdings of liquid
. unless you actually have to sell them!”’ (Kochen 2000: 112). “sure they’re liquid. most discussions of liquidity in the crisis.’ (The Economist. 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 .. 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. For instance. or. we like the expression. makes the connection between the excesses of private financial innovation and its liquidity-decreasing effects. by focusing on the problem of valuations and risk mis-pricing.in T roducT i on: T h e end of a Gr e aT i l l u s i o n
short-sighted and over-reliant on the market’s shared sentiments: ‘as a guide to market discipline. 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.. 9 August 2008). the Bank of England documented a depletion of sterling liquid assets relative to total asset holdings in the UK banking sector. Yet the evidence is abundant. diagnose the evaporation of liquidity as a result of market failure rather than as a systemic tendency.
If the participants of the credit boom themselves did admit that some of the foundations of their innovative techniques were shaky. and if a whole body of scholarship in heterodox political economy can explain the dangers of financial euphoria and innovations. Ponzi-type finance. Such a narrow subject matter may seem far too technical and specific. why is it that the illusion of liquidity and wealth was sustained over a prolonged period. these three elements helped sustain the illusion of infinite liquidity during 2002–7. can be found in three political-economic pillars of the liquidity illusion: the paradigm of a self-regulating financial system. yet it serves an important purpose in unpacking the political
. which has been replicated in other countries. which thrives in a climate of deregulated credit and robust financial innovation. (2008: 39–40)
In this instance. this book tells the story of the global credit crunch as a crisis brought about by a pervasive and multifaceted illusion of wealth. Together. as is explained in the following chapters. 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).22
f inanci al alchemy in crisis
assets in the united Kingdom. or more concretely. illusion of liquidity. therefore. In what follows. leading people like Greenspan to celebrate ‘the new era in credit risk management’? The answer. an important question about the credit crunch remains unanswered.
a bank or a whole industry – the concept of liquidity has played a crucial. role in the political economy of the credit crunch.
. it also encapsulates the politics of financial alchemy today. and ultimately destructive.inT roducT i on: T h e end of a G r e aT i l l u s i o n
economy of the credit crunch. or what is widely celebrated as a process of financial innovation. While any economic crisis is in a sense a crisis of belief and confidence – be it in a national currency. Not only does the idea of liquidity capture a range of axioms and assumptions that shaped the architecture of the unravelling global financial system.
the credit crunch has had no lack of chronologies: every major media outlet and financial institution updates the timeline of key events and figures. causing a chain of bankruptcies and job losses in manufacturing and the services sector. A year later. the global credit crunch has gone through three distinct stages.
The Prelude: The american sub-Prime crisis
Most records of the global credit crunch start at 9 August 2007. the meltdown goes back earlier
. Gradually. Rather than replicate these detailed records. the meltdown turned into a cross-border banking crisis which threatened the very viability of the financial services in key economies. the financial meltdown had matured into one of the deepest recessions recorded in the postwar history of capitalism. the financial malaise spread to the real economy. It began with paralysis in the international financial markets. this chapter uses the records of the crisis and traces the evolution of the global meltdown through its three distinct stages. commonly dubbed a ‘liquidity crunch’. To date.1 the staGes of the Meltdown
Since it began in the summer of 2007. By the summer of 2009. However.
or 20 per cent of the $3 trillion mortgage market. The great housing boom was supported by cheap and plentiful credit and the widely held belief that house prices would continue to rise. ‘Sub-prime’ designates a category of borrowers who otherwise would be considered ‘high-risk’ clients: they had poor or no credit histories. 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. In the United States. In global terms. 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. and the first
. Yet it was as early as 2006 that the price increases in the American housing market slowed down. the US sub-prime market was worth $600bn. sub-prime loans made up just 5. American MBSs became the largest component of the global fixed income market.T he s TaGes of T he me lTdoWn
than that. Between 2002 and 2007. which has been the epicentre of the global malaise.2 In 2001.1 The expansion of the mortgagebacked securities (MBSs) market drew investors into some of the more risky tranches of MBS debt.6 per cent of mortgage dollars. accounting for a fifth of its value. In 2006. the prelude to the global financial meltdown unfolded in late 2006/early 2007. supported by opportunities to manage the high risks that the new financial system offered. It all started with a boom. But in the booming housing market. housing markets in the Anglo-Saxon economies were booming at unprecedented levels.
Homeowners. from 1 per cent in 2004. who said: ‘I think [the risk] is containable … I don’t think this is going to be a cataclysm’ (in Kratz 2007). Lewie Ranieri. According to the structure of sub-prime loans. Commentators explained this by the fact that in 2006
. By the end of 2006. the trend historically was insignificant (IMF 2007: 5). sub-prime delinquencies more than 60 days late jumped to almost 13 per cent. began to default on their mortgages and defaults on sub-prime loans rose to record levels. Observers offered different readings of this trend: some argued that despite the notable increase in bankruptcies. crucially. came from the architect of mortgage-backed finance himself.35 per cent in 2006. many of whom could barely afford their mortgage payments when interest rates were low. thereby increasing the interest payment on the loans. The trigger to the rising number of defaults was the increase in the interest rate. compared to 8 per cent in 2005. Others began to anticipate a bigger wave of defaults and bankruptcies: most 2006 borrowers were still in the ‘teaser rate’ period of their mortgages. Some sceptics warned that against this background a default of one or two financial companies could well spark a worldwide financial crisis. their repayments were due to rise in a year or two. The sceptics were proven right. in 2006 the structure of US sub-prime mortgages shifted many borrowers out of their initial (presumably favourable) fixed-rate terms. Also. for those who needed them.26
financi al alchemy in crisis
wave of mortgage delinquencies started to spread. which climbed to 5. The words of reassurance.
In March 2007. interest rate. HSBC Finance. The number of bankruptcies and foreclosures also rose: according to Moody’s. On 22 February 2007 HSBC. through the complex web of mortgage-backed finance. in 2006 it reached almost 4 per cent. news of heavy losses from the ailing sub-prime market hit American building companies. The winter of 2006–7 brought the first signs of the real magnitude of the coming meltdown. 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).5bn loss in its mortgage finance subsidiary. Smaller sub-prime lenders operating on the American markets were in a less healthy position. compared to 2. and higher.3 announced a $10. the largest sub-prime lender in the US and a leading investment bank globally.T he sTaG es of T he me lT doWn
some of the more neglected sub-prime loans had reached their refinancing limits. Many smaller sub-prime lenders were already facing bankruptcy. most notably New Century
. Eventually. started to affect the financial and banking system more generally.2 per cent for a similar type of loan originated in 2004.4 At the time. the housing boom stalled and. a giant like HSBC could write off the $10bn loss and escape relatively unscathed from the mounting market distress. and borrowers could no longer afford to pay the mortgage on a new. Market sceptics immediately read this as a sign of a greater trouble ahead: HSBC’s total annual profits were around $15bn. This fuelled fears of bankruptcy in several sub-prime lenders.
Bear Stearns told investors
. for instance. The fall of the company marks the point when tensions in the sub-prime mortgage markets started to affect Wall Street directly. even as the prospects for the housing market and financial boom darkened. Specifically. commentary at the time viewed the unfolding downturn as no more than a cyclical adjustment to the otherwise normal trend of rising house prices. announced write-downs. explained the downturn as a combination of regional economic factors and a shift in the US mortgage market. over the following few months the sub-prime crisis escalated as more and more high-ranking companies. this reflected a ‘seemingly orderly re-pricing of credit risk’. 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). on 2 April 2007. The IMF. rather than as a systemic breakdown in finance and the economy. New Century Financial Corporation filed for Chapter 11 bankruptcy. According to the BIS.28
f inanci al alchemy in crisis
Finance Corporation. Interestingly. In just a few weeks. In July 2007. including UBS and the investment bank Bear Stearns.
from sub-Prime crisis to the Global credit crunch
Notwithstanding the optimism in the markets. conditioned by changing economic and policy factors in the US economy (Borio 2008: 5). at the time the largest American independent sub-prime mortgage lender.
the world’s financial indices went into free-fall and pretty much remained there over the following months. On 9 August 2007. the largest French bank. the list of casualties of the implosion included the hedge fund run by Bear Stearns. a US home loan lender. the European Central Bank (ECB) injected €95bn into the overnight markets and the Federal Reserve injected $38bn. Reacting to the news. Countrywide Financial.5 and the German bank IKB. American Home Mortgage Investment Corporation. the credit ratings agencies were downgrading asset-backed securities (ABSs). the world’s
. As large financial houses were calculating their losses from sub-prime loans. of the money invested in two of its hedge funds after rival banks refused to help it bail them out. In the space of just a few days in mid-August 2007. 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. if any. subprime-backed bonds and collateralised debt obligations (CDOs). Central banks around the world immediately offered liquidity support in an attempt to stem the panic.T he sTaG es of T he me lT doWn
they would get little. On that day. By early August 2007. BNP Paribas. Federal Reserve chairman Ben Bernanke estimated that the sub-prime crisis could cost up to $100bn. other central banks followed with similar actions over the following weeks.6 The fateful date 9 August 2007 became the official anniversary of the global credit crunch.
Aside from liquidity injections. With this. started to unfold.7 Despite these collective and unprecedented efforts to restore optimism in the markets. the first run on a bank in the UK for a century. and a subsequent political scandal. by harming those financial institutions that relied heavily on wholesale credit markets. the UK financial watchdog. Through its effects on the financial markets worldwide and. The best known of the casualties during this second phase was the British bank Northern Rock.30
financi al alchemy in crisis
central banks pumped an extraordinary $240bn into the ailing markets. on 13 August 2007. might be facing a liquidity crisis.
. Northern Rock Just days into the unfolding malaise in the financial markets. the first stage of the global meltdown – the sub-prime crisis in the US – had not been brought under control. was reportedly informed that the country’s fifth largest mortgage lender. Northern Rock. the Financial Services Authority (FSA). 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. it was transformed from a crisis in one segment of the market into an international banking crisis and global credit crunch. in particular. which went bankrupt in August–September 2007 and had to be nationalised.
On 13 September 2007. Northern Rock and the UK tripartite authorities (the Bank of England.).T he s TaGes of T he me lTdoWn
In 2006–early 2007. but a small customer deposit pool of only £24bn (Wood and Milne 2008). At the time. Northern Rock had a portfolio of loans and assets of £113bn. a takeover by another major bank. During the years of the credit boom. the Bank of England provided Northern Rock with emergency liquidity support. but it would later emerge that the UK authorities spent around £50bn of taxpayers’ money rescuing the bank. linked to the exceptional market
. it could no longer tap the international financial markets for financing. As credit dried up. Granting the cash. the amount of money used to save the bank was not disclosed. As the crisis in the international financial markets deepened and credit flows froze up. three scenarios of crisis management were discussed: a market solution (Northern Rock would try to obtain the necessary funding by itself). the first two options became unfeasible. the Financial Services Authority and the Treasury) debated how best to extricate the bank from its difficulties. As Wood and Milne document. this ‘aggressive’ business strategy had paid off handsomely. while the deposits it had on its books were simply not sufficient to cover its outstanding obligations. But fortunes turned against the bank in the summer of 2007. Between 10 August and mid-September 2007. the authorities also commented that funding problems at Northern Rock were of a temporary (liquidity) nature. and cash support from the Bank of England guaranteed by the government (ibid.
Despite these measures. JP Morgan Chase. the bank was nationalised in February 2008. entering the year 2008 in the gloom of foundering housing markets. Meanwhile the crisis intensified. By March 2008 things had become darker still. Despite government support. was acquired by its larger rival. the IMF estimated that total losses from the sub-prime crisis could reach $1 trillion. potentially. rather than a serious structural problem. panic in the financial markets and more losses being revealed by banks and other companies. depression. for $240m in a deal backed by $30bn of central bank loans.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. Sceptics warned that the true costs would be much higher still.
. Wall Street’s fifth largest bank. 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. On 17 March 2008. Bear Stearns.32
financi al alchemy in crisis
conditions. credit markets remained frozen. As banks were increasingly reluctant to lend to each other. After a failed attempt by the Virgin group to buy Northern Rock. however. In the midst of gloomy macroeconomic data now coming from economies around the world and debates about the imminent recession and. This continued until the government stepped in to guarantee depositors’ savings (BBC 2009).
according to market consensus and common sense.
. On the other side of the Atlantic.
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.Th e sTaGe s of Th e me lTd oWn
the crisis continued to accelerate into the summer and autumn of 2008. or nearly half of the US’s $12 trillion mortgage market. On 14 July. the largest holder of US debt. On 7 September. 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. owning or guaranteeing $5 trillion worth of home loans. The next dark moment in the crisis chain came in mid-summer 2008. They had been the drivers of the mortgage securities markets. In late August 2008. Alistair Darling. 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. signs of recession were becoming more visible. the UK Chancellor. The pressure. the two largest lenders in the US – Fannie Mae and Freddie Mac – appealed for help from the US government. Fannie Mae and Freddie Mac were taken over by the US government in one of the largest bailouts in US financial history. came from China.9 Although the Chinese government made no official comment at the time.
in return for an 80 per cent stake in the company. Alan Greenspan described the fall of Lehmans as ‘probably a once in a century type of event’. On 15 September 2008. it would emerge that having received the bailout. AIG. In the US. Under pressure from an angry Congress. Direct comparisons with the 1930s crisis and projections of a global depression became commonplace. Merrill Lynch. the Federal Reserve authorised an $85bn rescue package for the country’s biggest insurance firm. Lehman Brothers filed for bankruptcy protection under Chapter 11. Lehman Brothers – one of the largest Wall Street banks – posted a loss of $3. representing the biggest erosion of financial wealth since the 1930s. Markets went into free-fall for weeks in a row. after several futile attempts to find a buyer or secure governmental rescue.9bn for the three months to August 2008. These included top US firms Goldman Sachs
. The situation worsened as another high-profile US bank.34
f inancial alchemy in crisis
Three days later.10 Several months later. AIG paid out hundreds of millions of dollars in bonuses to its senior executives. agreed to be taken over by Bank of America for $50bn (BBC 2009). 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. The second half of September 2008 witnessed several attempts by governments to tame the panic in the markets and save individual institutions from bankruptcy. AIG eventually had to list the firms to which the money was actually paid.
the credit crunch spread further into the European banking systems. Barclays ($8. AIG named nearly 80 companies and municipalities that benefited most from the Fed rescue. Fortis. The deal allowed the Treasury to buy up ‘toxic debt’ from ailing banks.T he sTaG es of T he me lT doWn
($12. HBOS.3bn) and Wachovia ($1. In total.2bn).5bn) and UBS ($5bn). though many more receiving smaller payments were unnamed (Williams Walsh 2009).5bn). Citigroup ($2.11 Merrill Lynch ($6. The UK’s Bradford & Bingley – the largest provider of ‘buy to let’ mortgages in the country (controlling around £50bn of mortgages) – was part-nationalised. was facing bankruptcy. It was the biggest public intervention in the markets since the Great Depression and would take weeks to be approved by Congress. the country’s biggest mortgage lender. part-sold to the Spanish bank
. policymakers in the US drafted a massive $700bn rescue package for the American financial system. Bank of America ($5. Lloyds TSB took over the ailing bank in what would soon prove to be an unwise £12bn deal. was closed down and sold off to JP Morgan Chase. Towards the end of September. was nationalised. US mortgage lender Washington Mutual (whose assets were valued at $307bn).9bn). Meanwhile. 12 In the UK at around that time. The major foreign banks included Société Générale and Deutsche Bank (nearly $12bn each). Political disagreements and uncertainties over the nature of the deal continued to send shockwaves through the global financial system.8bn). a banking and insurance giant. On 25 September.
central banks in the US. The government also offered up to £200bn ($350bn) in short-term lending support. Over the following days. Iceland was on the brink of complete financial meltdown. Sweden and Switzerland cut interest rates. EU. Iceland would approach the IMF for a rescue loan. Glitnir. as governments around the world drafted recapitalisation plans for the financial systems. after the company faced short-term funding problems. Finance ministers from the leading industrialised nations announced action to tackle the financial crisis. Canada.36
f ina ncial alchemy in crisis
Santander. On 11 October. the UK authorities announced details of a rescue package for the banking system worth at least £50bn ($88bn). When another major UK bank – RBS – required a public rescue the UK financial system came to a standstill. and banks increasingly lost confidence in the safety of lending to each other. the G7 nations issued a five-point plan of ‘decisive action’ to unfreeze credit markets. The Icelandic government took control of the country’s third largest bank. All these events spurred action. funding costs rose sharply and for
. Governments throughout Europe announced multi-billion support packages for their economies. facing a currency attack and a systemic banking crisis. as carefully described by Mervyn King. On 8 October. companies and non-bank financial institutions accelerated their withdrawal from even short-term funding of banks. Governor of the Bank of England:
in the second half of september. Eventually. Meanwhile.
as markets and economies continued to stumble. (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). credit to the real economy almost stopped flowing … eventually. despite interest rate cuts and other state efforts to restore confidence in the economy.T he sTaG es of T he me lT doWn
many institutions it was possible to borrow only overnight. with the major European countries following the UK in authorising massive recapitalisation plans for their financial system. Nevertheless. similar action was adopted by most countries affected by the credit crunch. these extraordinary policy efforts appeared ineffective. the committee drafted a rescue plan (later known as the Brown-Darling bank recapitalisation plan). and over the course of the following weeks. By early November 2008. Over the weekend of 4–5 October 2008. on 6 and 7 october even overnight funding started to dry up. yet as Chapter
. 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. reacting to weakening economic data and ever more tangible signs of economic recession on both sides of the Atlantic. affecting economic growth in the emerging markets.14 The continuing crisis and deepening recession prompted multi-level attempts to form a coordinated global policy plan to reform international financial architecture. recession trends set in and spread globally.
At the end of 2008. 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. and eventually into a global credit crunch which has directly led to a global recession. 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. South
. This figure not only exceeds all previous estimates of sub-prime-related losses. By 2009. over the course of its two-year history.15 Overall. demand for manufactures. or just over one year’s GDP – suffering more than other regions of the emerging markets.2 per cent year-on-year in January.38
financi al alchemy in crisis
6 below shows. with some believing that the financial markets would not recover their pre-crisis levels until 2012. Data reflecting real economic losses globally are sobering. the global financial crisis had been transformed into a global recession. but is close to a year’s world output. 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. disagreements over the appropriate course and tone of regulatory action opened up at the transatlantic level.6 trillion. In March 2009.16 The loss of stock market wealth alone amounts to $25 trillion. world manufactured output and world trade in manufactures had fallen off a cliff: Germany’s industrial output was down 19.
as well as uncertainties over its potential effects on the economic activity and politics globally. The sheer severity and scale of the global meltdown. But before delving into the emergent schools of thought.T he sTaGes of T he me lT doWn
Korea was down 25. let us take a closer look at one particular event that.
. have spawned a rash of explanations and theories of the credit crisis and its major lessons. epitomises the politics and economics of the credit crunch: the fiasco of Northern Rock.6 per cent and Japan down 30. as argued in this book.8 per cent (in Wolf 2009).
it was reported. operational director for securitisation at Northern Rock. 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. ‘The beauty
.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. congratulated Whinstone Capital Management fund – a part of the British bank Northern Rock – on winning the award for the best securitisation deal of 2005. In technical terms. Essentially.4 million – and one of the largest subordinated debt issuances ever in the European market. three of which were stand-alone issues and the other ten under the Master Trust programme. The deal. David Johnson. the transaction represented the largest public placement of double-B risk – £117. London’s Credit Magazine. one of the financial industry’s glossy periodicals.
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. he declared. * * * 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. along with other high-profile financial collapses. but soon paralysed the world financial system. observers on the left and right started to argue. they merely disguised or
. ‘is in its simplicity. that securitisation techniques had never discovered new ways of managing or optimising risk.T he Tale of norT he r n ro cK
of it’. the UK government announced a controversial decision to nationalise the bank. Northern Rock. greed and fraud. such as Bear Stearns and Lehman Brothers in the US. Fortis in Belgium and most of the Icelandic banks. reducing the value of the company to £380 million. In the winter of 2007. Northern Rock was valued at £5bn. As the securitisation boom of the decade ground to a halt in the summer of 2007. quite persuasively. by February 2008. the bank’s shares had dropped to 90p per share. January 2006). Bradford & Bingley in the UK. On 18 February 2008. became victims of a convoluted chain of securitisation techniques that centred on the sub-prime mortgage industry in the US.
these three sets of factors can be summed up as market exuberance. the global expansion of the private risk management industry. a collective belief that debt – of whatever kind – can be bought and sold endlessly. see also Nesvetailova 2007. and third. it illustrates the extent to which the political and legislative environment set the conditions for the global crisis. has called ‘artificial liquidity’ (Borio 2000. a regulatory environment that occluded the build-up of bad debts and dubious investment practices. Together. Here. regulatory evasion masquerading as innovation and sheer fraud. 2004. But if the real foundations of financial health in the 2002–7 credit boom never existed.
. chief economist of BIS. second. as many analysts now seem to agree. we focus on one emblematic example of the effects of this process: the fall of the Northern Rock and its offshore. 2008): first. The following chapters delve deeper into the analysis of the dynamics driving this complex process. Granite. Encapsulating many wider trends of the global meltdown. driven by financial innovation. Jersey-based special purpose vehicle (SPV). 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. The story of the fall of this bank is significant in the analysis of the political economy of the credit crunch.42
f inancial alchemy in crisis
lower transaction costs and circumvent outmoded regulation (Silber 1983: 93). such as the rise of the hedge fund industry. Most accounts of financial innovation explain it as a market-driven process that. Structurally. Most theoretical interpretations of financial innovation also concur on the relationship between official regulation and the progress of private financial innovation. the invention of new credit products. rules or regulations. Hu et al. financial innovation has been theorised and understood. ultimately brings social and economic benefits and increases social welfare. at least within financial orthodoxy.
. whether direct or overt. most financial innovations – be they institutional changes. channels and financial institutions was facilitated by the deregulation of global capital markets and national financial systems starting in the late 1960s (Helleiner 1994.g. of the financial industry to official restrictions. as a technologically-driven process of ‘market completion’ (e. 2005). The orthodox view holds that innovations in instruments and institutions improve the ability to bear risk. Although actors in the public domain tend to lag far behind advances in financial engineering.Th e Ta le of norT h e r n ro cK
The controversy over financial innovation
For the past three decades. or product inventions like the myriad of new asset-backed securities and their derivatives – are in fact a reaction. Burn 1999). much like any other technological innovation in the economy. Chinloy and Macdonald 2005.
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. financial derivatives or mortgage securitisation (e. Kane 1988). on the other. reflective and to a large extent cyclical. the Swiss National Bank (SNB) and the Federal Reserve (the Fed) – entered into mutual currency swap arrangements. financial innovations are often designed. tend to involve some type of new financial practice. Although
. It is also worth noting that public authorities often tend to ‘innovate’ in their own techniques and methods when reacting to financial crises. compliance and other regulatory norms (Chick 2008). What is apparent at this stage is that there is no straightforward dynamic between regulation and financial innovation. the relationship is reciprocal.44
fin anci al alchemy in crisis
Not surprisingly. accounting. 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. respectively. be that cross-border trade. But. as many scholars have pointed out.g. as history suggests. which. introduced and established in the markets in reaction to changes in official rules on taxation. Indeed. in light of the global crisis. The scheme allowed the SNB and ECB to conduct repo operations1 in US dollars against the usual collateral of the SNB and ECB. On the one hand. as we noted in Chapter 1. in December 2007 the world’s leading central banks – the European Central Bank (ECB). Rather.
The Act was designed to compensate banks for the difference in interest rates between the European and the US financial systems. the interaction between regulation and innovation tends to bring out the evolutionary. 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. rather than structured or revolutionary. this example of international regulatory innovation was one of the few of its kind. according to many critics. an outcome of the complex interplay of incentives and governmental controls over finance. character of financial globalisation. Financial innovations rarely emerge ab initio. therefore.T he Tale of norT he r n ro cK
critics at the time said that the measure was neither well coordinated nor justified by the market’s need (Buiter 2007). Generally. Any new product or practice needs a motive and a context in which to thrive. Commonly. For instance. American banks not only failed to repatriate their investments. economic and structural changes that prompt a wave of financial innovation include: (i) volatile inflation rates and interest rates. (The only previous example of such coordinated effort dates back to the policy response to the 9/11 attacks. (ii) regulatory changes and the circumvention of
.) Generally. In fact. or financialisation. dating back to the late 1960s. the most recent wave of financial globalisation. is. but opted not to leave the Euromarket altogether (Palan 2003). and attract American funds back into the US economy.
(iv) technological advances. interestingly. Both factors have been at the epicentre of the global credit meltdown generally and of the fiasco of Northern Rock in particular. Some 20 years ago. without necessarily breaking the law’ (Miller 1986. (mcBarnet and Whelan 1992. The rules of the level playing-field themselves become obstacles to some but not all. academic work on market efficiency and inefficiencies (van Horne 1985: 622). (v) the level of economic activity. (iii) tax changes. Specifically. Two of these structural elements are pertinent to our focus on Northern Rock: the circumvention of the regulation and rules of taxation. cited in shah 1997: 86)
At the time. cited in Shah 1997). and (vi). 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
. van Horne 1985. 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.46
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regulations. regulation … becomes a further stimulus for innovative use of law both to defeat unwelcome regulation and to secure advantage over competitors. 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. with some more able than others to creatively escape even harmonised regulatory restrictions.
When interest rates are low and the traditional function of financial intermediation – taking deposits and lending – is no longer appealing. financiers look for alternative ways to make money through commission fees. ‘creative accounting’ and. financial innovation has produced a skewed structure in the financial system itself. were at the heart of the Northern Rock fiasco. the media and analysts were unable to expose these practices publicly and restrain such creativity: ‘practising creative accounting is not that difficult. 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. 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). bankers.
. Worryingly. 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. they are also representative of more general trends in the financial industry. often. outright fraud. These elements. Thriving in this zone. the regulators. In turn.T he Tale of norT he r n ro cK
the help of investment bankers and lawyers. tax avoidance and evasion. owing to the significant grey area that exists between compliance with the rules and non-compliance or evasion … The collusion between management.
Refco. which ultimately has to bear the resulting risk without enjoying the risk premium that created it. by definition. The argument is that opacity benefits those who are. more recently.
. have been blamed. at least the one least equipped to handle complex and rapidly changing information. entities (SPEs) or investment vehicles (SIVs). The function of both SPVs and SPEs raises severe prudential problems. as one of the directors of Enron reputedly quipped. The small investor is. Enron. 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). Parmalat and. as well as the scandals associated with the dot.com bubble. at least in part. if not the stupidest in the room. Northern Rock and the 2007–9 credit crunch. including those in East Asia and Russia.48
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offshore: The uses and abuses of sPVs
Most financial crises in the past two decades. WorldCom. ‘the smarter men in the room’. The offshore entities that seem to have caused most of the problems are the special purpose vehicles (SPVs). they leave many workers without pensions and jobs. 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). But these crises revealed a more critical dimension: scandals and frauds not only cheat investors. and have a contagious effect on the entire economy. The term SPV covers a broad range of entities. Tax havens have made it exceedingly easy to set up offshore SPVs.
For example. 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. they have few incentives to ensure that appropriate due diligence and regulation are undertaken. the Cayman banking system holds assets of over 500 times its GDP and Jersey holds resources of over 80 times its GDP. Yet considering that they are competing with better equipped but almost equally unregulated centres such as London and New York.3 Unsurprisingly. 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. There is a broad consensus that the Caymans. We have no way of knowing. exactly how many of the world’s SPVs are based in these tax havens. A report by the UK’s National Audit Office clearly suggested that they do not (NAO 2007). It seems pertinent to ask whether such small jurisdictions can allocate sufficient resources to monitor and regulate such colossal sums of money. especially in terms of people. Murphy and Chavagneux 2010).T he Tale of norT he r n ro cK
yet crucially they do not have the resources. We
.2 to perform appropriate due diligence on what are very sophisticated financial vehicles. The only reliable indicative data can be gleaned from the BIS locational statistics. Ireland. however. executives of financial companies do not like to see their names mentioned in the context of scandals or fraud. Luxembourg and Jersey are attracting much of the world’s SPVs.
.3 1. International Financial Statistics. Enron’s fraud was organised through 3.5 1.9 8. reported that the company created complex financial arrangements.8 4.1 The share of ofcs in international financial flows.5 326.3 210.8 773.5 761.2 4. that we do not see the two as being the same thing.50
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would like to stress.1 205.7 0.1 0.6 2. The Powers Committee. Troubb and Winokur 2002: 4). not to achieve bona fide economic objectives or to transfer risk’ (Powers.8 4.3 1.0 71. The report states that ‘[m]any of the most significant transactions [of Enron] apparently were designed to accomplish favorable financial statement results.5 436. which investigated Enron’s collapse.7 0. 2008.164.218.334.5
Source: BIS.0 1.226. partnerships and SPVs in order to shift debt around and make illicit payments to its directors.6 1.7bn 1.0 % share 5. though.
SPVs hit the headlines following the collapse of Enron.691.
Table 2.2 2.413. 2007 All countries Caymans Switzerland Netherlands Ireland Singapore Luxembourg Bahamas Jersey Guernsey Bahrain Isle of Man Total $29.3 28.
In 1997. In this context. Northern Rock became a public limited company. neither the Powers Report nor the congressional hearings demonstrated that offshore structures were palpably more poisonous that the onshore ones in the Enron case. Banks. after the wave of demutualisations of the 1990s. that Enron’s offshore SPVs were set up primarily for tax avoidance purposes. It appears. the fifth largest mortgage lender in the UK in early 2007. can get ready access to larger sums from the money markets. 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. despite headline reports. Nevertheless. 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. began life as a building society in 1965. on the other hand. Building societies typically raise the money they lend conventionally.T he Tale of norT he r n ro cK
SPVs ‘with over 800 organised in well known offshore jurisdictions. and about 600 using the same post office box in the Cayman Islands’ (US Senate 2002: 23).
northern rock and Granite
Northern Rock. including about 120 in the Turks and Caicos. by attracting it from depositors. rather. This was an aggressive expansion technique: the audit of Northern Rock’s accounts in 2006 showed that it raised just 22
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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.
Th e Ta le of norT h e r n ro cK
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
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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
then Chancellor of the Exchequer. the FSA. the Bank of England is responsible for monetary policy and systemic financial stability. This division of labour was supposed to make the overall maintenance of financial stability more efficient by facilitating a clear distinction between the micro. In 1997. 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). and the Treasury for the overall institutional structure of financial regulation and the legislation which governs it.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). failed to compile an accurate picture of the financial
. formalised a division of labour between the Treasury. In Northern Rock’s case. As Willem Buiter argues.56
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several fundamental problems that financial regulators encounter in the age of thriving financial innovation. First. the arrangement failed in a number of ways. the Bank of England and the newly established Financial Services Authority (FSA). the information-gathering body. According to this ‘tripartite’ arrangement. the FSA for prudential supervision of financial institutions and market segments. Gordon Brown.
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. Second. The supervisory reviews of the bank’s books were only conducted every three years. which drained much-needed cash from a bank tightly dependent on the ailing sub-prime market in the US. Of the 3. 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. 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.000 staff working at the FSA. the FSA’s implementation of the few rules on liquidity risk also raised concerns. In the midst of the unravelling crisis (July 2007).T he Tale of norT he r n ro cK
health of the bank. Probing questions about the bank’s finance model (relying on wholesale markets for funds) and its liquidity position were never asked. other parties to the tripartite arrangement are blamed for the Northern Rock fiasco as well.5 Third. 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. The Treasury has been
. and of Northern Rock in particular. only three were reportedly dealing with Northern Rock. Northern Rock was allowed to pay out large dividends to its shareholders.
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 tripartite arrangement as a whole failed in the task of passing information from the FSA to the Treasury. (In 2006. imposing a political solution to nationalise the bank (Lascelles 2007). on 14 September 2007. by taking the initiative in the Northern Rock case. Applegarth reportedly was paid a $1. Fourth.5 million bonus.58
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faulted for overriding the terms of the agreement and. 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.36 million. is one of the many uncomfortable puzzles of the credit crunch. the bank’s senior management were
. Adam Applegarth. On 14 August 2007. the bank did just that. he cashed in shares worth more than £2 million. the Treasury did nothing to prevent the collapse (Moulton 2008). In the midst of the collapse. the Treasury was told that Northern Rock might run out of money. The Northern Rock crisis has raised many issues about how private financial gains and socialised losses are addressed by political leaders. In the period between those dates. a month later. Northern Rock’s former CEO. During 2007. When he resigned. as is maintained in this book.
JP Morgan and Morgan Stanley. market segment or even a financial model. sweeping under the carpet the complex legal situation
. 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.) But apart from this. quasi-legal Ponzi schemes or regulatory avoidance techniques. and prominent. 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. sub-prime lending and hence the current crisis are not the outcome of one malfunctioning institution.000 in compensation pay. Lead underwriters on the Granite programme were Lehman Brothers. vehicle of financial innovation. a regime that has made the pyramid (or Ponzi) principle a legitimate. The scheme that Northern Rock set up with its Jersey SPV illustrates one of the problems the financial markets face. underwriters were Barclays Capital. The UK government was prepared to accept the arrangement. preventing public authorities from adjudicating in cases when private financial manipulation leads to systemic risks and public losses (Palan 2003). The list which links the names of the world’s largest investment banks with an obscure offshore financial scheme suggests that bad debts.T he Tale of norT he r n ro cK
offered £100. Citigroup. Rather. Merrill Lynch and UBS. The secrecy and lack of transparency offered by offshore financial centres facilitate outright scams.
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it found itself in. one answer to this puzzle (and some others) of the credit crunch centres on the contentious notion of liquidity in finance today. raises another concern about the systemic role of financial innovation today. Private investors are not as forgiving. As is argued in the following chapters. of the economic system that precipitated the global meltdown. orphaned and legally separated yet holding massive amounts of debts. In other words. essentially. plays a crucial role in perpetrating mistrust – and for good reasons. the crisis was brought about by the multifaceted illusion of liquidity that. The fall of Northern Rock. The web of offshore entities. 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. knowing full well that most if not all of their counterparties holding accounts and SPVs offshore are beyond the scrutiny of any regulatory authority. banks and other financial intermediaries have no recourse but to rely on each other’s goodwill. as the following chapters show. Specifically. Ambiguity of this sort may be ignored in good times. and hence stability. while temporarily
. why so many dubious debts were regarded as safe investment vehicles for so long. a Ponzi investment principle. namely. with its use of an obscure finance scheme and. In contemporary finance. it was a flawed understanding of the effects of financial innovations on the liquidity.
in the end proved to be a dangerous and destructive myth.T he Tale of norT he r n ro cK
profitable. it is worth examining how the crisis has been understood so far and what questions about the global credit crunch remain unanswered. But before we turn to this part of the story.
credit crunch theories can be divided into ex-ante and ex-post explanations.
. blogs on crisis-related issues and journalistic investigations. this chapter aims to systematise the spectrum of emerging views on the nature and implications of the financial meltdown.3 how the crIsIs has Been understood
The continuing economic malaise has produced a whole industry of credit crunch analytics. Ex-post explanations were put forward once the crisis started to engulf world markets. are those that warned about the possibility of such a collapse – and eventually predicted it – before the events of 2007 engulfed world markets. to high-profile policy discussions commissioned by official bodies and academic analyses. These range from popular commentary. Focusing mainly on the latter.
Ex-Ante and Ex-Post Visions of the credit crunch
At first cut. The ex-ante theories. Whilst readings of the crisis do overlap. as the term suggests. 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.
polities and cultures). the sheer sense that the Anglo-Saxon economies were overheating and asset and financial bubbles would soon burst. as opposed to ‘capitalism as usual’ (a system marked by periodic crises. Whereas more pessimistic predictions of the imminent collapse of US debt-driven consumption
. and deeper scholarly analyses of the credit system that detected profound abnormalities and tensions accumulating in the economies of ‘advanced’ Anglo-Saxon capitalism. 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. the ex-ante theories originated both in a simple ‘gut-feeling’ understanding of what was happening in the financial markets. Here. communications and finance. the distinction focuses on what is ‘normal’ and what is ‘abnormal’ in the structure and functioning of the economic system. as well as globalising trends across markets. the basic difference between these two schools of thought is their reading of the place of finance in the evolution of capitalism more broadly. 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. conflicts of interest and profound structural dislocations).hoW T he crisis has B een un de r s Too d
Within this rather broad classification. Specifically. 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. Apart from the timing.
the deregulation of the financial system has popularised access to credit and finance. In most cases. 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. Ultimately. 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. the dominant mood in the markets during 2002–7 is probably best expressed in the admission of a risk manager of a global bank. The Global Credit Crunch as an Exogenous Shock Within this ex-post group of analyses. virtually no defaults in our loan portfolio
. market regulators. political leaders and observers totally by surprise. as argued from these perspectives. making the economy more flexible. they were simply dismissed or. 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. four years of falling credit spreads. efficient and diversified.64
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emphasised the destructive role of unprecedented levels of debt in the US and the global economy. low interest rates. Instead. penalised. 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.
according to his colleague at Barings. everyone borrowing up to their eyeballs. 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. even if risk managers did acknowledge that the history of finance offers unsettling lessons about bubbles and crises. In this sense. we went through this in the eighties and early nineties. this logic seems rather odd. typically with a crash.hoW Th e crisis has B e en un de r s To o d
and historically low volatility levels: it was the most benign risk environment we had seen in 20 years. reflecting a price correction in one isolated sector of the global economy – the US sub-prime mortgage sector (Dymski 2009). it doesn’t matter if i’m running up the money on my credit cards because next year i’m going to earn more. eventually come to an end. they comment that complacency and collective reliance on fashionable techniques of trade and risk valuation have taken the markets into the crisis. In hindsight. anyone who believes things are going to go on up forever is a fool. crisis or painful recession. The fact that house prices and the
. (The Economist. and that some events in the markets in 2006 had implied that the credit boom might unravel. the crisis should have been a relatively minor event in finance. taking the real economy into recession.’ (in Gimson 2008)
Moreover. We said then: ‘Well hell. whether small or large. All booms. 7 august 2008)
As a result. the air of general optimism translated into pervasive short-termism and lack of basic foresight and accountability among market players:
… things go in cycles.
the financial system itself has come to be defined by the paradigm and practice of scientific finance (Greenspan 2001.66
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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. this process has been viewed as the financialisation of everyday life (Martin 2003. Williams et al. Seabrooke 2006. Academically. To begin with. 2002). brand or logo capitalism. demography and the political economy of today’s financial industry. The many other dimensions of such short-termism include changing patterns of production. the changed character of work and. Second. as a culmination. 2008. the rise of the digital economy. Yet there are also reasons why long-term historical regularities and warning signs were ignored or dismissed. They concern a peculiar anthropology. yet often having minimal understanding of the ways the economic system works as a whole. Montgomerie 2009). as we shall see in Chapter 4). these professionals have no
. typically with excellent and highly specialised training in mathematics and physics. Langley 2008. Blackburn 2006. Having embarked on a career in finance or banking in the past 10–20 years. The major engine of financial innovation today is in the hands of a class of young and narrowly educated geeks. finance and credit are only one facet – albeit a defining one – of the general short-termism of contemporary society as a whole. the unprecedented rise of the financial sector to a dominant position in the economy.
hoW T he crisis has B een un de r s Too d
memory of earlier recessions or even structural financial crises. Interestingly. as far as this new generation was concerned. Criticised for his direct role in creating the bubble of easy credit during the 1990s/early 2000s. the ‘shock’ vision of the global crisis has also been common in courtrooms and on news screens. their role was to make the sophisticated and complex financial markets work more efficiently. therefore. (in Gimson 2008)
During the boom years of 2002–7. 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. 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. as one insurance broker noted:
We did the south sea Bubble at school. 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. While most of them would be familiar with the story of the 1929 Crash. and many might remember the collapse of Barings in 1995 or the 1998 LTCM fiasco. 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. Indeed.
Gordon Brown. bluntly. creating a crisis of credit and of confidence. 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. 17 October 2008). In October 2008. 4 march 2009)
Outside the courtroom. was how extreme it was going to be …’ (Financial Times. (Brown. his lawyer argued: ‘the credit crisis took everyone by surprise. 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. including the Fed and the Treasury. one of the Bear Stearns executives charged with a nine-count indictment of conspiracy and securities and wire fraud. Defending Ralf Cioffi. 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. the risks unleashed and accentuated by the
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Alan Greenspan called the crisis a ‘once-in-a-century phenomenon’ (Greenspan 2008b). What we had no idea. it simply does not make sense to view the crisis as a surprise or shock. however. Dozens of the largest financial institutions in the world have lost over $300 billion to date on the same investments’ (Kelly 2008). Lord Turner. a newly appointed boss of the FSA.
Parmalat. they were easily dismissed as problems specific to the financial structure of the emerging market economies. already heavily indebted. Either way. event. more broadly. When it did experience breakdowns (in 1982. Enron. the reliance of banks in many countries on revenues from dealing with the household sector.hoW T he crisis has B een un de r s Too d
securitisation process. 1994–5. etc. the global financial system seemed to have worked smoothly and efficiently for several decades. William White of BIS observed in 2006:
… the opacity and complexity of the financial system today shrouds in secrecy who finally bears the risks. none of the financial crises of the past 30 years was understood
. 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. – as isolated episodes reflecting troubles in individual firms. According to the philosophy of self-regulating and self-correcting markets. 1987. 1997–8 and 2000). or – in the case of the crises of the LTCM. had been noted repeatedly by many commentators long before the boom started to unravel in the summer of 2007. To take just one example. and increases the likelihood of operational problems. certainly a once-in-a-career. as well as the fragility of the US mortgage market and the economy as a whole. it is understandable why many market practitioners and politicians view the global crisis as a once-in-a-lifetime. (White 2006: 5–6)
So what should one make of ‘shock’ explanations of the credit crunch? On the one hand.
explains nothing in terms of its real causes. the ‘exogenous shock’ interpretations of the crisis are problematic. 16 March 2008). or a once-in-a-lifetime event. believes that it is impossible to draw any lessons about the financial system in the future: ‘In the current crisis. essentially because it did not reflect systemic flaws in the financial systems of the core. ‘advanced’ capitalism – until. as in past crises. it is telling that the thesis about the ‘shock’ of
. these explanations are simply unhelpful: stressing its immediate effects.70
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to require a global response. while recognising the crisis as potentially ‘the worst since World War II’. The sheer scale of the global meltdown certainly came as a shock to all of those who thought that financial capitalism had reached new. sustainable and historically unprecedented levels of development and growth. both intellectually and politically. we can learn much. But we cannot hope to anticipate the specifics of future crises with any degree of confidence’ (Greenspan. the gloomy autumn of 2007. Yet characterising the global crisis as an extraordinary episode. these theories make it impossible to draw any long-term lessons about the nature of the crisis in its historical context. Moreover. as the term suggests. and policy in the future will be informed by these lessons. In this light. Greenspan. Every crisis. On the other hand. reflects a lack of anticipation and foresight. that is. Thus the ‘shock’ theory of the crisis has some superficial plausibility. while emphasising the scale of the disaster. and involves an element of a shock. for instance.
in reality the meltdown is more pervasive. economic. Broadly.
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. 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. At the same time. Thus emphasising the historical origins of the current crisis. cultural and ideological foundations of market-based capitalism.hoW T h e crisis has B e en un de r s To o d
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. these views can be classified as structural or cyclical explanations of the global meltdown. social. but largely predictable result of the operation of a type of economy that had replaced the Keynesian welfare state of the
. the emergent theories of the credit crunch have incorporated deeper scholarly inquiries into the nature of finance today. 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. structural theorists view it as a specific. As such.
the growth of debt-financed consumption and business activity has been more pronounced in the UK.547. The ratio of debt
. personal debt jumped from $5. and its role in the overall economic organisation. Gamble 2009. higher than in any other major industrialised economy. 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. Shiller 2008. have been growing much faster than incomes and wages in the Anglo-Saxon economies. individuals in the UK held over £1. leaving the country more vulnerable to the effects of the credit crunch.72
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1950s–1960s with a neoliberal model of capitalism. Turner 2008. deregulated capital markets. In the US over the course of the decade.4 per cent during the first ten years of the New Labour government.5bn.1bn to $14.5 per cent of GDP to 227. etc. Debt.5 trillion in debt. minimal savings.). The levels of borrowings. Tily 2007. 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). is the key structural cause of the meltdown. In 2007. 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. both private and corporate.374. Pettifor 2003. And according to Turner (2008). Wade 2008. 2002. debt-financed consumption. and total private sector debt had risen from 133.
Many historically-oriented and systemic visions see the crisis.4 per cent to a post-1945 record of 139 per cent (Turner 2008: 26–7). In the long run. as an inevitable result of the Anglo-Saxon mode of capitalist organisation. and thus unravelled. sparked by the fiasco of the sub-prime industry in the US.hoW T he crisis has B een un de r s To o d
to disposable income went up from 93. therefore. therefore. 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. Essentially. both the credit super-bubble and debt-financed consumerism were unsustainable. it is interesting that another group of structural theories of the credit crunch takes
. Emphasising the role of key features of such a model. 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. This vast growth of debt was evolving into what George Soros (2008) has called a ‘super-bubble’ – a concoction of a housing bubble. In this instance. an explosion of leveraged buyouts and other financial excesses. or what Greenspan called ‘active credit management’ (in Morris 2008: 61). 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.
so the argument goes. with the funds coming from a combination of reduced fiscal deficits and increased domestic
. the crisis is the unwitting outcome of an abnormal state of affairs in world financial flows. Trying to rebuild their economies in the wake of the 1990s crises. The abnormality has been noted by many. 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. a related strategy has focused on reducing the burden of external debt by attempting to pay down those obligations. Essentially.74
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a diametrically opposite view. He then elaborated on why the Asian countries and other raw material exporters chose to transfer their savings to the mature markets. International Imbalances: Naughty Asian Exporters This school of thought views the credit crunch as a result of a structural discrepancy at the international level. a shift that has transformed those economies from borrowers on international capital markets to large net lenders’ (Bernanke 2005). not least by the economist Ben Bernanke. channeling domestic saving away from local uses and into international capital markets. effectively blaming the crisis on the role of emerging markets – mainly East Asian exporters – in skewing the balance in the world macro-economy. the governments of these countries
have acted as financial intermediaries.
Overall.1 current account imbalances as a Percentage of GdP (1975 Q1–2006 Q4)
source: Bracke and fidora 2008. (ibid. reducing US national savings and contributing to the nation’s rising current account deficit. this shift by developing nations. widening homeownership was supported and facilitated by securitisation – the ability of financiers to price the risk in mortgages and other loans. of necessity.)
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
United States 1995 1997 1999 2001 2003 2005
Figure 3. Bernanke argued. and to diffuse it efficiently through the advanced system of financial intermediation to those who were assumed to be best placed to bear it:
. together with the high saving propensities of Germany. 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. Japan and some of the other major industrial nations. this strategy also pushed emergingmarket economies toward current account surpluses. Within the US.hoW T he crisis has B een un de r s Too d
debt issuance. resulted in a ‘global savings glut’.
By reducing the risk of making long-term. a similar understanding of the global liquidity glut was of fered by the BIS. Within this unique arrangement. 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. (Greenspan 2005)
At the time. reflecting the surprisingly strong performance of the world economy and still abundant liquidity’ (BIS 2006: 98). the secondary market helped stimulate widespread competition in the mortgage business. 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’.76
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The development of a broad-based secondary market for mortgage loans also greatly expanded consumer access to credit. which makes it attractive for
. such as auto and credit card loans. in turn. fixed-rate loans and ensuring liquidity for mortgage lenders. Dollar reserves. reflected ‘the exceptional depth and liquidity of the US financial markets. 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. 1 The bank commented that ‘conditions in the major financial markets remained calm and accommodative for much of 2005 and early 2006. it was argued.
4 138.9 17.5 –40.1 Global current account Balances.2
Middle East and Africa 5.0 3.8 5.4 17.2 –530.8 –23.1 137.0 –8.4 21.1 –20.2 –2.5 Statistical discrepancy
Source: Bernanke 2005.7 47.8 3.3
.6 25.3 –120.8 7.1 42.5 –15.4 12.2 88.4 39.9 Eastern Europe and former Soviet Union –13.7 –23.7 65.8 –13.9 29.8 7.3 8.3 45.4 –39.0 11.4 4.hoW T he crisis has Be en un de r s To o d
Table 3.5 20.2 –342.9 –87.9 4.6 0.
41.5 205.1 10.1 –6.2 –2. 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
46.2 –30.0 148.5 24.3 –30.9 –14.5 55.3 –10.6 –23.
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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.
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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
behavioural and market-specific – that together diverted the markets away from a correct strategy and attitude to pricing risks. it is argued. securitisation and complex derivatives. Rather. cyclical views of the credit crunch accommodate another crucial aspect of financial volatility: the human factor. As such. (ambler 2008: 8)
Generally. importantly. including the paradigm of financial regulation and governance. Altogether. Also. therefore. one strand of interpretation stands out in particular. This socially motivated policy has relaxed lending criteria in the financial industry and pushed financial institutions into risky and opaque areas.82
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packages. Incompetence and Exuberance Within the range of cyclical theories of the crisis. the crisis was caused by a combination of factors – policy-related. The Human Factor: Greed. 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.
. the crisis was the result of long-run efforts by Anglo-Saxon governments to encourage low-income people to become homeowners. 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. which ultimately proved unsafe.
The two problems. place greater emphasis on some of the implications of the process of financial innovation and competition. The focus of these theories tends to be twofold: first.hoW Th e crisis has B e en un de r s To o d
Broadly. it is the problem of the knowledge or expertise gap associated with the process of financial innovation. 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. What makes these analyses distinct is that their advocates. incompetence and exuberance’ school. which became the defining feature of the most recent bout of securitisation. The ‘expertise gap’ thesis relates to the dilemma of asymmetric information that financial agents and market regulators tend to encounter. while intertwined. opacity of financial practice. and second.
. stress different aspects of financial transformation. The ‘skewed incentive structure’ argument captures managerial and institutional problems associated with the changes in banking and financial systems generally. while viewing the crisis as the inevitable end of the preceding credit boom. simply. it can be called the ‘greed. 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. as well as a lack of transparency or. supervisors and policymakers).
’ In the 1940s. In the sea of new. it was the younger generation of employees – and institutions more broadly – who came to shape the face of global finance. 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. The problem of unaccountability and lack of ethical standards in finance goes beyond financial dealers and
. who spent 60 years working in the City. One anonymous 78-year-old accountant.84
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With increasingly fierce competition in the markets generally and growing specialisation within financial firms themselves. blamed young. inexperienced traders for adopting aggressive practices from the US. There was always someone overseeing someone to see things didn’t go too far. before they got to a position of responsibility... We said then: “Well hell. 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). we went through this in the eighties and early nineties. he said. 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.’ Now. have no sense of responsibility. when he started. ‘scientific’ finance the traditional. recruits were regulated: ‘They had experience. They’ve been lending out money on securities that are worthless. years of it. and typically more conservative. ‘The trouble today is that the people .
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. it captures the inherent conflict between financial market developments and the reach of the regulatory oversight.hoW T he crisis has Be en un de r s To o d
institutions. Some of the most staggering examples come from the UK. on the other. the rise of institutional investors and the development of the ‘shadow banking system’. and the corresponding transformations within financial institutions themselves. their sluggish reactions to the unfolding crisis and simply not being up to the task or
. As such. 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). now increasingly oriented towards taking and passing on risks. In the wake of the global crisis. as well as on the role of managerial practice and business conduct within the financial industry itself. these schools of thought place greater emphasis on the role of policymakers and regulators in creating the crisis. It also has important implications for various segments of financial practice and control. the failure of regulatory and supervisory bodies to read market developments accurately has come to light on many occasions. it describes the institutional transformations of banking and finance that have paralleled the erosion of the function of traditional banking. On the one hand. proper insight into the state of the financial sector.
there are those critics who argue that it was not the lack of regulation but rather the plethora of financial
. according to many analysts. this policy. 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. Third. but the Bank produced an inflation report that did not mention the word. placed a large chunk of bad debt in the hands of people who are least able to hold it. a member of the Monetary Policy Committee at the Bank of England.g. Second. a former director of the FSA. Amery 2008) have pointed out that the main problem of the pre-crisis regulatory system was the classic case of moral hazard. ways to manage and redistribute the debt to third and fourth parties. Anecdotes about the breathtaking incompetence of regulators and supervisors abound. Chris Rexworthy. 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. thus prompting financial institutions to invent new. David Blanchflower. First. But criticisms of the official policy stance are manifold and go beyond those directed at individuals. admitted that he considered resigning in August 2008 at the point when the UK economy was sliding into recession. many commentators (e. 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). driven by social motives. and increasingly risky.86
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‘asleep at the wheel’. As is being argued.
purpose or even the name of the products their company was trading in. 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]. where senior managers often had no idea about the composition. critics argue that it was the inadequate implementation of financial policy as much as its flawed theoretical assumptions that precipitated the crisis. sales. outside the traditional set of requirements imposed by regulations) and that they generated positive earnings. (carmona and sircar 2009)
Fourth. They were mostly concerned that the company’s trading techniques provided legitimate means of raising funds off balance sheet (i. and other attention-deficit-promoting activities ranking high.hoW T h e crisis has B e en un de r s To o d
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. As Willem Buiter (2008) writes.e. those responsible for the grossly irresponsible credit derivatives trading and the ensuing risk exposure were not people who had been quantitatively trained. with deal-chasing ability. There also emerged a peculiar state of affairs within financial companies themselves. and not understood by the FSA or UK Treasury’ (Ambler 2008). this problem was apparent
. they rose to their positions on other criteria. unseen by. far too often.
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 Bank of England (the lender of last resort) claims not to have had any individual institution-specific information and never considered market liquidity. therefore. the central bank did not play a supervisory and regulatory role for the banking system. which led to a paucity of information about the financial circumstances of individual banks and other systemically important financial institutions. The UK financial systems have suffered from a flawed tripartite arrangement between the bodies responsible for financial stability. as the crisis continued. The FSA (the market regulator) focused almost exclusively on capital adequacy and solvency. On the one hand. A product of the many vices of the age of ‘scientific finance’. On the other hand. it fell victim to regulatory capture by Wall Street (ibid. In the US. In the Euro area.). likewise. the crisis was aggravated by the chaotic and extremely convoluted regulatory structure for banks. cyclical visions of the credit crunch emphasise that the crisis reflected a classic problem of the knowledge gap between policymakers and the financial markets.3 And while the Fed did have better access to institution-specific information.88
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in all major geographical corners of the credit crunch. near-banks and financial markets. 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.
wasn’t the securitisation bubble one giant fraudulent scheme? In what follows. operation and governance of the financial system today.
. they leave a host of concerns about the crisis unaddressed. for instance. raise many important questions about the structure. Altogether. made some people anticipate the crisis almost to the letter. but convinced others that the boom would continue indefinitely? What was it that the financial markets invented and traded so aggressively? And. the emergent schools of thought on the global meltdown. What. this book addresses these questions. Yet while analysing the many tentacles of the highly complex crisis.hoW T he crisis has B een un de r s Too d
bigger trend in Anglo-Saxon financial capitalism – namely. individually and collectively. 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. considering the many grey zones of finance today and the sheer obscurity that finance had reached. politics.
Most painfully.000 for every citizen. on average. who have rescued private financial firms through massive injections of taxpayers’ money into individual banks and financial markets.4 soMe uncoMfortaBle Puzzles of the credIt crunch
Any financial crisis has its villains and fools. 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. 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. Their governments will then owe about $50. it has shown that those supposedly tasked with financial supervision and stability often have very little idea of what financial institutions actually do. demographic
. and their children. of course. If unchecked. it has revealed that greed can be very blinding. ten times that of the financial meltdown. The IMF also estimated that the present value of the fiscal cost of an ageing population is. Yet it is they. and the credit crunch has its share of both. The meltdown has exposed the ineptness of many people – in high places and elsewhere.
many market players. therefore. have admitted that nobody anticipated that a devastating collapse could take place in the twenty-first century. questions about today’s finance which. Generations of taxpayers. remain unanswered. Indeed. 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. These are just some of the long-term concerns raised by the burst of the credit bubble. globalised economy. yet important. 11 June 2009). are destined to pay for the vagaries of the credit boom. despite occasional corrections to the markets.
. But the crisis has also posed somewhat smaller. including traders in big investment banks. baffled by the scale of the unfolding turmoil. As the markets imploded. the West has been enjoying a decade of unprecedented prosperity.uncomf orTaB l e P uzzles of Th e cre di T c r u n c h
pressures will increase the combined public debt of the wealthy economies to 200 per cent of GDP by 2030 (The Economist.
dismissed: The Warning signs and the Whistleblowers
The first puzzle is the timing and the apparent unpredictability of the meltdown. eroding the values of many companies and individuals. They centre on the ethics of financial industry and the question of social justice in financial capitalism. so far. analysts and brokers.
these whistleblowers were routinely ignored or. an internal risk compliance manager. To date. the global credit crunch has its own whistleblowers. fired. In other words. 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. Just like Northern Rock. as we learned in the wake of the crisis. In fact. It was the freezing up of these markets that pushed the bank into insolvency. as in any major financial scandal. ABM Amro. As two member banks of the group – RBS and HBOS – came close to bankruptcy and public money was put to their rescue.1 it emerged that the then chief executive of HBOS had fired Paul Moore. who had warned management about the excessive risks in its loan portfolios. warnings about the possibility of a structural financial collapse had been voiced at different levels of financial and economic analysis. this simply does not make sense. neither HBOS nor the FSA believed that it was appropriate to assess the riskiness of its rate of growth
. HBOS was lending too much by relying on wholesale financial markets. unfortunately.92
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Yet in light of the arguments outlined in Chapter 3. many people knew and warned that the end was imminent. the UK’s best known case is the Royal Bank of Scotland (RBS). they were not heard even though. At the level of individual companies. 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. in some cases.
Sir Fred was not asked to stand down until 28 January 2009. According to the Financial Times. thanked him for his good service. Kennedy 2009). 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. on an annual pension of £693. James Crosby. Alistair Darling. The scandal surrounding the fiasco of HBOS-RBS was further fuelled by the revelation that Sir Fred Goodwin. In a subsequent development. Another embarrassing revelation came in the summer of 2009. former chief executive of the fallen RBS. In a letter. The group included more than a dozen bankers and City grandees. served on the official committee that advises the UK Treasury on financial stability until well into the credit crunch (Hope 2009). the Chancellor of the Exchequer. the UK authorities had been informed about potential trouble at Northern Rock as early as 2004 (Cohen and Giles 2009). three months after quitting RBS.000.uncomforTaB le Pu zzles of T he cre di T c r u n c h
on the grounds that funds from wholesale sources could dry up (Peston.
. 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). newly appointed deputy chairman of the FSA. Part of its remit was to examine ‘proposals to reduce administrative burdens of regulation’. 11 February 2009.
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As the Financial Times reported. In late 2006. According to the accounts. though not to the auditors. It was felt that it was too harsh to say Northern Rock’s business model was excessively risky. the risk simulation planning. In the US we learn that Bernard Madoff’s Ponzi scheme came as a surprise to his clients. The warnings included the fact that Madoff’s books were audited by a three-person accounting firm. highlighted the systemic risks posed by Northern Rock’s business model and its potential domino effect on HBOS. Madoff Securities had $1. then the UK’s largest mortgage lender. though the Bank did warn of the growth in wholesale deposits repeatedly in its financial stability reports. including $711m in marketable
. hedge fund investment adviser Aksia LLC warned clients not to invest with Madoff after learning of ‘red flags’ at his company. the regulators concluded they could not force the lenders to change their practices. even though the exercise revealed the banks’ vulnerability. According to a number of people well versed in the subject. conducted by the FSA. the Bank of England and the Treasury.3bn in assets. 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. and in any case banks following that strategy were profitable and growing. Subsequently. 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’.
an academic and market practitioner advising many policymaking bodies. 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. typically herding in the markets. Such a ratio of debt to equity made Madoff’s company a classic pyramid scheme (Bloomberg News. the firm’s net worth. 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. They may be about to do so again on their syndication of collateralised debt obligations – the next bubble to burst. 13 December 2008). Warren Buffet. famously described derivatives as ‘financial weapons of mass destruction’. In circles closer to academic commentary. In the winter of 2008. were likely to suffer from systemic collapse:
large banks with their sophisticated internal risk systems have been caught up in every market cycle. Surviving the Soft Depression of the
. In 2002 Avinash Persaud. was $604m. (Persaud 2002)
In the same year. himself a successful market player. They lost considerable amounts during the dotcom bubble and on companies with crooked accounting. Members’ equity.uncomforTaB l e P uzzles of Th e cre di T c r u n c h
securities and $67m in US debt. warnings about the crisis were formulated more systematically. Madoff confessed that his fund was indeed a Ponzi pyramid. Let us take as an example Financial Reckoning Day.
the BIS pondered:
. published in 2003. In 2006. consumers cannot continue to go deeper into debt. (Bonner with Wiggin 2003: 276)
They continued: ‘America will have to find a new economic model. This is not a cyclical change. for instance. However.96
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21st Century. 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. More interestingly. concluded their study of the new. for it can no longer hope to spend and borrow its way to prosperity. consumption cannot go down much further. but a structural one that will take a long time’ (ibid.: 256). The book’s authors. the dominant tone in the official understanding of financial development remained puzzlingly optimistic. 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 the run-up to the credit meltdown. drawing on Hyman Minsky’s work. noted the dangers of overoptimistic risk assessments in the markets. foreigners will not continue to finance america’s excess consumption … and fiat paper money will not continue to outperform the real thing – gold – forever. several research publications by official financial institutions like the BIS.
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. could withstand a variety of shocks. The credit and financial boom. then. Another reason is political. 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. (2006: 141)
Why was it. the flourishing
. has been essential to the longevity of political regimes on both sides of the Atlantic. however. the success of New Labour was founded on the greater availability of credit to the population. strengthened by the forces of globalisation and financial integration. unfortunately. recourse to such ‘fundamentals’ does not seem adequate to explain either the extent or the duration of the unusual circumstances currently being observed. 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. 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. supposedly heralding a new era of prosperity.uncomf orTaB l e Puzzles of T he cre diT c r u n c h
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. no one wants to be the one who stops the music. In the UK during 2002–7. even if these did arise. The sceptics and whistleblowers were too few to mention.
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position of London as a financial centre and the new nature of economic growth which. it was observed in the Economic Report of the President that:
The expansion of the u. The administration forecast calls for the economic expansion to continue in 2007. economy continued for the fifth consecutive year in 2006. with real gross domestic product (GdP) growing at 3. economy and pro-growth policies such as tax relief. restrain government spending. regulatory restraint. With the Labour Party’s position and appeal fatally damaged by the deeply unpopular war in Iraq. meant ‘the end of the boom-and-bust’ character of the inflation-prone economic cycle with which the Conservative Party was associated.. and expand free and fair trade. enhance national energy security. In the US.s. overlooking evidence of the deterioration in the housing market and the growing risks of the debt-driven financial expansion. Indeed. and opening foreign markets to u.s. the signs of growing economic fragility were missed or simply ignored (Galbraith 2006).4 percent during the four quarters of 2006. but we must continue to pursue pro-growth policies such as those designed to keep tax relief in place. the economy was never a priority for President Bush and his administration. goods and services . (2007: 23)
. the economic argument remained one of the few things supporting Labour’s success with voters. economic growth was strong. 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. in 2007. slow the rate of health care inflation. As a result. on the other hand.s.
the inflation-adjusted income of the highest-paid fifth of US earners has risen by 60 per cent since 1970. for instance.) pay 25 per cent of all income tax. In the UK.uncomforTa Bl e Puzzles of T he cre diT c r u n c h
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. according to 2006 data. In both the US and the UK.a. At the same time.000+ p. 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).3 Domestically. 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. At the peak of the credit boom. According to Société Générale. during the decade of credit frenzy. London’s model historically had been much more global. Under New Labour. the City dominated the economy and emerged as a unique global financial centre. while its rivals in New York and Tokyo. while it has fallen by more than 10 per cent for the rest. which made it a peculiarly
. reliance on finance-led growth produced its own political dynamic. financial and business services accounted for 45 per cent of UK corporate tax income. The financial sector’s high earners (earning £100. It appears that the Wal-Mart Walton family is wealthier than the bottom third of the US population put together – about 100 million people. tended to service domestic economies.
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. are driven by deliberate deceit.com boom of the late 1990s.4 Are we to understand. tend to be a magnet for rogue dealers and outright crooks. Murphy and Chavagneux 2010).100
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unregulated. from the tulip mania in Holland in the seventeenth century to the dot. as the allusion to the original fraudster. implies.
Ponzi capitalism: a crisis of fraud?
From its very start. that the whole financial system has become one giant Ponzi scheme? Ever since finance was liberalised. Gowan 1999). But aside from the longer-term contradictions of the mode of economic growth in the advanced capitalist economies and issues of political short-sightedness. then. 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. trade in money has often been described as a Ponzi game. the credit crunch has been described as the crisis of ‘Ponzi’ finance. offshore financial space where financial innovations flourished (Burn 1999. But Ponzi schemes. who seize the
. ineptness and cynicism that thrive at different levels of the political economy. Palan 2003. Carlo Ponzi. a giant casino or a global game of fictitious capital (Strange 1997. Palan.
As the crisis unfolded. commentators often talk about the global credit crunch as the collapse of a gigantic Ponzi scheme. reflecting the element of deceit and fraud. 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. In essence. it transpires. scams and pyramid schemes as legitimate investments.
. venture.uncomforTaB le Pu zzles of T he cred i T c r u n c h
opportunity to make a lot of money by deceiving the public by promising high returns from a new. fictitious. but also. the notion of Ponzi finance. 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. they view the credit boom of 2002–7 and the process of securitisation as one massive industry of deceit and fraud. during the securitisation boom. The securitisation boom of 2002–7 proved to be no exception. corruption and financial machinations hit the headlines. 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 principle of a pyramid scheme applied to the dynamics of the sub-prime mortgage industry in the US – the epicentre of the crisis. such as Bernard Madoff and Allen Stanford. Observing these cases. First. more and more cases of fraud. Second. Third. Ponzi pyramids were exposed as the particularly nasty practice of some high-profile financiers.
where both interest and principal are repayable. At the same time. In Minsky’s original taxonomy. turn into more risky speculative finance. Wray 2008). Ee and Xiong 2008. For Minsky. Minsky (1982. particularly during periods of economic optimism.
. this progression describes the spiral of financial innovation and the progressive underestimation of risk by financial agents. 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. and then into the Ponzi state. 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. which develops after hedge finance. where even interest payments have to be financed by new debt. ‘Ponzi’ is a method of financing old debt with new debt. Broadly speaking. Dorn 2008. the Ponzi principle implies that fraud and deception are key motives. where cash flows only cover interest payments. Several facts about the structure of sub-prime lending substantiate this assertion. Kregel 2008.102
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Ponzi Finance and ‘Sub-Crime’ In his financial instability hypothesis. Ponzi finance is the ultimate phase in the evolution of a financial cycle. therefore. The three types of finance mark the transitions starting with a conservative financial strategy and working towards an economic agent taking ever greater risks.
specialised in making what are known as ‘liars’ loans’. the interest rates on their loans rose. In the US. this belief proved to be self-fulfilling. along with the actual terms of the sub-prime loans.uncomforTaB l e Puzzles of T he cred iT c r u n c h
First. through a complex chain of financial innovations. 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. and house prices can not only stop rising. was not
. Yet from the very start it was clear that many of those sub-prime borrowers would be unable to pay their mortgages if. In 2006 alone. sub-prime lending was justified by the belief that the rising value of property would be sufficient to repay the loans and. what is most worrying is that this was happening far beyond the sub-prime mortgage business: liars’ loans were securitised and. For instance. the entire US housing market entered a bubble phase. it sold $80bn such loans to other companies (Black 2009). once the bottom tier of properties was inflated through the creation of massive demand. constituted a web of new markets for exotic financial products. as in any Ponzi scheme. are notoriously cyclical. Housing markets. they can tumble too. one of the first large US mortgage houses to crumble in the global meltdown. or rather when. As Black argues. IndyMac. the practice of providing people who have uncertain credit histories. Any Ponzi scheme can thrive only as long as it attracts new participants. This possibility. According to Jan Kregel (2008). however.
and the related securitisation boom. On the other hand. Australia and New Zealand) due to historically low interest rates in the 1990s and 2000s which offered ample opportunities for borrowers. On the one hand. enticed by commission fees. low ‘teaser’ rates that were later reset at much higher rates. In retrospect. The reasons why the sub-prime industry flourished for so long go beyond economics.104
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mentioned by the scores of financial advisers who sold the products to their clients.5 In the aftermath of the crisis. were deliberately diverting clients to more expensive sub-prime products. sub-prime lending flourished in the US (and to a lesser extent in other Anglo-Saxon countries such as the UK. This suggests that the Ponzi pyramid of sub-prime finance. it also transpired that many lenders. knowingly inducing borrowers to accept loan terms they will not be able to meet (Wray 2008: 51). correspondingly. 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. the terms of borrowing and the conditions for repayment appear to have been the key block in the Ponzi pyramid of sub-prime loans. by the benign and ill-informed view of the financial and monetary authorities of the risks posed
. was facilitated by the political climate in the Anglo-Saxon economies and. even when the applicant could have qualified for a ‘prime’ loan. Ponzi-type methods employed by lending institutions included large pre-payment penalties.
It is in the wake of the sub-prime fiasco that clear evidence of mortgage fraud hit the headlines. the housing and securitisation boom was in fact celebrated by many officials on both sides of the Atlantic. credit rating agencies. 406 defendants were charged in 144 cases across the US.6 According to the Federal authorities. fraud was a ‘contributing factor’ to the overall credit crisis (Kirchgaessner and Weitzman 2008).uncomforTa B le Pu zzles of T he cred i T c r u n c h
by the expanding credit bubble. accounting firms and hedge funds – as part of a wide-sweeping probe into mortgage fraud. which brings us to the next terrain of Ponzi finance: the business of securitisation itself. Journalists following the investigations likened the instances of sub-prime fraud to the Enron and WorldCom scandals. The first was put together by Bernard
. FBI investigators were homing in on 19 ‘large corporations’ – including investment banks. such as Bear Stearns in the US. In the summer of 2008. As of June 2008. As noted above. The majority of the large corporate cases involved accounting fraud. two major cases of pure Ponzi pyramids have come to light. The Ponzi Business of Securitisation To date. insider trading and failures to disclose – with criminal intent – the proper evaluation of securitised loans and derivatives. 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.
rather than demanding money up front. as noted above. In truth.106
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Madoff. thorough accountants did smell a rat in
. By turning some investors away. In the summer of 2009. Essentially. 20 February 2009). his hedge fund was a Ponzi pyramid. as well as well-established banks like BNP Paribas. questions mount about how many people knew about the nature of Madoff’s business and why his scheme was not exposed earlier. HSBC. Madoff was sentenced to 150 years in prison for fraud. RBS and other financial institutions. Madoff admitted to his sons that. 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. with a wide portfolio of clients who included thousands of individual investors and pensioners. According to many financial supervisors. he reassured his clients that they were benefiting from a specialised inside track. a New York-based financier. Madoff was building the steadily increasing flow of money he needed to keep the scheme going (Financial Times. In the winter of 2008–9. And although. once a Ponzi-style activity is suspected it is relatively easy to uncover the truth. a laborious and well-choreographed effort to produce accounting books every month and report to clients was nothing more than a confidence trick. he encouraged investors by suggesting they pour their cash into his funds incrementally. For several years he had been running what was known as a super-profitable hedge fund. Banco Santander. As it would emerge later.
Yet while they continued
. who knows how many more billions of dollars would have disappeared into fictitious books. Stanford. The second now notorious case of a Ponzi scheme involves Sir Allen Stanford.uncomforTaB l e P uzzles of Th e cred i T c r u n c h
Madoff’s books. Regulators allege that Stanford’s pyramid operated primarily through Stanford International. an Antigua-based bank. Madoff and Stanford dominated their companies and used peculiarly inconspicuous auditing firms to check them. unlike Madoff. continues to deny any Ponzi element in his business (Ishmael 2009). 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). which sold about $8bn of certificates of deposit to investors by promising improbable and unsubstantiated high interest rates. 20 February 2009). another well-known financier. Stanford ran institutions that are alleged to have misled investors about their exposure to risky illiquid assets (Financial Times. In both cases. Accused of an $8bn fraud. 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. If Madoff himself had not confessed. analysts grew suspicious of the returns the two financiers were offering. nobody in a senior position in the US regulatory system seems to have suspected the massive pyramid scheme. In both cases. What is most astonishing is that there were real warning signs about both men.
two New York-based money managers. whereas as we have seen. In the wake of the sub-prime crisis. large and small investors alike invested with Paul Greenwood and Stephen Walsh. in the belief that an ‘enhanced equity index’ strategy was superprofitable. It is thus unclear for how long the pyramids would have continued had the international credit markets not seized up. But according to prosecutors and regulators the money simply filled the two men’s personal piggy banks. What is worrying is that although these two cases are certainly the most well known. they represent a much wider trend of fraudulent financial practices which had been concealed by the credit boom and securitisation industry. Madoff came clean voluntarily (Chung 2009). They are just the latest in a stream of alleged Ponzi pyramids. the most it did was fine them for relatively minor transgressions. they evaded any serious scrutiny (ibid. Although the SEC investigated both companies. For instance.108
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to post astronomic returns.). for at least 13 years. the case against Stanford was brought only after a Venezuela-based analyst made his criticisms public. In the end. at least twelve complaints involving Ponzi schemes and similar scams have been filed (Chung and Masters 2009). The sheer number of schemes under investigation and their geographic spread – from Alaska to Florida and with a whole raft of overseas investors
. 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.
including the regulatory framework in which it flourished.000 registered investment advisers on the other (Chung and Masters 2009). Milan has lost millions on a derivatives deal. The growth of hedge funds and offshore finance made secrecy and high returns seem more common (Picciotto 2009). In Italy. As many critics argue. JP Morgan Chase. In Germany. have helped entrench fraud as a legitimate practice of financial innovation. the last time the US saw anything like this was during the 1920s. According to historians. regulators were hampered by political pressure to leave hedge funds alone on the one hand.’ At the same time. and a lack of resources to inspect more than 11. The Ponzi web has spread beyond America’s shores. as many as 700 local authorities may have lost money on similar deals (ibid. when Ponzi’s original postage scam flourished. 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
– dwarf what was uncovered in any recent recession. According to one former SEC official. In the spring of 2009 four big banks – UBS. After all. ‘the beauty of these recent cases is that very little money ever went out. It was all on paper. securitisation has
. the institutional foundations of the securitisation industry. Deutsche Bank and Hypo Real Estate – came under investigation for what prosecutors believe may have been fraudulent or ‘illicit’ profits amounting to €100 million.). It is very likely that in the aftermath of the crisis more such revelations will surface.
On the other hand. then. flexibility and thus economic stability. to the high-profile scams mentioned above. by creating a market for these assets and transforming them into liquid assets. 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. rather than just one bank. securitisation has as its aim facilitating wider economic turnover. having gained access. 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. the process of securitisation widened their ownership structure as several parties. thus spreading and diversifying the risks. could own or claim a portion of a loan portfolio. Consumers and producers in many segments of the world market benefited from securitisation. so far conceptualising the credit crunch as one massive crisis of financial fraud has not gained much popularity. In principle. even in radical academic circles. diversity. Ponzi and Madoff are convicted crooks. coupled with widespread expectations that more fraud schemes are bound to be exposed as the recession
. they set up their businesses with the sole purpose of reaping personal profits by deceiving their clients. to a variety of options on their mortgages. for instance. Theoretically at least.110
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existed for decades and its economic purpose had been to attract previously unpriced (because unmarketable) assets into market circulation. Indeed.
regulators and. Third – and much more worryingly – when warnings about the true nature of these schemes were voiced. as the booming industry of credit crunch studies suggests. bankers. 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. that outright fraud. 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. whose very name implied something very rotten. First.uncomforTa B le Pu zzles of T he cre diT c r u n c h
continues – does suggest that something went terribly wrong with the business of securitisation. politicians. 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. lawyers. Second. as the political connections of both Madoff and Stanford imply. for the most part they were ignored. Notwithstanding various explanations of the long-term
. it appears that the many parties to this process included financiers (large and small). How is it. The credit boom of 2002–7 and the whirlpool of new financial techniques and products made these schemes almost impossible to detect.
both direct and indirect. Put more simply. thus contributing to greater and wider prosperity. they also enhance the liquidity and welfare of the economic system as a whole. They are the products. this book suggests that most of the riddles brought up by the credit crisis have a common origin. by innovating in credit instruments and techniques. As explained in the next chapter. this illusion has complex socio-political. of one great illusion that has become an axiom of financial innovation over recent decades: the misconceived idea that.
. financial markets not only optimise the risks. economic and theoretical origins. it is the naïve belief that the financial market today creates wealth and spreads it through the economic system.112
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causes and short-term triggers of the global meltdown.
This environment. 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.5 2002–7: the three PIllars of the lIquIdIty IllusIon
Even in purely financial terms. in turn. The following pages identify three interconnected forces that.
liquidity and the Paradigm of self-regulating credit
In narrow terms. in its broader
. the global meltdown is a crisis centred on the US sub-prime mortgage industry. emerged as a combination of historical. political and institutional developments. This chapter unpacks the role that ideas. behaviour and the institutional organisation of financial regulation played in constructing and sustaining the illusion of liquidity. analytical. helped disguise the deepening fragility of the North Atlantic economies. Even so. facilitated and encouraged a particular market-based approach to managing risks in finance. the sub-prime lending industry was a time-bomb waiting to explode (Wray 2008). having reified the myth of efficient finance. liquid markets and economic prosperity.
it is argued. crucially. The key reason lies in the ideology of perfect markets and the theory of market-completing financial innovation. by the search for greater liquidity. As in any other area of economic activity. liquidity is about desire for and ownership and transferability of one’s claims on wealth (Berle and Pederson 1934). On the one hand.114
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international dimension. Some scholars even suggest that liquidity is synonymous with the wider meaning of capitalism itself: ultimately. innovation in finance has always been driven by the desire for quicker and greater profits. securitised and transferred to others in the market (Shiller 2008). Liquidity is the absolute essence of all market exchanges and is paramount to the functioning of any financial system. The way liquidity has been understood in this framework is representative of many other important assumptions underlying the paradigm of self-correcting financial markets. as the preceding
. efficient finance which has constituted mainstream thinking on finance and financial regulation for the past decades. liquidity of financial markets has often been assumed. it is a crisis of securitisation. yet not necessarily warranted. and defined by the notion that every eventuality can be priced. Yet precisely what this greater liquidity implies remained a somewhat fuzzy notion. In the era of highly financialised capitalism. It is important to realise in this instance that securitisation itself has become a functional form of the paradigm of self-regulating. but also. dominated by sophisticated trading techniques and products.
have argued that the relationship between new financial products and the liquidity of the economic system as a whole is far less straightforward. thereby increasing market turnover and. critics of the financial orthodoxy. liquidity. in popular terminology. Securitisation has had its own controversial effects on the idea and functioning of liquidity in the markets. rely on the liquidity of the underlying assets. Securitisation. On the other hand. willing and able owners. new financial instruments. 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). Theoretically. from Minsky onwards. markets and institutions has been driven by the search for greater liquidity across the global financial markets. At the same time. The process of inventing. financial engineers and traders have expanded the reach of the financial markets. valuing and introducing new credit instruments. while adding to a sense of greater liquidity in the markets. securitisation has been understood to be
.T he T hree Pi llars of T he li Qu idi T y i l l u s i o n
chapters have noted. by pricing them and then transferring them to new. It ‘enhances the liquidity of underlying receivables by transforming them into tradable securities. 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. for instance – the latest wave of financial engineering – both relies on and enhances liquidity. On the other hand.
By doing so. Historically. In practical terms. by creating securities out of illiquid assets. one can design several securities (tranches) with different risk-reward profiles which appeal to different investors. Generally. much like other important financial segments (say.116
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a technique to create securities by reshuffling the cash flows produced by a diversified pool of assets with some common characteristics. In simple terms. thus allowing them to make more loans. therefore. securitisation meant that risky (but profitable) assets were moved from the banks’ balance sheets into the unregulated financial system.). Unsurprisingly. 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. the Eurodollar market which emerged almost by accident but later become widely established). (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. This idea did not emerge out of the blue. the Basle requirements made it unprofitable for banks to hold safe and liquid assets on their balance sheets (Wigan 2009). securitisation has been the banking sector’s reaction to the introduction of the Basle II accord of financial regulation. securitisation was believed to increase liquidity across the financial system and the economy as a whole (ibid.
At the heart of this process lay the transformation of the US banking system (Kregel 2007. in a deregulated. ultimately destructive repercussions for the stability of the financial system as a whole. valued and traded by banks and financial houses since liberalisation reforms were introduced in the 1980s
. the experience of the first Basle accord illustrates the law of unintended consequences. This shift in turn has become a major institutional transformation of the global financial system. As noted above. the liquidity of the banking system declines’ (Minsky 1982: 174).T he Th ree Pi llars of T h e liQ u idi Ty i l l u s i o n
This trend has had its own. 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. Chiefly. but on such a scale as to change the whole manner in which banks operate (Chick 2008). securitisation was undertaken not just as a small part of bank operations when banks needed liquidity. it was transmitted through its impact on liquidity. securitisation reflects the way risk has been modelled. As a result of the introduction of the Basle rules. In this regard. 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. As Minsky foresaw. 2008). according to Victoria Chick.
1 These reforms led to the introduction of a new type of banking. now known as the ‘originate and distribute’ (ORD) model. and servicing them. Thus. and thus spread moral hazard around the financial system. According to one estimate. The adoption of the ORD model has underpinned a phenomenal rise in commission fees and income from banks’ capital market-related activities. the gap between a bank’s capital and its managers has widened. Lenders have become progressively indifferent to risk and obsessed by reward (Credit Magazine 2008). simply because the interest and principal on the loans will be repaid not to the bank itself. managing those assets in off balance sheet affiliate structures such as special investment vehicles (SIVs). Instead. The incentive to be a prudent lender has been replaced by an overarching drive to maximise commissions. it is a competitive financier seeking to maximise fee and commission income from originating assets. in which the bank is no longer an institution whose principal purpose is to take deposits and grant loans. banks and hedge funds became careless because they were acting as intermediaries.118
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in the US and elsewhere. but to the final buyers of the collateralised assets. In recent years. bonuses and profits. between 2004 and 2006 earnings from
. not as principals (Wade 2008: 32–3). underwriting the primary distribution of securities collateralised with those assets. the banker today has no motivation to conduct proper credit evaluation. Crucially from the point of view of financial fragility. according to Robert Wade.
and just over 40 per cent for Asia Pacific). The resulting series of financial innovations created a sense. In the wake of the global meltdown. the Bank of England.T he Th ree P i llars of T h e liQ u idi Ty i l l u s i o n
trading in derivatives and capital market-related activities at the top ten global investment banks rose by almost two-thirds. In 2006. of abundant liquidity in the sub-primerelated financial markets and of financial wealth being created and spread. for instance.2 Reflecting these changes. it seems naïve and short-sighted to draw a straightforward. noted that while the ORD model ‘does not alter the financial sector’s aggregate credit exposure to the non-financial sector’. Middle East and Africa. Politically. profits from sales and trading operations had not only been growing. At
. cited in Langley 2009). but also assuming a greater share of the investment banks’ revenues (over 90 per cent for the Americas. linear link between securitisation and systemic stability. though not a guarantee. it promises to ‘improve systemic stability if risk is held by those with the greatest capacity to absorb losses’ (Bank of England 2006. over 80 per cent for Europe. 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. from $55bn in 2004 to $90bn in 2006. The concern with creating new markets for their products prompted financial institutions – both in the official. this trend has been commonly viewed as an indication of a more efficient financial system and foundation for economic stability.
such representations of finance meant that a ‘liquid’ market became an object that investors increasingly regarded as a given fact. the mainstream political discourse that paralleled the expanding credit boom invariably
represented the markets as efficient … and liquid. As Paul Langley writes. The key concern for
. the central parameters of international financial governance were founded on regulatory developments in the private sector: when the first Basle accord proved ineffective.120
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the peak of the credit boom. the solution was sought in private risk management tools (Wigan 2009). liquidity that disguised many fallacies – both conceptual and political – at the time. the accord established a system of regulatory principles that delegated to the individual institutions themselves the management of their portfolio of risks. Specifically. (langley 2009)
With regard to how liquidity has been approached within the regulatory architecture. a particular emphasis in the Basle II accord proved fatal in the lead-up to the global credit crunch. things were much murkier. or more accurately the illusion of. Basle II has been built on the assumption that a well-functioning financial market is always liquid. With the assumption of an infinitely liquid market there was no need to install a systemic provision to guarantee its liquidity. external to them. As a result. however. since the sub-prime industry seemed to exemplify what was possible in an era of liquid finance. there was little to suggest that markets for assets named ‘liquid’ would be any different from the norm. Here again it is the idea of.
Paralleling the rise and spread of financial markets.g. Through the alchemy of financial engineering. although seemingly only an analytical fallacy. this assumption itself is a
Playing with debt – Together. The advance of financial engineering. 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. in both practical and analytical terms. Put simply.Th e T h ree P i llars of T h e liQ u idiT y i l l u s i o n
policymakers at the time was market efficiency and the efficiency of individual banks (Davies 2009). in popular terms liquidity has increasingly come to describe the volume and speed of financial transactions. 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. Warburton 2000). rather that the content of those transactions (e. the idea of ‘liquidity’ has come to describe the liquidity of the market. liquidity as a ‘state of mind’
The popularisation of finance has had its own impact on the way liquidity is understood. or market turnover. the banks were assumed to optimise their own risk strategies. while the market as a whole – founded on financial innovation and competition – was made liquid.
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key reason why many destabilising trends and risks in the credit bubble had been overlooked. Assuming that anything can be bought and sold in the financial market is simply wrong. Therefore. The other important element of the illusion in the run-up to the global credit crunch lies in the dynamics of market liquidity itself. made possible when a crowd of knowledgeable buyers meets a crowd of knowledgeable sellers. Believing that market turnover is infinitely sustainable and hence synonymous with liquidity is a dangerous illusion.
. But market activity is always a social process and thus constitutes a complex interactive process of information flows. unfounded conceptual assumptions and beliefs constitute only one side of the liquidity illusion. At the same time. In narrow technical terms. perceptions. or market liquidity in a more narrow sense. And building a whole system of theories and regulatory principles on these two assumptions borders on something much more serious. market fluidity. and it is important to understand how social and behavioural factors shape liquidity. attitudes and expectations. market liquidity is about prevailing price trends and the ability to execute transactions reasonably swiftly. in the realm of the financial markets three basic mechanisms underpin the creation of liquidity: 1. is a social construction. According to Carruthers and Stinchcombe (1999). Continuity of trade.
The magic of securitisation. This standardisation in turn. by grading natural products. are willing to risk transferring large quantities and thus maintaining a continuous price. the belief in and reliance on the capacity of securitisation to optimise risks became ever greater. is a collective and cognitive achievement: buyers. cognitive and social processes of valuing risks.T he T hree Pi llars of T he li Qu idi T y i l l u s i o n
2. spawning theories about
. Homogenisation and standardisation of commodities. for a small margin. comprises the spatial.: 353–4). The existence of market-makers who. on an over-the-counter (OTC) basis. offering them to a host of seemingly willing buyers. As the boom expanded. 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. Standardisation of products and financial techniques is absolutely central to sustaining market liquidity (ibid. Financial geeks were extending the range of financial products and services. in turn. more typically. therefore. manufacturing standard products or by creating legal instruments with equal claims on an income stream. either on organised market platforms or. seemed to ensure that these products contain accurate information about their underlying risks and values. 3. intertemporal. as the authors argue in their original study. For a while during the credit boom this conviction appeared to function well. Market liquidity.
until quite late in the period under review. and changes in attitude altered what people wanted to do. not least in the area of credit to households. credit was both cheap and commonly available with weaker conditionality than had previously been the case.124
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‘abundant market liquidity’ and a ‘global liquidity glut’. only in recent months … has the downside to these new practices become more apparent. peculiar impact on the construction of liquidity. According to one market player. this was generally considered to be a healthy development supporting owner-occupied housing. speculation. examples of new practices abound. In June 2007. for instance. Rather. 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. the BIS observed:
the prevailing view that the world was awash with liquidity – that is. in the united states and a number of other countries. both mortgage and consumer credit became available to many who previously would not have had access at all. mortgage credit has become available on easier terms to borrowers almost everywhere. market liquidity was increasingly taken to be synonymous with the shared appetite for financial trading – or put bluntly. indeed. thanks both to deregulation in many countries and to the global extension of the mortgage scoring techniques pioneered in the united states. it is ‘the result of the appetite of investors to underwrite risk and the appetite
. Stripped of its relation to the underlying assets. (Bis 2007: 7–8)
Optimism during the global credit boom had its own. liquidity was no longer about the available pool of money or even credit more generally.
it was increasingly difficult to shift them in the markets. Standardisation. While one side of liquidity is about finding a willing buyer and exercising one’s ability to transfer claims. was absolutely pivotal both to sustaining the investment boom and to preserving the notion of a liquid market. a liquidity boom can only be sustained as long as a collective belief in the tradability of assets persists. First of all. a tendency
. as noted above. this twofold function became ever more difficult to maintain at a systemic level. so central to the sense of market liquidity. But here is one of the many paradoxes of liquidity. As Gillian Tett (2008) notes. In fact.Th e T h ree P i llars of T h e liQ u idiT y i l l u s i o n
of savers to provide leverage to investors who want to underwrite risk. the idea that collective reliance on financial innovation and sophistication automatically creates ‘the market’ proved to be an illusion. the new derivative products had become so obscure that it could take days for computer programs to value them. the greater the liquidity. As the techniques of securitisation became ever more complex and opaque. proved to be dangerous. Standardising these securities and making them transferable in the market. and vice versa’ (McCulley 2008: 1). the other side is the ability to sell. crucially. From the point of view of markets as social institutions. Most people understand this as ‘market confidence’. more and more of these newly minted securities were left on banks’ balance sheets. Confidence in turn depends on a level of transparency in the markets and knowledge about the new securities being traded. The greater the risk appetite. Tett argues.
and the actions of buyers and sellers taken together. in common terms. other buzzwords include ‘herding’
. as Persaud and Nugée (2006) explain. but also on the diversity of opinions and positions of the market-makers. liquidity. precipitated the liquidity crunch. the standardisation of techniques and products. It is the erosion of this diversity. ultimately. trading practices and pricing methods is essential for ensuring a certain level of transparency in the market. After all. its fluidity and thus. standardisation has given rise to its own dangerous dynamic in the market. Knowledge about markets and products. Second. In this sense. As the ensuing crisis showed. Financial commentators call this problem the ‘concentration level’. The success of credit derivatives markets and the profits they offered attracted many investors who used broadly similar market positions and pricing models. this proved to be fatal to the idea of a liquid financial system. Yet. constitute an important aspect of market turnover. liquidity is contingent not only on the standardisation of products and market trends. 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. that contributed to the misinterpretation of market liquidity trends and.126
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that was overlooked by most financial supervisors and regulators at the time. With the spread of financial innovation this crucial component of heterogeneity of the market context gradually eroded during 2002–7.
and. especially liquidity risk. the major risk posed by the growing homogeneity of market behaviour is that when distress strikes the market. herding and the concentration of risks
. As the first waves of the crisis combined with a spate of downgrades and uncertainty over valuations. There were simply too many speculators operating in one market segment. proved the point. Therefore. they magnify it. while during a boom similar attitudes and shared positions create a sense of greater vibrancy and liquidity in the market. At the same time. the use of quasi-legal investment techniques and outright swindles.T he T hree Pi llars of Th e liQ u idi T y i l l u s i o n
and ‘crowded trades’. Instead. 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. hordes of investors were left holding similar positions in a falling market (Madigan 2008). similar investor positions are unable to diffuse the shock. in stressful periods and crises these common practices erode more values than a more diversified market would allow. the conventional trends of a bubble and Minsky’s Ponzi finance prevail: the undervaluation of risks. In this herd-driven process of financial innovation. in many cases. the aggressive expansion of new borrowings. The global credit crunch. warnings were voiced about the dangers of what looked like herding in the derivatives markets. it is noteworthy that while speculation. Whatever the term chosen. During the later years of the credit boom. much like any other systemic financial collapse.
such as synthetic financial structures. ‘sliced and diced’ them with other MBSs. reiterates the scale of the problem of obscure debt and financial manipulation. as the preceding chapters have shown. offshore facilities helped conceal the risks of the transactions. it eroded the transparency of the markets. The tale of the biggest casualty of the credit meltdown so far. securitised them. importantly.2 trillion of open positions spread across almost every market counterparty. The post-crisis investigation of the fallen bank revealed that globally. at the time of collapse. Also crucially. all of whom were looking to minimise their exposure to Lehmans. Lehman Brothers. at the level of counterparties – those at the other end of a transaction.128
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tend to be generic features of any financial crisis. then moved the resulting assets overseas. Lehmans. accumulated mortgage-backed assets (MBAs) in one country. often registered in unregulated spaces of offshore finance and associated primarily with the strategy of financial deregulation. both in relation to supervisory bodies and also. It held over $1. like many other banks. blurring the valuation basis of the original
. As with Northern Rock. As the spiral of financial innovation progressed.2m derivatives contracts with a total notional value of $6 trillion. it has blurred the line between financial innovation and financial fraud. the credit boom of 2000–7 had been defined by a specific element within the underlying regulatory paradigm: the sophistication of new products. Lehmans is estimated to have held 1.
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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
Arthur Andersen. Overall. In the case of WorldCom.3 Enron employed a much more elaborate scheme of financial innovation. with the corollary of bolstering Enron’s potential return on investment and
. The combined effect was to overstate earnings per share. 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. the company seems to have relied on old-fashioned cooking of the books: by treating routine expenses as capital investments. WorldCom’s auditor. involving special purpose entities (SPEs) and financial manipulations. somehow failed to see what they were doing (Kadlec 2002). corporations whose executives have been convicted of serious financial fraud. the accounting violations at Enron included revenue overstatement. Using its exemption from brokerage regulations and oversight by the Commodities Futures Trading Commission. The basic idea was to represent losses as profits. The two most notorious scandals of that particular bubble were WorldCom and Enron. The method of market-to-market accounting allowed the company instantly to book future earnings it forecast on energy deals. masking of risk and overvaluation of assets.Th e T h re e P illars of T h e liQ u idiT y i l l u s i o n
liquidity for the shares of those companies. cost understatement. 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).
For the financial industry. accounting representations set the competitive conditions for others to match if they were to survive in the marketplace (Tinker and Carter 2003: 580–1. in reality.com euphoria made things much less clear-cut. analysts note that this trend was supported by the standards of the private regulatory body. or helped disguise (Grey 2003). Yet the dot.com crash
. however. and the general culture and political ideology of efficient markets (Lowenstein 2004). Yet both facts and the controversial role of financial innovation suggest that the speculative drive of the dot. Lowenstein 2004). In both these high-profile cases the companies’ auditors chose to overlook. During the boom. both of whom have since been imprisoned for fraud. the financial frauds. the dot. the dot. Vivendi and many other firms for cooking the books and deceiving their shareholders.com bubble must have been painful to the CEOs at Enron and WorldCom. Guttman 2003. a giant Ponzi scheme. Enron was a typical Ponzi scheme. The inevitable implosion of the dot. It is tempting to blame individual executives at Enron. the Financial Standards Accounting Board.com bubble and the competition for markets set a general trend across the new economy: while appearing temporarily profitable and highly liquid. In essence.134
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diminishing the firm’s cost of capital (Tinker and Carter 2003). dominated by the five largest accounting firms in the US.com boom was. and individual accounting firms like Arthur Andersen for lack of due diligence. WorldCom. Importantly.
. 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. bundles of toxic debts. and make the complex structures of IOUs ‘worth – or seem to be worth – more than the sum of its parts’. Credit rating agencies (CRAs) have been with us for a long time. became the ‘new masters of capital’. During 2002–7. In 1909. John Moody extended the practice to rating securities. was needed to act as market-maker on a large scale and sustain collective belief in the liquidity of what were. in the words of Timothy Sinclair (2005). in order to turn sub-prime loans into liquid securities someone. in essence. Today’s CRAs are the products of their time. 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.T he Th re e Pillars of T h e liQ u idi Ty i l l u s i o n
seems to have been no more than a blip in the larger trend of speculation and expansion. In the age of ‘scientific’ finance and securitisation. when information is key to managing risks and structures of knowledge are essential for market turnover and. 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. or something. That something was the credit rating agency (Lowenstein 2008). much as in the bubbles of the 1980s and late 1990s. starting with US railroad bonds (Cantor and Packer 1994).
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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.). and the like have been required to buy investment-grade securities as rated by one of the nationally recognised rating agencies.
. the liberalisation of the financial markets and the general transformation of finance into the business of risk optimisation have increased the importance of investigation. and as the valuation mechanisms and trust implicit in the older system of bank intermediation have broken down. The functioning of the market and the tradability (synonymous for many with liquidity) of mortgage-based securities fundamentally depended on the ratings they acquired. it suffered no penalty (Wade 2008: 30–1). Opinions do diverge. Some argue that. analytical mechanisms and calculative practices in finance. ratings agencies have acquired unprecedented power. as to precisely what aspect of their operation was so detrimental to the financial economy. 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. Institutional investors. insurance companies. however. the rating agency in question bore no responsibility for its rating: if it made a mistake. As capital markets have displaced bank lending. As Sinclair explains. crucially. the easier it is to sell the asset to a final buyer. trusts. by and large. The higher the credit rating of a security. At the same time. market liquidity. such as pension funds.
As Partnoy (2008) insists. In principle. they cannot serve as an effective assessor of value for the financial market. the crisis made it clear that CRAs have
. Still others argue that the core problem with CRAs is structural: as private companies.T he Th re e Pillars of Th e liQ u idi T y i l l u s i o n
CRAs performed well. the AAA ratings of these instruments were granted not because of the underlying information. the financial Frankensteins that the CRAs’ mathematical models said were low-risk. therefore. the rating business has shifted from providing information to selling ‘regulatory licences’ – or keys to ‘unlocking financial markets’. ratings-based rules precipitated the crisis by creating perverse incentives for arrangers. Being regulated under the Basle accord. but it is the methodological assumptions of the models they used – for instance. they face a conflict of interest between their objective to make profits and their role as independent risk assessors (Wade 2008). 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. Others note that the CRAs themselves are not the villains. issuers and ratings agencies to create complex financial instruments that received higher ratings than they deserved. Notwithstanding the nuances of this continuing debate. In the case of Constant Proportion Debt Obligations. predicting valuations of future risks based on narrow historical records – that were flawed (Boorer 2008). the real problem lies with the rules and regulations that govern them. Partnoy (2008) argues.
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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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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
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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
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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
the illusion of liquidity eventually came to a destructive end. Institutionally. partly by capitalising on the contribution of the financial sector to the economy. Mainstream finance theory. however. 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. in turn. Politicians reaped the benefits.142
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operating in such a system. and partly by advocating the social welfare gains of new. ‘democratised’ finance. Like most illusions. has guided this trend. as a result.
. the global financial architecture reflected the idea of liquidityenhancing financial innovation. and the financial trade based on credit ratings. arguing that this new approach to managing risks enhances market liquidity and the financial robustness of the economy.
financial institutions and traders enhance the liquidity – and thus the stability – of the financial system as a whole. 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
. the social institutions of the financial markets today and. crucially. 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.6 after the Meltdown: rewrItInG the rules of GloBal fInance?
Essentially. economic and political – became an axiom of modern finance. 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 illusion of liquidity was supported by the political and theoretical edifice of global financial governance. As the credit boom of 2002–7 illustrated. Scholars and analysts had long pointed out the flaws in such reasoning.
several central banks agreed to offer their guarantees in exchange for toxic assets from financial institutions. As the crisis progressed.144
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was built on these three pillars of modern finance. high-powered
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. Hence the efforts of the regulators centred on opening up the markets. often coordinated internationally. cutting interest rates and trying to make the financial institutions lend to each other. the answer is. Now that the global credit meltdown has passed its second anniversary. unblocking credit lines through monetary injections that were quite unprecedented in their scale. Essentially. to restore confidence (understood as liquidity) in the financial markets. with this move. central banks rushed to put out the fire with massive injections of cash. quite a lot: the policy response to the global meltdown has evolved through three distinct stages. one question naturally arises: What has been done? At first glance. Effectively. governments validated the experiments of private financiers by offering state-backed. the first phase was about pumping money into the frozen markets and was defined by the efforts of the national monetary authorities. The amounts set the tone for how the crisis would be handled for the year ahead.
however. decisive action.1 it is also unclear what will happen to the billions of dollars of toxic debts now being held by the banks. Neither the exorbitant size of cash injections nor the central banks’ attempts at transatlantic regulatory coordination helped quell the turmoil. allowing little time for deep analysis or musings about the actual causes or lessons to be learnt from the crisis. In the midst of the panic that paralysed the global markets in the late summer of 2007. the immediacy of political reaction was understandable.af T er T he me lT doW n
liquidity to individual institutions which could no longer shift their junk paper in the markets. Not only does it go against the golden rule of monetary theory and the principle of a lender-of-last-resort action. whether governmentsupported or not. National Recapitalisation Schemes (9 October 2008–2009) Following the government takeover of Fannie Mae and Freddie Mac and the collapse of Lehman Brothers. Yet as the crisis intensified and transformed into deeper problems in the national and international credit systems. the ad hoc measures proved to be insufficient. the world entered the second phase of crisis management:
. This decision remains one of the most controversial policies of the global credit meltdown. Panics require urgent.2 Even this radical response to the crisis brought feeble results.
The UK rescue plan therefore contained a vital element of conditionality within the new liquidity provisions to the banking system. governments in the US and Europe followed the example set by the UK in launching recapitalisation or bailout plans for the troubled banks. where since April 2008 the Fed had been expanding its lending facilities (and its balance sheet).
. 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. In a quite extraordinary turn against the principle of the free market.146
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national recapitalisation programmes. With the election of Barack Obama as president in November 2008. The British solution to the problem of de facto insolvent banks was drafted over the first weekend of October 2008. The conditions attached to the use of taxpayers’ money included curbs on executive pay. In parallel. The government’s goal was to restore the credit circulation not only within the financial system but also in the ‘real’ economy. In the US. A Troubled Assets Relief Programme (TARP) gave the Treasury. suspending payment of dividends to shareholders and maintaining lending to small businesses and homebuyers at 2007 levels. an additional $787bn fiscal stimulus was launched. authority to buy or insure up to £700bn of illiquid assets from private financial institutions (Wigan 2010 forthcoming). via the Office of Financial Stability (OFS). 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 government is now the majority shareholder in both RBS and Lloyds TSB. Financial Products AIG. 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. The bailout plans met with little success. 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. In November 2008. since the funding plan effectively recognised that the insurance giant had transformed itself into a de facto investment bank through its subsidiary. he notes. The banks in turn. starting with Northern Rock. several big banks in the US and the UK have come – either partly or totally – under state ownership. Cavanagh and Redman 2008). although publicly shamed by various governmental committees for their experiments during
. In the US. since the latter’s acquisition of the stricken HBOS. Overall.3 In total. the rescue plan for AIG is of particular significance. Oxfam (2009) estimates that governments have pumped $8.afT e r T h e me lTd oWn
As a result of these bailouts. As Wigan (2010 forthcoming) writes.42 trillion – made up of capital injections. The reaction from the financial markets was half-hearted: although market indices stopped falling uncontrollably. toxic asset purchases. subsidised loans and debt guarantees – into the failed financial institutions. the mood in the world of finance was far from optimistic.
DC for a summit that was dubbed ‘Bretton Woods 2’. such as AIG and Goldman Sachs in the US and RBS-HBOS in the UK. It did not help when it emerged that executives in the key financial institutions. it did mark the beginning of a series of efforts at the global level to reform world finance. have received vast amounts in bonus payments. fuelling public and media fury. The Obama administration has been behind a radical plan for financial reform announced in June 2009. and the chain of bankruptcies expanded into the real economy. was a central forum in
. Although the summit did not bring any tangible results. other than public commitments to bolster the global financial system and rethink existing approaches to financial governance. albeit rather too hastily. were slow and reluctant to accept state help. when world leaders gathered in Washington. two key events have spurred progress on these efforts: the election of Barack Obama and the G20 London summit in April 2009. The G20 summit. even claiming that ‘they are not charity’ cases.148
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2002–7. Its inception can be dated to 15 November 2008. International Financial Reform (15 November 2008–?) The deterioration of economic conditions worldwide has moved crisis management into its third phase: an international regulatory response. which reconvened in September 2009. In the meantime. the world financial crisis descended into a global recession. To date. Lending levels remained low.
The crisis and Geopolitics: a new special relationship?
The first visible crack in the seemingly global reaction to the crisis is geopolitical. if any. finally. from localised injection of money to national bailout schemes and. 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. the chapter delves into some of the key rifts that have surfaced to date. Indeed.af T er T he me lT doWn
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. is likely to be implemented as policy action. both analytical and geopolitical. As this book goes to press (winter 2009). it can be understood as a reflection of the
. So. Instead. as it seems likely that both political and analytical differences will affect the course of action. to coordination at the international level. plans for a new architecture of global finance are still being negotiated. all three stages of the policy response to the meltdown have been marked by divisions and conflict. And while it is difficult to predict which form the world financial architecture will assume. and simply impossible to foresee which version. Put in somewhat crude terms. therefore. at various levels. it is difficult to comment on the proposals that are being debated. In what follows. it is clear that these differences are determining the path of financial reform. in the evolution of the policy reaction to the crisis.
the UK has built its economic strength on the power of the City of London as the world centre for financial innovation. most notably France and Germany. Originally. where there is a sharp divide between the UK and other EU members. 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. one important conceptual detail of the US bailout plan stands out. Whereas the EU has traditionally been more in favour of closer regulation of the financial industry. Both sides of the conflict centre on how national (and supranational) authorities view the process of financial liberalisation. In the age of financial capitalism. the line cuts in two ways: between London and Wall Street on the one hand and Brussels on the other. The US. the official reflection on the
. has been opposed to the idea of preventing market progress by administrative or political interference since the 1970s. the political response to the credit crunch was simply an attempt to restore confidence by pumping liquidity into the markets. In the context of the global credit crunch. for its part. The United States As noted above. Here.150
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long-running differences between the Anglo-Saxon and continental models of capitalism. in the US until the nationalisation of Freddie Mac and Fannie Mae and the collapse of Lehman Brothers. within the EU itself.
3. new requirements for regulation of the financial products that previously were traded in unregulated exchanges.afT e r T h e me lTd oWn
lessons from the crisis. Comprehensive supervision of the financial markets. as articulated by the US Treasury Secretary in the March 2008 blueprint for a new system of regulation (Paulson. installing. or ‘objectives-based’ plan. Specifically. Oversight and close supervision of financial firms. rewards innovation and is able to adapt and evolve in line with changes in the financial markets (US Treasury 2009: 2). the blueprint. stressed that innovation and market competition remain the priority for the US economy. in particular. Stronger regulatory potential by the government. The version of the reform proposal launched by the Obama administration in early summer 2009 takes things much further. extending the scope of regulation to non-banks
. protects consumers and investors. was designed to address individual market and business failures rather than question the core principles of the functioning of the financial system. 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. Steel and Nason 2008). The proposal targets financial regulation at four key levels: 1. 2.
4. by raising international regulatory standards and levels of coordination. and as many analysts continue to reiterate. it is a long-needed and welcome step towards public acknowledgement that financial excesses have disastrous consequences for society and the state. calling for more regulatory bodies and extended powers in the US network of financial regulators. nationally and internationally. In its call for a system-wide overhaul of financial supervision.152
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and adding to the apparatus of existing financial supervisory authorities at the Federal level. Although full of good intentions. the proposal is thin on concrete initiatives and fails to address many important issues. 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. critics have pointed out that the apparent comprehensiveness of the plan is illusory. The plan also commits the US to taking a lead in strengthening international financial reform. a more
. and that existing market-friendly standards of governance have been unable to address them.5 Moreover. 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. there is a risk that the reform will only complicate the already cumbersome structure of financial governance in the US.4 At first glance. As noted above. In this respect. At the same time.
the EU followed the US in acknowledging the need for international policy coordination. In spring 2008. To complicate matters. Europe Things in Europe have been somewhat different. the EU’s initial regulatory response to the crisis echoed the themes of the US March 2008 blueprint. notwithstanding its radical tone. Therefore. A more complicated domestic regulatory framework would also undermine the effectiveness of any international coordination in terms of cross-border supervision. between the US and Europe gradually surfaced. Yet. significant divisions. of the proposals is likely to make it to the final policy act. which has been a key problem in the global meltdown (Crook 2009). though not decisively so. On the face of it.afT e r Th e me lTd oWn
effective mechanism of crisis resolution would need to be much more transparent and simple. both conceptual and policyrelated. Fundamentally. they centre on the differences between American and European officials in drawing lessons about the risks and benefits of financial innovation and liberalisation.
. not least because the risk of a cross-border banking crisis was deemed high. the Obama administration’s proposals for a better governed financial system have left many questions about the credit crisis unanswered. if any. rather than complex. the plan has yet to gain congressional approval and it is unclear which version.
upgrading valuation standards. these distinctions became ever more apparent. 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.154
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The European ‘roadmap’ for a new regulatory structure is built on four conceptual areas: improving qualitative information and transparency for investors. including the European divisions of US banks. Specific regulatory norms proposed by the EU include higher and tighter capital and liquidity requirements for all banks operating in Europe. in Europe arguments have centred on the split between the UK and continental Europe. While the voice of American delegations in these summits has been muted due to the political changes in the US. the Financial Times reported that ‘fears are rising in the City [of London] that strict new European regulation could hit the financial services
. 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. As proposals for regulatory reforms matured from initial discussions to the level of procedural planning and implementation. strengthening prudential frameworks and risk management in financial institutions. and reviewing the role and use of credit rating agencies in the financial markets. Over the course of 2008–9. In June 2008.
set out in an EC paper. Specific European proposals that trouble Britain include: • The proposal. A European institution setting minimum standards would fetter the competitive drive to deregulate between countries. 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. But the devil. as they say. • The idea that an EU ‘systemic risk council’ (a new supervisory body) would be chaired by the president of the ECB.af T er T he me lT doWn
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). All these proposals have unnerved
. Financial institutions would also have to meet increased minimum capital requirements and limits on borrowing. should be at the EU level. is in the detail. for tighter regulation of hedge funds and private equity. such as credit ratings agencies and central clearing houses. • The proposal that EU supervisors be empowered to demand that national governments bail out banks. • The proposal that supervision of entities with a pan-European reach. 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).
But the problems with the crisis response unfortunately do not stop here. 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).156
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the City. the efforts will be too vague and hesitant. as well as the poor record of previous efforts to design a global financial architecture. there are serious stumbling blocks. As some commentators and politicians began talking about the ‘green shoots of recovery’ in the second half of 2009. technical and political. Financial Services Secretary to the UK Treasury. 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. In July 2009. At the level of global geopolitics. The plans for a new financial architecture are also riddled with opacities and conflicts at a deeper. the post-crisis regulatory fallout can broadly be divided into two
. Lord Myners. therefore.
conceptual dilemmas and Traps
In terms of its theoretical underpinnings. Considering the politics of financial regulation on both sides of the Atlantic. en route to a new architecture of financial governance. 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. conceptual level.
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. systemic solutions to the crisis. In essence. more mainstream set of opinions and plans come under the rubric of ‘making financial innovation work’. The first. 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 . The second.. these theories tend to be built on structural explanations of the crisis. these proposals call for a better.. I believe that the Fed still has powerful tools at its disposal to fight the financial crisis and the economic downturn …’ (Bernanke 2009). 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. is a search for comprehensive. democratised finance and financial innovation has brought to society. more up-to-date and competent approach to financial regulation and governance.afT e r T h e me lTd oWn
distinct paradigms of finance. Their emphasis in challenging the basic paradigm of finance today could be called the ‘traditionalist’ approach to financial reform. therefore. The resulting reform agenda. Stressing the benefits that the era of new.
. or the structure and principles of the economic organisation as a whole: ‘[T]he global economy will recover.
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 2008.158
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A notable distinction between the two groups lies in their intellectual origins. The Traditionalist School: Return to Prudence and Old Values
you have forgotten the basics of what finance and banking are for. it is time to return to some old-fashioned banking. Intellectually. at the expense of all of us. are couched in the specialised financial language of today and are formulated by a range of financial practitioners. on the contrary. The audience – comprising mostly young finance geeks – was clearly not impressed. private financiers. are dominated by expert forums. The latter approaches. the ‘traditionalists’ frequently draw their insights from history and non-economic academic disciplines and they often appeal to a wider audience. the second is mostly built on the idea of improving the current practice of investment. who started his career in the 1950s at a desk in a provincial bank. While the first school of thought is informed by considerations of the place of finance and money in society. on occasion. valuation and supervision techniques. specialists in academic finance theory. you have carried your institutions into abyss. trading. observers and. was asked only one question from the audience at the end of his address: ‘So has
. in your financial experiments.
the use of common analytical and trading techniques. they argue.af T er T he me lT doWn
your bank avoided all the losses then?’ Later. and made aggressive greed the code of practice in the financial industry. This anecdote captures the essence of the ‘traditionalist’ school on the lessons of the credit crunch. The markets’ appetite for apparent efficiency. senior managers and analysts. Innovation and speculation. exuberance and short-termism. it emerged that the bank in question is the only British bank that has got through the credit crunch with minimal losses. As the traditionalists argue. underpinned by the desire for quick profits and market-making opportunities. amidst calls to overhaul this dangerous and obscure financial industry. ‘liquidity’. Therefore. the advocates of this group call for a rethink of the very structure and purpose of the financial system today. has made finance a very brittle system. supported by unanimous understanding in the markets that things will be fine ‘as long as the music is playing’. but ultimately came at the high cost of the public good of financial stability. corrupt and unaccountable financial industry. Blaming the crisis not merely on specific investment and speculation techniques. have gone too far. encouraged herding. the anti-greed
. the views of some politicians and a few financiers – most prominently Warren Buffet and George Soros. but rather on the whole culture that has bred irresponsible. flexibility and profits has not only bred pervasive unaccountability on behalf of individual traders. It accommodates the many angry voices of civil society groups.
by drawing on the virtues of a more ‘Asian’ type of capitalism. one that is more prudent and long-term in its orientation. as an executive of a medium-sized lender argued (in Guerrera 2009). (ibid. long-term profits even though they happen to be lower than your rivals’ in any given year’. at some extreme.’ says an executive of a medium-size bank commenting on the role of the culture of big-bank aggressive competition in the crisis.)
Crucially. speculative investment banking. at the expense of us all. Accordingly. boring banking and conservative finance – in terms of both size and aspirations: ‘The market will reward you for safe. 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. our goal is not to maximise earnings in any given year but to have a profitable business for centuries. based on a culture of thrift rather than spending. a new financial order.160
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and ‘pro-prudence’ regulatory camp calls for the return of old-fashioned.
We have a very conservative business model not by luck but by design. the world needs to make a clear distinction between socially useful banking (retail and commercial) and the more parasitic. Specifically. the vision of a better capitalist system of finance tends to be charted either along Keynesian lines of the regulatory state or. the traditionalists argue. to ensure a better financial system in the future. hierarchies of power and coordination rather than horizontal
. ‘We see ourselves as retailers.
in July 2009. Predictably. etc. are typically caught between electoral priorities and pressures from the financial industry. consumers and the real economy would have been deprived of now mundane services. The technique enables clients to reduce the amount of capital they must hold. as noted above. while analysts and critics argued that the plan is far too anaemic and not radical enough in challenging the culture of greed and unaccountability. on the other hand. the UK itself was vehemently resisting EU pressure for a pan-European system of tighter financial supervision and regulation. and maintain that without the massive investments poured into the industry by competitive lenders. Meanwhile. for example. On the one hand. such proposals prove to be far too threatening for the financial industry and hence too sensitive for political authorities. paternalistic loyalty rather than aggressive competition and flexibility. are keen to find ways to recycle their old.6 Within hours of being published. Politicians. especially in Anglo-Saxon capitalism. toxic products. such as ATM machines and internet banking. in the meantime. the UK authorities drafted a White Paper proposing changes to the existing system of bank regulation. for instance. Indeed. The financial markets. has designed new tools of ‘smart securitisation’. It works by
. the plan came under fire from two sides: bankers accused it of being politically motivated and even incompetent. Barclays Capital. representatives of big financial firms defend the culture of competition and innovation.af T er T he me lT doWn
but also creating opacity within the financial markets. With some variation. ‘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. Highlighted by the G20 statement on financial architecture in April 2009 as well as several high-profile
. not only widening the gap between the regulators and financiers. These practices. such a vehicle would require a lower level of capital to be held against it (Tett and van Duyn 2009). various improvements to the current self-regulating financial system are being proposed. that needs to be addressed by the new regulatory paradigm in the post-crisis environment. Structures should become simpler. 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. 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’. With a decent rating. It is this gap. doesn’t it? Making Financial Innovation Work The second. Sounds familiar. it is argued. and the obscurity of finance.162
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pooling their assets with those of other clients into a securitisation vehicle large enough to be rated by a credit rating agency. plain-vanilla deals’ (in Tett and van Duyn 2009). To these ends.
thereby making financial trades more transparent and hence accountable. • The need to license and control credit rating agencies that have disgraced themselves by assigning AAA ratings to toxic and illiquid securities. especially when these are funded by the taxpayer. (These controls are mainly advocated by the EU.afT e r T h e me lTd oWn
reviews of the lessons of the global credit crunch. 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. This proposal concerns financiers themselves: CEOs should not receive excessive pay and bonuses. they are based on the idea of rebalancing private gains and social losses. 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.) • 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 change the structure of incentives. • National plans to re-empower and strengthen the mandates of existing monetary and financial
. and on regulating what is being understood as ‘systemic risk’ in finance.
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. ‘scientific’ risk management and financial sophistication. The G20 plan for strengthening the
. In terms of the analysis of the crisis presented in this book. that in the current discussions of the future of finance. • 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. the process at the core of the crisis – the ability of financial engineers to transform obscure debts into ‘liquid’ assets – is not being questioned. (The most recent negotiations have charged the IMF with this task. In essence. there are also proposals to set up a pan-European body with a similar agenda.164
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institutions. This illusion led politicians. though these ideas remain riddled with political conflicts. it is difficult to predict which version of the proposals will be incorporated into concrete policy. It is particularly disappointing. 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. therefore.) Again. regulators and home buyers to believe that global capitalism had entered a new era of resilience and prosperity based on deregulated credit.
interferes with the appropriate allocation of capital. that
. especially if government starts to intervene with direct controls over bank lending. restrictive control of financial intermediation stifles innovation and. 2009: 10)
Generally. The authors of the Geneva report. avoid adverse impacts on other countries. with appropriate assistance from the state. in general. Indeed. can re-balance itself in the event of failure. indeed crucial. 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. and keep pace with innovation in the marketplace’ (G20 2009: paragraph 14). support market discipline. support competition and dynamism. The regulatory and policy adjustments necessary for stabilisation and recovery in turn should not compromise the abiding principles of free competition: ‘It is important. one of the high-profile policy reports on the crisis. reduce the scope for regulatory arbitrage. as stressed in the G20 communiqué: ‘Regulators and supervisors must protect consumers and investors.af Te r T he me lT doW n
global financial system. (Brunnermeier et al. for instance. therefore. 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 a principle. The logic underpinning these proposals is that. appearances notwithstanding. As a result. the emerging debate over an appropriate regulatory response concerns the fine-tuning of existing principles of financial policy and governance. few seem to understand 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). and adjustments to. Moreover.166
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any reforms in. risk-taking is a healthy and positive part of economic activity. but for reasons specific to 2002–7. privatised finance. competition and liberalisation of markets. A better approach to financial regulation in the future should therefore compensate for these flaws. 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. it has been mispriced and misallocated. 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. without undermining the key benefits of innovative. At the same time. As a result. importantly. without killing the underlying drive for financial innovation. confidence itself is not synonymous with liquidity.
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. attempts to re-regulate finance can aim to be.afT e r T h e me lT d oWn
however. the paradigm of market-driven progress has not been seriously challenged and. every crisis – economic and financial – almost invariably rekindled the calls for a ‘new Bretton Woods’ system. the injustices of globalising markets fuelled anti-globalisation movements across the world. and stringent. Since the late 1970s. has firmly shaped the ‘constitution of global capitalism’ (Gill 2002. history is a useful indicator of how effective. up to now. the wave of financial crises of the late 1990s has given rise to what has been dubbed a New International Financial Architecture (NIFA). Indeed. NIFA was briefly in vogue from
. Vestergaard 2009). restoring market liquidity without questioning the essence of financial trade today. while more recently. Even if critics like Minsky appear to be taken seriously during crises. the nature of assets being created and traded. very few of the ideas being put forward are essentially new. and the very meaning of what ‘liquidity’ is. few heed their warnings once the financial cycle and market ‘liquidity’ are restored. Despite the waves of financial disasters and growing tensions within the economies of advanced capitalism. It is thus likely to lead us into another one in the not-too-distant future. has led the financial system into the gigantic hole it finds itself in today. In this instance. Moreover.
etc. Ambitious yet vague on concrete detail.168
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1999 until the 9/11 attacks diverted the attention of policymakers from finance-related problems to other areas. Financial Stability Forum. everyone senses it should be a good thing. Apart from a plethora of forums and committees set up in the wake of the 1997–9 crises (the G20 forum. policymakers tend to search for the same weapon. financialised capitalism. it targets qualitative parameters of financial risk – the macro-prudential approach is in a fact a big elephant in a very dark room. 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. macro-prudential regulation risks becoming to finance what ‘good governance’ has become to politics: instinctively. Recent history also suggests that in another important parallel to earlier attempts to deal with the legacy of the financial crises. various Basle-centred groups. microeconomic indicators of financial stability.
. liberalisation and competition further. NIFA remained pro-market-centred and aimed to facilitate financial innovation.). The bodies and committees that were set up under the NIFA umbrella remained poorly coordinated and impotent in terms of their juridical status. With regard to its focus. now fashionably called a macro-prudential approach to financial governance. Apparently radical in its tone – unlike conventional quantitative.
Under closer scrutiny. however. contagious and quite dangerous for the system. as to what ‘systemic’ risk might be and. Second. The world of finance. current proposals are) – is not a panacea which will necessarily save us from financial instability and crises. national-based statistics and the assumptions of monetarism. at the core of the macro-prudential approach is the idea of better management of ‘systemic risk’ in finance. politically and economically. derives from the assumption that. had macroeconomic analysis played a larger role in governing finance during the bubble. Yet again. macroeconomic governance has been based on obsolete. measure or control it. aside from an intuitive understanding that ‘systemic risk’ is widespread. least so at the international level. has moved economies far
. as John Plender (2009) argues. there is currently very little understanding. crucially. the crisis might have been averted. the macro-prudential approach. 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. 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
but no one knows precisely how best to define. this argument appears quite naïve: for a while now. It certainly has not. how it evolves (Davies 2009). There are several reasons for saying this. First.
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beyond national boundaries. including John Eatwell and Charles Goodhart. the IMF published proposals for a new macro-prudential approach. congressional approval. policymakers did not pursue it seriously and the idea remained purely academic. Yet lacking a current crisis. After all. As the political rifts underlying the post-credit crunch reforms outlined above suggest. Third. in the excitement about post-credit crunch reform people tend to forget that the idea of macro-prudential regulation has a long history. and finally. History in turn
. the global meltdown. Despite appearances. making macroeconomic targeting and even analysis somewhat old-fashioned in an age of obscure financial engineering. as the argument of this book has implied. To incorporate qualitative indicators of risk in the framework of governance is a good idea.7 In the wake of the 1990s crises. the foundations of financial reform continue to prioritise the benefits of financial competition and innovation. very little has changed. while Obama’s radical programme to re-regulate finance still needs more concrete detail on the parameters of national regulatory framework and crucially. analysed in detail the pros and cons of a new paradigm. but how best to implement it today remains a very open question. The City of London is becoming increasingly uneasy about EU-based initiatives for a stronger and wider system of financial regulation. is a crisis of economics as a profession as much as it is the crisis of finance. and several prominent scholars.
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. On the one hand. and even various Basle-centred initiatives for international financial cooperation in the late 1990s. ‘advanced capitalism’ – has come to collapse since the Depression of the 1930s. slow and. It has exposed financiers as villains. This is what happened to the 1988 Brady Report. financial reform. made banking a dirty word. ultimately inefficient in preventing another global crisis in the future. briefly. As the recession lessens and the conflicts within the post-crisis policy debate deepen. While some less controversial and technical proposals for re-regulation may eventually materialise. aside from installing new jargon in the world of finance. the momentum for a comprehensive financial reform is fading away. including the pillar of macro-prudential regulation. more accurately. hence. On the other hand. policymakers as laggards and. the pressure from the financial industry and the anaemic nature of the reform proposals noted above render the plan incomplete.afT e r T h e me lTd oWn
. the global credit crunch is the closest the world – or. is likely to bear little fruit: the global meltdown simply was not painful enough. to the 1999 US Priorities for a Global Financial System. That is probably the most tragic paradox of the current crisis.
the international financial system teetered on the brink of a collapse. or ‘boom-and-bust’ pattern of growth. in early October 2008. more accurately. In September 2008. Like other crises. competition for quick and easy profits and lack of oversight of – or. it was preceded by optimistic.
. after a year of credit paralysis. 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. Like any other crisis. what is most extraordinary about the global meltdown is that in the history of financial capitalism it has been a rather mundane event. And yet aside from its geography. the credit crunch was brought about by the strategy of financial deregulation. Like most of the crises of the past two decades. it came at the end of an unsustainable economic boom and a bear market. Critically. following the sinking of Lehman Brothers. the global payment system was on the verge of total breakdown.conclusIon: a very Mundane crIsIs
The global financial meltdown wrought havoc in the countries of ‘advanced’ capitalism. ‘expert’ opinions about a ‘new economy’.
conclusion: a Ve ry munda n e c r i s i s
insight into – the nature of ‘investment’ today. the peculiar and complex relationship between three factors – herd behaviour on the part of financiers. murky speculative practices and the outright frauds of some financiers and bankers. the concept of liquidity encapsulates crucial socio-economic and
. Although ostensibly nothing more than a technical term. Like every other bubble. Contrary to mainstream views that the credit crunch was caused by the problem of risk valuation. the availability of easy leverage. the credit crunch has been driven by the interplay of market psychology. Built on the theory that by creating a market for a new financial product or technique. today’s financial alchemy and. As the preceding chapters have shown. strengthen economic stability. therefore. the global credit crunch showed that the fashionable enterprise of ‘financial innovation’ only helped disguise the buoyant trade in toxic products. debt structures and the myth of prosperity. the illusion. The global meltdown revealed ‘liquidity’ as a dangerous beast of modern finance. crucially. 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. And just like every other financial crisis. is still with us. the paradigm of modern finance – has created the most dangerous of all myths: the liquidity illusion that precipitated the crisis. financial engineers enhance the liquidity of the financial system and. despite the severity of the crisis.
The global meltdown. According to financial orthodoxy. not in kind but in it geographical spread. The global meltdown has been anticipated and even foreseen.
. specifically. their pessimistic messages were seen as sour grapes on the part of the financial markets and were unpopular politically.174
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political dynamics of the modern financial system. those opinions were heresy vis-à-vis the dominant ‘religion’ of efficient finance theory. the Ponzi pyramid of bad quality. Sadly. long banished to the sidelines. and did just that. In the midst of the economic boom. but also by market analysts and participants. The trouble is. then. and the notion of wealth-enhancing financial engineering. is unique. Sceptical voices were mostly heard from the heterodox schools of economics and political economy. The sophisticated. not only by scholars of financial history and capitalism. crises normally affect emerging economies or perhaps individual companies who mismanage their financial affairs. the widespread belief in the infinite and abundant liquidity of the global market has fuelled the latest bout of securitisation. transparent and advanced financial systems of the West and. illiquid loans was bound to collapse. 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. In the end. Predicated on the confusion between market confidence and systemic liquidity. as Minsky and many of his intellectual successors warned. Yet the debt that was the foundation of the securitisation industry could only be shuffled around temporarily.
the shock seems to be both shallow and short-lived. to shake the orthodox view of financial innovation. There are some proposals that aim to eliminate and control
. this rehabilitation is only partial. That is perhaps the greatest paradox of the global financial meltdown.conclusion: a V ery munda n e c r i s i s
of Anglo-Saxon capitalism had been assumed to be robust. It has erupted as an historical shock to the world of advanced capitalism. along with Keynes and Irving Fisher. one odd outcome of the global meltdown is that Minsky. It has been unable. Minsky and Galbraith – suggest. Minsky’s most profound message concerned the role of financial innovation in socio-economic stability. Unfortunately. He argued that while financial innovation marks any period of economic optimism and tranquillity. efficient and democratic. At the same time. however. The mechanism that produces such a tendency centres on the myth of liquidity-creating and wealth-enhancing financial innovation. The global credit meltdown has shown this idea to be a dangerous and costly myth. 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. seems to have been rehabilitated by the economic and financial mainstream. Some of the post-crisis moves towards a new architecture of global financial governance do touch on various problems exposed by the credit crunch. In this respect. however. it also inevitably drives the system towards the brink of a crisis. as references to both the Great Depression and its classic analysts – Keynes.
recur. 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. and even challenge the place of offshore financial centres and tax havens. of the rules of global finance. and is likely to. At the same time. It also means that such a crisis can. After all. or even a profound rethink.
. the notion of ultimately beneficial financial innovation seems to be too sensitive – or perhaps too complex – to be confronted openly. Watch out for comments about ‘abundant liquidity’ and new frontiers of financial innovation and engineering. unaccountability and lack of transparency.176
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greed. the global credit meltdown has been neither deep nor painful enough to initiate a radical overhaul. All this suggests that despite the emergent buzz of reform.
compared to 2. 2. for instance. FSF and the IMF.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.
1. According to the Mortgage Bankers Association.notes
1. According to Inside Mortgage Finance. It filed for Chapter 11 bankruptcy on 6 August 2007. ResMae Mortgage filed for bankruptcy and Nova Star Financial reported a loss that analysts had not foreseen. the ECB. 5. the BIS. 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).5 per cent of mortgages originating in the US were sub-prime. 4. 6. In 2004. Forbes ranked HSBC as the seventh largest company in the world. IKB had to be rescued with a $3. 3.
.6 per cent in 2000. in 2007 HSBC was the world’s seventh largest bank in terms of shareholders’ equity (data from Euromoney). Occasional studies of liquidity have been published by other central banks in the wake of the crisis. The Bank of England. but according to what others might consider to be ‘beautiful’. in 2006 13. Keynes likened finance to a beauty contest run by a newspaper. 2. Most notably.
Bear Sterns had been worth £18bn. 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. According to 2008 data. Also. 10. 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). then US Treasury Secretary. such as Goldman Sachs. while the bulk of China’s holdings of US debt is in the hands of the government. or a fifth of outstanding agency debt (Bloomberg News. A few months later. according to Brad Setser. including the Treasuries. 9. the AIG bailout would balloon to around $150bn. In the autumn of 2007. in the past had repeatedly claimed that derivatives were valuable risk -management tools which did not need
. the largest recipient of the AIG debt.178
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7. including bonds sold by Freddie Mac and Fannie Mae. On 13 December 2007. According to official US data. Commentators note an odd coincidence here. the key beneficiaries of the Fed rescue. analysts put the total exposure of the six biggest Chinese banks at $30bn (data from Bloomberg News). who actually authorised the AIG bailout. is more likely to be about $1 trillion. was the ‘home’ institution of Hank Paulson. The second largest holder is Russia. It was credit derivatives. China held $376bn of long-term US agency debt. Interestingly. China controls more than $1 trillion of US debt. 8. The actual amount. JP Morgan and Merrill Lynch. (a type of insurance intended to protect buyers should their investments turn sour). 11. In July 2008. A year earlier. the two states hold at least $925bn in US agency debt. 12. Goldman Sachs. 14 July 2008). Analysts estimated that. China’s biggest banks own large chunks of agency debt. reacting to falling market indices and more and more bad news coming from individual companies.
world manufactured output and world trade in manufactures shrank dramatically. Until the liquidity squeeze of autumn 2008. Interestingly. In the wake of the credit crunch. We are grateful to Victoria Chick for highlighting this key detail. saying that losses were out of the question (Williams Walsh 2009).n oT es
13. South Korea down 25. Ireland and Luxembourg. Yet the banking systems in Eastern Europe – mostly controlled by European banking giants – are at a major risk of collapse. AIG officials also dismissed those who questioned its derivatives operation.2 per cent year-on-year in January. 2.6 per cent and Japan down 30.2 trillion (IMF 2009: 2).
to be regulated.8 per cent (in Wolf 2009). the rest. Granite had no employees whatsoever. At the end of 2008. COBRA (Cabinet Office Briefing Rooms) is the UK government’s crisis response committee which deals with national crises such as pandemics and floods. 14. or more than 50 per cent from the peak reached in summer 2007 (Papademos 2009). The figures include the Netherlands. In the EU. clearly attract these SPVs due
. 3. threatening in turn the stability of European banking generally. the IMF predicted that the total expected losses by banks and other financial institutions were in the range of $2.
16. including Singapore. which may be controversial. Switzerland. In March 2009. Latvia and Ukraine suffered the most. 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. Germany’s industrial output was down 19. Among the emerging markets affected.
1. Sale and repurchase agreements. the value of equity has fallen by €6 trillion.
Dispatches. Insurance. India and South Korea. Investment banks fall under the Securities and Exchange Commission (SEC). As of April 2007. This compared with 68 per cent in the US. 4. while in Japan and Malaysia the ratio was between 5 and 6 per cent.
. According to the BIS. Financial markets are supervised by the SEC or by the Commodity Futures Trading Commission.180
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to their very low tax regimes and because they offer a high degree of opacity and secrecy. ‘How the Banks Bet Your Money’. is not supervised at the Federal level at all (Buiter 2008). The data for the state of the markets for securitised debt also suggested that the financial systems in the Asian economies were ‘too shallow’. 5. the Federal Reserve Board and the Office of the Comptroller of the Currency. the Asian sovereign bond market (valued at $830bn) was less than a tenth the size of its US and Japanese counterparts. Other depositary institutions are supervised at the Federal level by the Office of Thrift Supervision and the National Credit Union Administration. Channel 4. As Buiter explains. at the Federal level commercial banks are supervised by the Federal Deposit Insurance Corporation.25 trillion. 18 February 2008. only 1 per cent of housing loans were securitised. 3. in Hong Kong. which played a key role in the crisis through the credit risk insurance industry.
1. 2. The European market is 12 times as large. from just over $800bn at end of 2004 (2006: 103–4). by early 2006 the combined holdings of China and other large emerging markets had increased to an estimated $1. 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.
Bernard L. Carlo Ponzi. In 2006. 5. Madoff Investment Securities LLC used Friehling & Horowitz. and has been the leading hub of financial innovation globally. the scandals of pyramid schemes run by Madoff and Stanford made the notion ever more widespread. financial services incurred £19bn in trade surplus.n oT e s
1. 1 in foreign equity. which involved roughly $1bn (£510m) in losses. As a result of the bailout. up 9 per cent from 2003 (Caulkin 2006. 2. Employed in analytical terms by Minsky. an auditor operating out of a 13 × 18 foot location in a business park in New York City’s northern suburbs. cross-border bank lending and as a secondary market for international bonds. borrowers were persuaded to take a mortgage without being told that they would be unable to pay it off early or change the terms. the City of London was global No. from estate agents and appraisers to underwriters. IFSL 2007). It was the fastest-growing hedge fund market. 3. 4. In the context of the credit crunch. 6. who made millions of dollars by fleecing Americans during the 1920s economic boom. The 144 cases. 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. 68 per cent of the bank is currently owned by the state. the term actually commemorates the life of a scandalous crook.
. developers. In 2004. targeted anyone involved in fraudulent mortgage loans. derivatives and foreign exchange trading. Often. lenders and lawyers. but was ultimately caught and died in poverty. they were ensnared in the sub-prime net (Kregel 2008).
’ 5. Data from The Economist. 2. the ongoing financial crisis differs from the context Minsky identified. Here. 4. several financial institutions started repaying the taxpayer funds.6bn and $3. Accepting toxic debt as central bank collateral did not give the central banks a clear ‘way out’. respectively) in June 2009. supervision of internationally active financial firms. US Bancorp and BB&T repaid billions of dollars ($10bn. Kregel (2008) notes. By the summer of 2009. such loose ends concern technical aspects of regulatory capital and leverage ratios for financial institutions. In this regard. 4.4 million a year to certify that WorldCom’s books were honest. Observers agree that the institutions are mainly motivated by the desire to ‘get out from under US government thumb’ (Reuters 2009). By issuing ratings downgrades. $6. The accountancy firm Arthur Andersen. At least 22 smaller banks have been allowed to repay some or all of their taxpayer money. Morgan Stanley. According to the classic doctrine of Walter Bagehot (2006 ). claims that WorldCom’s finance chief Scott Sullivan never handed over the material Andersen asked for (Kadlec 2002). 3. and crisis prevention and management. 17 May 2007. 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. which was paid $4. there is vagueness about how
. the plan notes that ‘We will focus on reaching international consensus on four core issues: regulatory capital standards. oversight of global financial markets. As Crook (2009) writes.1bn. 2. 3.
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7. The paper includes tighter capital and leverage requirements. 6.n oTe s
Fannie Mae and Freddie Mac – central to the mortgage securities bubble – will be regulated under the new rules.
. and new norms of consumer protection in the country. I thank Victoria Chick for highlighting this important point to me.
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regulatory arbitrage 46. 106. 179n. 86. 30. 117. 139 and securitisation 9. 110. 9. 11. 85. 110. new economy. 167 and risk 67. 49. 116. 21.2 and Northern Rock. 119. 19. 162 Banking and liquidity. 74–5.9 Agencies. 171. 107. 78. 141 Agency debt (USA). 81. 146 system 2. 85. 116. 27. 91. 177n. 95. 131. 105. 88. 14–15. 29. 94 Tripartite Agreement 31. 119. 36. 3. 115. 194 Asia – 38. 48. 141. Ponzi. 88. 118. 35.14 commercial (traditional) 13. see also Ponzi capitalism 66 ORD model 15. 133. 118 shadow 15. 73. 78. 146. 117. 94. 129. 115–16. see ratings agencies Arbitrage. 58. 134 Accounting standards: 135–8. 144. 74 ‘Naughty Asian exporters’. 42. 158. 88
. see also fraud.2 ADB 38 Asian capitalism 160 Asset(s) Asset-backed securities (ABS) xxx. 35. 96. 79. 77. 63. 83. 147 and capital 31. offshore. 153 Bank of England and credit crunch 21. 34. 77–8. 163 and liquidity (also liquid assets) 6. 49. 48. 160 investment.
21–2. 164. 161. 119 Banking crisis 2. 128 asset inflation 2. 132 creative accounting 47. 38. 85. 95. 139–40. 56. 120–1.index
Accounting. 139 and fraud 94–5. 44–8. 124. 88. 43. 16. 178n. 165. 57. 180n. 133 toxic. 87. 31. 36. 117. 136. 125. 8. 24.
167 crisis of 24.5. 96. 114. 171 Bernanke. 43. 143. 160. 69 Credit rating 142
. 53. 95. 155. 26. 178n12 City of London 150. 182n2 ECB 16. 135. 30. 79. 177n2 Federal Reserve (the Fed) 29. 148. 170. 30. 127–8. 69. 124. 63. 181n3 Credit boom 3. 76. 44. 145. 130. 99.198 financial alchemy in c risis
Bankruptcy 24. 88. 146. see also Ponzi 100–12 Central bank(s) 29. 180n. 157. 100. 18. 89. 64. 174–5 financialised 3. 42. 31. 66.1. 114. 65. 74. 177n. 80–3. 160–1 Anglo-Saxon 63. 91–2. 175
Capitalism 1. 139. 171–2. 122. 177n2. 124. 180n. 116–17. 114. 42. 81. 111. 136. 28. 183n. 101. 156. 169. 105. 91. 41. 129. 164. 22. 157 BIS 19. 43. 165 Capital adequacy (also norms) 88.2 on liquidity 19. Ben 29. 173. 72. 162. 168. 161–3. 120. 123. 137. 177n. 154–5. 133. 167 Bubble 3. 148. 25. 32. 134 securitisation 20. 80 Capital see also recapitalisation: 1. 70.4. 92. 172 varieties of 150. 178n7. 136 dot. 96. 164 Credit derivatives 87. 108. 76 Bretton Woods system 9 ‘Bretton Woods-2’ 76. 68. 74–5. 36. 71–4. 178n7. 34. 29.2. 120. 179n1. 63–7. 157. 49. 44. 88. 161.com 48. 96. 47. 27. 100.4 Basle Accord 95. 126. 178n12 Credit expansion 19. 172n. 34. 172n. 183n. 89. 127. 71–4. 135. 50. 133–4.5 ‘super-bubble’ 73 Business cycle theory of. 67. 129. 35. 12. 91–2. 44. 175 Ponzi. 28. 91. 103. 144. 18. 163 committees and groups 168. 138. 35.6 Capital markets 41. 79. 160.
37. 63–4. 36. 171. 25. 178n. 163. 16. see central bank Fannie Mae 33.12.index 199
Credit rating agencies (CRAs) 22. 154. see also crisis of the 1930s. 77. 50. 104. 167. 183n. 95–6. 105. also Eurocurrency. 99.15 Euromarket. 163. 131. 150. 100. 102 Derivatives 10. 135.9. 172 Depression. 101–2. 32. 59. 164. 95. 134. 178n.2 toxic 7. 119. 40. 3. 138. 176. eurodollar market 9. 95. 78. 45. 87. 139. 170 theories of. 35. 116. 140 Europe 36. 128. 86. 109. 95–6 Global 34. 182n. 33. 181n. 171 Great Depression 35. 72–5. 116 Enron 48. 180n. 163 Crisis of the 1930s. 40. 50. 132.5 Federal Reserve (Fed). 55.2 mortgage-backed. 73. 82. 145. 60. dot. 62–89 structural theories 71–9 cyclical theories 80–9 policy responses to. 165. 164 EU 32. 150. 42. 121. 170.11. 178n. 117. 171. 178–9n.com bubble 48. 173–4. 119. 43. 29 public 90–1 US debt 33. 172 of the 1990s. 69. 98.9 Debt culture 9–10. 144–9 Debt 2. 124. 135 role in the crisis 135–9. 178n. 178n. 105. 44.5 Freddie Mac 33. 81. 77. 32. see central banks Financial expansion 98
Deregulation 11. 161. 179n. 132. 51. 150. 69. 175 Dot. 52–3. 34–5. 45. 128.9.9. 78–9. 74. 6. 95. 146 Eastern Europe. 162 regulation of. 179n. 42.com crisis. 145. 183n. 153–4. 64. 161. 156. 133–5. 20.14 response to crisis 153–6. 141. 145. 140–1 European Central Bank (ECB). 95. 43. 126–8.
83. 66 Fraud 40–2. see also Northern Rock and Offshore 40. 82. 116. 109. 52–5. 157. 38. 43–7 role in crisis. 68. 140. 181n. 107.200 financial alchemy i n crisis
Financial fragility 20. 128. 95. 22. 156 Global recession. 84. 84. 181n. see also depression and crisis. 174 House prices 25. 143. political economy) 3. see crises Greed 41. 60. 89. 146. 133–4. 109. financial 16. 47. 68. 141. 33. 47–9 and Ponzi. 28. 102. 166. 120.2 Great Depression.3 Herding. 22. 173. 162. 56. 175 Geeks. 153. 142. 148. 2. 179n. 100–3. 42–3. 159 Heterodox (economics. investor 95.3 and liquidity 129–42 crisis lessons. see also NIFA. 34. 118. 43. 32. 83. 168–70. 59. 45. 155–6. 65. 55. 140 Hedge fund(s) 15. 28. 73. 149. 168. 15. 159–61. 150.6 and offshore. 105–6. 175–6 controversy over. 160. 175 Granite. 70. 167 Financialisation 12. 25. 165. 176 Greenspan. 501. 103 Housing market(s) 2. 37. 42. 156. 94–5. 118. 89. in crisis 82–9 Iceland 36. 29. 181n. 96 Governance. 166 Hedging 16. 20–3. 118 Financial innovation 8. 158 Geopolitics 149. 162.1
. 173. 175 and liquidity 20 and ORD model. 90. 100. JK 1. 156–7. 130. 111 Galbraith. 163 institutions 182n. 126–7. 41 Illiquid asset 14. 59. 148 Global savings glut see also savings and liquidity glut 78
Gold (standard) 9. 164–6. 123. 109–20 Financial liberalisation 150 Financial architecture. 98. Alan 14. 13–17. 103 Human factor. 82. 66. 76. 100–9. 152. 81. finance 66. 51. 129–30.
144. 177n. 141–2.7 and subprime 103–6 Japan 39. 125. 76. 143. 28. see also asset price inflation 45. 175. 12.1 Keynesian welfare state 71 Kindleberger.16. 144. 166. 79. 159. 60. 178n. 126. 112. 163.2 liquidity glut. 73. 173. see also savings glut 7. 121–4. 88. 17–23 pillars of. 179n. 182n. 30. 145 and assets 8. 124–5. 91. also liquidity boom. 29. 179n. 104. 20. 86. 173. 164. 18. 104–5. 180n.2 Junk (securities) 145. 36–7. 126. see financial innovation Interest rate 26–7. 6. 178n. 140. 183n. 73. 177n. also debt 6. 5–6.5. 11. 36. 97. 177n. 140. 121.index 201
loans. 34. 141. 98–9 Innovation. 47. also crunch. 17. 119. 161. 113–42 paradox of. 177n. 129 Systemic 141 IMF 26. see also toxic debt Keynes. 115. 16–17. 121.15 Inflation. 154. 32. 174. 173–6 and regulation 57. 10–11. 136. 10.2 crisis. also meltdown 5. 143. Charles 85 Lender of last resort 88. 90. 174 system 20. 136. 24.7
. 129–30. 132.6 Liquidity artificial 42
concept. 30. 125 risk 19. 145. 75. 8. 77. 16–17. 127 types of. 81. 135 and markets 7. 142. 115–17. 141 Illiquidity 117. 45. 112.2. 57. 179n. 113. 146. 126–7. 173–4 and financial innovation 9–10. 182n. 76. 64.1 (ch. 159. 12. 143. 34. John Maynard 3–4. 114. 137–9. 150. 7–8. 60. 173. 6) Leverage 1. 167 and system 14. 115–16. 176 Liquidity support in crisis 30–1.12 illusion of 4. 164. 146. 176 defined. 170. 78. 128–31. 107. 167. 10–12.
4. 100. 103. 128. 139 Over-the-counter (OTC) 123. 132. 25. 179n. 174 Ponzi. 134. 105. 100–4. 129. 28. 163. 174. 38. 59. 181n. 112. 53–5. 152. 128. 181n. 81. 42. 92–4. 102–3. 39.1.202 financi al alchemy in c risis
Loans. see also Ponzi 96. also Ponzi scheme 19. 146. 34. 174 Ponzi principle 59–60. 69. 79. 114. securitised 7. 41. 55.4 on financial innovation 115–17 Monetarism 169 Monetary policy 2. 139. 26. 95. 109. 172 New International Financial Architecture (NIFA) 165. 129. 57. 178n. 20. 147 and Granite 40–2. see also Granite and Northern Rock 15. 56. 181n. 104–5. Hyman 3. 106. 59. 51–61 Offshore finance. 127 Privatisation of financial risk 11. 167. liars’ 103 LTCM 67. 163 Panic 29. 128. 102 and Ponzi finance. 102. 121. 32. 134. 103. 22. 30.1 taxonomy of finance. 14. 59. sub-prime 2. 144–5. 182n. see also Minsky. 176 Offshore. 102–3. 176 and securitisation 106–10.2 Loans. 17. 104. 107. 141. 60.4 Ponzi era 96 Ponzi finance. 138. 48. 69 Mania. Hyman Ponzi capitalism 100–2. see also Granite and offshore 30–2. 128. entities 48. 13. 105.7 Mortgages. capitalism 72 New economy 67. 166
. 167. 134. 180n. tulip 100 Minsky. 168
Northern Rock. 101. 96. 86. 105. 18–19. 65. 127. 127. Carlo 100. 113 Residential 135 Neoliberal. 44. 78. 145 Ponzi. 174–5. 51.
171. 154. 87. 148 Regulation. 59. 137. 82. 19. 121. 150–7. 86–7. 19–22. 166. 112. 139–40. 109.index 203
. 172 global 2. 78. 137 and innovation. 18. 118. 33. see credit ratings agencies Real economy 12. 84. 85. 96. 133. 136. 82. 64. 130. 173 systemic 59. 28. 9. 48. 83. 102. 13. 121–5. 81–2. 13–15. 120. 177n. see also liquidity glut 75. 65. 41–2. 59 SPV 42. 135. 11.14 underestimation (also misunderstanding) of. 168. 67. 163. 169. 67. 179n. 6. 25. 161 Real estate 14 Recapitalisation: 36. 155. 85. 148. 81. 172
management of. 56. 161. 165–6 and Basle 116–17. 40. 145. 49. 146. 105. 177n. 15. 55. 89. 92–3. 133. 42–3. 14–15. 68–9. 159 Structured finance 13. 131.3 SIV 15. 6. 76. 116. 170. 127. 94. 8. 48–51. 94. 152. 102. 78. 82. 64. 52. 57. 79–80. 37. 48. 172. 155. 112. 172. 37. 92–3. 117. 25–6. 86. 113. 50. 110. 33. 111–12. 78 Speculation 73. 146. 24. 21. 155. global glut. 127. 141–2. 95. 24. 147 Recession 2. 75. 65. 180n. 143.2 in the political-economic system. see also NIFA. 128–30. 65. 128. 43–7. 65. 65. 178n. 138–9.3 Savings. 124. 165–6 Risk and liquidity 10. 86. 11–12. 119. 18. governance 9. 38. 111. 64. 81.2 macroprudential 168–71 light-touch 89. 19. 135. 98–9. 179n. 16. 59–60. also valuation.12 optimisation of. 38. 107. 165 paradigm of. 114 in wake of the crisis. 113. 32. 138. 164 pricing of. 124. 153. 43. 65. 93–4. 142.
114. 58. 150
Wall Street 1. 119. 154. 71. 33. see debt True sale 139–40 United Kingdom 21. 150. 143. 73. 77. 34. 133–4. 49. 88. 28. illusion of 1.5n. 22. 179n. 40–1. 150. 124. 97–100. 38. 95. 17. 30. 59. 85. 75.13 United States 2. 156. 161. 112. 173–6 Welfare 13–14. 91. 43. 71–2. 32.3
. 12. 18. 164. 104. 7. 34. 2.204 financial a lchemy i n c risis
Toxic debt. 51. 35–7. 105. 25. 86–8. 112. 146–8. 142 WorldCom 48. 182. 99. 53–5. 160 Washington Mutual 35 Wealth. ch. 92–4. 31.