Financial Alchemy in Crisis

Financial Alchemy in Crisis
The Great Liquidity Illusion
AnAstAsiA nesvetAilovA

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

For Alexandre Gennady Palan .


How the Crisis has been Understood Ex-ante and ex-post visions of the credit crunch structural theories of the credit crunch Cyclical theories of the crisis 4.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 tale of northern Rock: Between Financial Innovation and Fraud (Anastasia nesvetailova and Ronen Palan) the controversy over financial innovation offshore: the uses and abuses of sPvs northern Rock and Granite 3. some Uncomfortable Puzzles of the Credit Crunch Dismissed: the warning signs and the whistleblowers Ponzi capitalism: a crisis of fraud? ix x 1 4 17 24 24 28 33 40 43 48 51 62 62 71 80 90 91 100 . 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.

2002–7: the three Pillars of the Liquidity Illusion liquidity and the paradigm of self-regulating credit Playing with debt – together. 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 .viii fI nanc IaL a Lchemy In cr Is Is 5.

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

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

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


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

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

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

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

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

Liquidity is also a probability – a calculated chance of a transaction being completed in time without inflicting a major disruption on the prevailing trends in the market. Liquidity can literally vanish overnight. To make things more complicated still. the global financial 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. national economy and finally. Or. 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. liquidity to sell is not always the same as liquidity to buy. the liquidity of an individual bank. a segment of the market. complex. illiquid debt when confidence and optimism evaporate. multidimensional notion. Liquidity also denotes a quantity – most often associated with the pool of money or credit available in a system at any given time. portfolio. an institution or even an economic system as a whole.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. Liquidity is a very fluid. It describes a quality – of an asset. Liquidity is also an intertemporal category: liquidity in good economic times is not the same as liquidity in bad times. Liquidity is also about depth – of a market for a particular class of assets – and speed – with which a certain transaction can be completed. a market. . as economists like to stress.

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

the concept of liquidity has undergone its own series of mutations. . an intermediary between lenders and investors. And even though the concept of ‘money’ remains probably the most controversial aspect of economics and finance. however. As such. But then the real life of the financial markets complicated matters. 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). In 1971. the diversity of views becomes ever more apparent. In the brief age of Keynesian economic stability. into an industry of trading and optimising risk. As the field of credit crunch studies expands.8 f inancial alchemy in crisis consensus. 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. the postwar system of fixed exchange rates and financial controls was dismantled. Not that long ago things were somewhat simpler. In parallel. The financial sector has been transformed from being part of the service economy. ‘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. it is conditioned by the market context.

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

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

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

liquidity has progressively lost its public good component. therefore. This in turn has produced several interrelated assumptions that have shaped finance theory and policy in the run-up to the global credit crunch. centred on financial institutions’ ability to transform illiquid loans into tradable securities. therefore have been progressively abstracted from the dynamics of productivity. an important assumption correlated with this trend.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. or what social scientists understand as financialisation. and second. 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). In terms of understanding what liquidity is and how it behaves. As financialisation advanced. trade. The first trend concerns the expansion of the global credit system and can be described as a process of demonetised financialisation. marked by the inherent contradiction between money as a public good and as a private commodity. It encapsulates two intertwined tendencies in contemporary capitalism: first. the process of securitisation (depicted above). Just as money itself is. The expansion of the credit system and the accumulation of financial wealth. real economic . reaping profits in the process. both spatially and intertemporally. or financialisation.

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

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. Those applicants obtain a welfare gain by having more choices and flexibility. By pricing the risks of different types of credit quality. therefore. cited in Wigan 2009). thereby optimising risks and enhancing the liquidity of the financial system as a whole (Cifuentes 2008). (chinloy and macdonald 2005: 163–4) Ultimately. 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. such as real estate. as Alan Greenspan foresaw. securitisation. . Financial innovation. into tradable and liquid financial securities. for instance. is believed to create new facilities for risk optimisation and thus complete the system of markets. ‘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. by relying on scientific approaches to risk management and calculative practices. 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. car or student loans and sub-prime mortgages. According to Greenspan. even to applicants able to qualify in a prime-only market. As the theory holds.

and the spread of new methods of risk management and trade. Yet instead of being traded. In addition to the structural shift towards the ‘originate and distribute’ (ORD) banking model. the expansion of the so-called shadow banking industry. all leading to the extraordinary growth of variety and complexity of financial products themselves. in ways almost nobody understood.inT roducT i on: T h e end of a Gr e aT i l l u s i o n 15 Third. . the growing sophistication and specialisation of offshore financial centres and techniques (Palan 2003). as Gillian Tett writes. she argues. there has been a remarkable rise in the number of hedge funds. or simply left on the books. 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. in 2006 and early 2007. Indeed. Generally. a set of innovations that were supposed to create freer markets and complete the system of risk optimisation actually produced an opaque world in which risk became highly concentrated – worryingly. as the principle of active credit risk management would imply. such as value-at-risk (VAR) models. the spiral of demonetised financialisation has been underpinned by institutional and operational advances in financial innovation. such as structured investment vehicles (SIVs). no less than $450bn worth of ‘collateralised debt obligations of asset-backed securities’ (CDOs of ABSs) were created. most were sold to banks’ off-balance-sheet entities.

or between search and funding liquidity (ECB 2006). 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). the axiom that financial innovation and engineering have the capacity to liquefy any type of asset – or. Here. debt – has resulted in the now mainstream notion of liquidity that is divorced from any attribute of assets per se. able and willing to trade at a given point in time at a prevailing price level (Warsh 2007).16 fina nci al alchemy in crisis Officials at Standard & Poor’s admit that. by 2006. they conceive liquidity fundamentally as a property of the market or an institution. more accurately. liquidity is most commonly understood as ‘confidence’ of the markets. At the level of financial institutions themselves. rather than as a quality of assets as such. And although some recent analyses have drawn a distinction between market and systemic liquidity (Large 2005). 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. Namely. 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 illusion and the Global credit crunch ‘Stability is always destabilizing’. it is . T roducT i on: Th e end of a G re aT i l l u s i o n 17 contributed to the illusion that this is the real cause of the global credit crunch. The first fallacy is the assumption that it is the market-making capacity of financial intermediaries to identify. 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. Second is the view that general market trade and turnover are synonymous with market liquidity. I believe. 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. 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. Amidst the ostensible rehabilitation of his name. Hyman Minsky famously stated in his financial instability hypothesis. Altogether. price and trade new financial products that creates and distributes liquidity in the markets. 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. consequently. originates in a hollow notion of liquidity itself and. This misunderstanding.

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

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

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

For instance. or. 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. 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. Yet the evidence is abundant. we like the expression. “sure they’re liquid.’ (The Economist. the Bank of England documented a depletion of sterling liquid assets relative to total asset holdings in the UK banking sector. by focusing on the problem of valuations and risk mis-pricing.. indeed.2 However. 9 August 2008). most discussions of liquidity in the crisis. 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 . during more benign periods.. diagnose the evaporation of liquidity as a result of market failure rather than as a systemic T roducT i on: T h e end of a Gr e aT i l l u s i o n 21 short-sighted and over-reliant on the market’s shared sentiments: ‘as a guide to market discipline. This has been part of a longer-term decline in banks’ holdings of liquid . makes the connection between the excesses of private financial innovation and its liquidity-decreasing effects. unless you actually have to sell them!”’ (Kochen 2000: 112). stating that: The ongoing turmoil has revealed that. in October 2008. None of the studies.

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

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

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

It all started with a boom. or 20 per cent of the $3 trillion mortgage market. the US sub-prime market was worth $600bn. But in the booming housing market. which has been the epicentre of the global malaise. Between 2002 and 2007. ‘Sub-prime’ designates a category of borrowers who otherwise would be considered ‘high-risk’ clients: they had poor or no credit histories. the prelude to the global financial meltdown unfolded in late 2006/early 2007. 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.1 The expansion of the mortgagebacked securities (MBSs) market drew investors into some of the more risky tranches of MBS debt. In global terms.2 In 2001. and the first .6 per cent of mortgage dollars. sub-prime loans made up just 5. Yet it was as early as 2006 that the price increases in the American housing market slowed down.T he s TaGes of T he me lTdoWn 25 than that. American MBSs became the largest component of the global fixed income market. In 2006. supported by opportunities to manage the high risks that the new financial system offered. 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. housing markets in the Anglo-Saxon economies were booming at unprecedented levels. The great housing boom was supported by cheap and plentiful credit and the widely held belief that house prices would continue to rise. In the United States. accounting for a fifth of its value.

which climbed to 5. thereby increasing the interest payment on the loans. crucially. The trigger to the rising number of defaults was the increase in the interest rate. By the end of 2006.26 financi al alchemy in crisis wave of mortgage delinquencies started to spread. Others began to anticipate a bigger wave of defaults and bankruptcies: most 2006 borrowers were still in the ‘teaser rate’ period of their mortgages. began to default on their mortgages and defaults on sub-prime loans rose to record levels. for those who needed them. sub-prime delinquencies more than 60 days late jumped to almost 13 per cent.35 per cent in 2006. Also. the trend historically was insignificant (IMF 2007: 5). Some sceptics warned that against this background a default of one or two financial companies could well spark a worldwide financial crisis. in 2006 the structure of US sub-prime mortgages shifted many borrowers out of their initial (presumably favourable) fixed-rate terms. Lewie Ranieri. The sceptics were proven right. The words of reassurance. According to the structure of sub-prime loans. Commentators explained this by the fact that in 2006 . Homeowners. their repayments were due to rise in a year or two. Observers offered different readings of this trend: some argued that despite the notable increase in bankruptcies. many of whom could barely afford their mortgage payments when interest rates were low. who said: ‘I think [the risk] is containable … I don’t think this is going to be a cataclysm’ (in Kratz 2007). compared to 8 per cent in 2005. came from the architect of mortgage-backed finance himself. from 1 per cent in 2004.

On 22 February 2007 HSBC. most notably New Century . The number of bankruptcies and foreclosures also rose: according to Moody’s.3 announced a $10. interest rate. The winter of 2006–7 brought the first signs of the real magnitude of the coming meltdown. Eventually. the largest sub-prime lender in the US and a leading investment bank globally. In March 2007.4 At the time. through the complex web of mortgage-backed finance. Market sceptics immediately read this as a sign of a greater trouble ahead: HSBC’s total annual profits were around $15bn. and higher. a giant like HSBC could write off the $10bn loss and escape relatively unscathed from the mounting market distress. started to affect the financial and banking system more generally. 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).2 per cent for a similar type of loan originated in 2004. HSBC Finance.5bn loss in its mortgage finance subsidiary.T he sTaG es of T he me lT doWn 27 some of the more neglected sub-prime loans had reached their refinancing limits. This fuelled fears of bankruptcy in several sub-prime lenders. compared to 2. Many smaller sub-prime lenders were already facing bankruptcy. Smaller sub-prime lenders operating on the American markets were in a less healthy position. the housing boom stalled and. news of heavy losses from the ailing sub-prime market hit American building companies. in 2006 it reached almost 4 per cent. and borrowers could no longer afford to pay the mortgage on a new.

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

As large financial houses were calculating their losses from sub-prime loans. Reacting to the news. subprime-backed bonds and collateralised debt obligations (CDOs). a US home loan lender. 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.6 The fateful date 9 August 2007 became the official anniversary of the global credit crunch. of the money invested in two of its hedge funds after rival banks refused to help it bail them out. the largest French bank. Central banks around the world immediately offered liquidity support in an attempt to stem the panic. the world’s . By early August 2007.T he sTaG es of T he me lT doWn 29 they would get little. On 9 August 2007. the credit ratings agencies were downgrading asset-backed securities (ABSs).5 and the German bank IKB. BNP Paribas. In the space of just a few days in mid-August 2007. On that day. the world’s financial indices went into free-fall and pretty much remained there over the following months. American Home Mortgage Investment Corporation. other central banks followed with similar actions over the following weeks. the European Central Bank (ECB) injected €95bn into the overnight markets and the Federal Reserve injected $38bn. if any. the list of casualties of the implosion included the hedge fund run by Bear Stearns. Federal Reserve chairman Ben Bernanke estimated that the sub-prime crisis could cost up to $100bn. Countrywide Financial.

on 13 August 2007.7 Despite these collective and unprecedented efforts to restore optimism in the markets. might be facing a liquidity crisis. the first run on a bank in the UK for a century. it was transformed from a crisis in one segment of the market into an international banking crisis and global credit crunch. started to unfold. 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. With this. by harming those financial institutions that relied heavily on wholesale credit markets. Northern Rock Just days into the unfolding malaise in the financial markets. Through its effects on the financial markets worldwide and. which went bankrupt in August–September 2007 and had to be nationalised. Aside from liquidity injections. in particular. the first stage of the global meltdown – the sub-prime crisis in the US – had not been brought under control. and a subsequent political scandal. The best known of the casualties during this second phase was the British bank Northern Rock. the Financial Services Authority (FSA).30 financi al alchemy in crisis central banks pumped an extraordinary $240bn into the ailing markets. . Northern Rock. the UK financial watchdog. was reportedly informed that the country’s fifth largest mortgage lender.

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

however. potentially. depression. . entering the year 2008 in the gloom of foundering housing markets. Despite government support. Bear Stearns. Despite these measures. As banks were increasingly reluctant to lend to each other. In the midst of gloomy macroeconomic data now coming from economies around the world and debates about the imminent recession and. On 17 March 2008. was acquired by its larger rival. After a failed attempt by the Virgin group to buy Northern Rock. This continued until the government stepped in to guarantee depositors’ savings (BBC 2009). By March 2008 things had become darker still. credit markets remained frozen. Sceptics warned that the true costs would be much higher still. 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. for $240m in a deal backed by $30bn of central bank loans. the bank was nationalised in February 2008.32 financi al alchemy in crisis conditions. Meanwhile the crisis intensified. panic in the financial markets and more losses being revealed by banks and other companies. Wall Street’s fifth largest bank. rather than a serious structural problem.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. JP Morgan Chase. the IMF estimated that total losses from the sub-prime crisis could reach $1 trillion.

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. 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. The next dark moment in the crisis chain came in mid-summer 2008. On 7 September. . 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. Fannie Mae and Freddie Mac were taken over by the US government in one of the largest bailouts in US financial history. In late August 2008. On the other side of the Atlantic. the largest holder of US debt.9 Although the Chinese government made no official comment at the time. They had been the drivers of the mortgage securities markets. came from China. Alistair Darling.Th e sTaGe s of Th e me lTd oWn 33 the crisis continued to accelerate into the summer and autumn of 2008. the UK Chancellor. The pressure. On 14 July. owning or guaranteeing $5 trillion worth of home loans. according to market consensus and common sense. the two largest lenders in the US – Fannie Mae and Freddie Mac – appealed for help from the US government. signs of recession were becoming more visible. or nearly half of the US’s $12 trillion mortgage market.

34 f inancial alchemy in crisis Three days later. Under pressure from an angry Congress. Lehman Brothers – one of the largest Wall Street banks – posted a loss of $3.10 Several months later. agreed to be taken over by Bank of America for $50bn (BBC 2009).9bn for the three months to August 2008. in return for an 80 per cent stake in the company. The situation worsened as another high-profile US bank. AIG eventually had to list the firms to which the money was actually paid. the Federal Reserve authorised an $85bn rescue package for the country’s biggest insurance firm. These included top US firms Goldman Sachs . AIG paid out hundreds of millions of dollars in bonuses to its senior executives. representing the biggest erosion of financial wealth since the 1930s. The second half of September 2008 witnessed several attempts by governments to tame the panic in the markets and save individual institutions from bankruptcy. In the US. Lehman Brothers filed for bankruptcy protection under Chapter 11. Alan Greenspan described the fall of Lehmans as ‘probably a once in a century type of event’. after several futile attempts to find a buyer or secure governmental rescue. it would emerge that having received the bailout. On 15 September 2008. 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. AIG. Markets went into free-fall for weeks in a row. Merrill Lynch. Direct comparisons with the 1930s crisis and projections of a global depression became commonplace.

9bn). HBOS. 12 In the UK at around that time. was closed down and sold off to JP Morgan Chase. the country’s biggest mortgage lender. On 25 September. In total. Lloyds TSB took over the ailing bank in what would soon prove to be an unwise £12bn deal. Towards the end of September. Meanwhile. policymakers in the US drafted a massive $700bn rescue package for the American financial system. though many more receiving smaller payments were unnamed (Williams Walsh 2009). Political disagreements and uncertainties over the nature of the deal continued to send shockwaves through the global financial system.5bn) and UBS ($5bn).3bn) and Wachovia ($1.2bn).8bn). a banking and insurance giant. The UK’s Bradford & Bingley – the largest provider of ‘buy to let’ mortgages in the country (controlling around £50bn of mortgages) – was part-nationalised. the credit crunch spread further into the European banking systems. It was the biggest public intervention in the markets since the Great Depression and would take weeks to be approved by Congress. was nationalised. The major foreign banks included Société Générale and Deutsche Bank (nearly $12bn each). Bank of America ($5. AIG named nearly 80 companies and municipalities that benefited most from the Fed rescue. Fortis.T he sTaG es of T he me lT doWn 35 ($12. US mortgage lender Washington Mutual (whose assets were valued at $307bn). Citigroup ($2. Barclays ($8.11 Merrill Lynch ($6.5bn). was facing bankruptcy. The deal allowed the Treasury to buy up ‘toxic debt’ from ailing banks. part-sold to the Spanish bank .

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

yet as Chapter . as markets and economies continued to stumble. these extraordinary policy efforts appeared ineffective. with the major European countries following the UK in authorising massive recapitalisation plans for their financial system. the committee drafted a rescue plan (later known as the Brown-Darling bank recapitalisation plan). By early November 2008. similar action was adopted by most countries affected by the credit crunch. 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. Over the weekend of 4–5 October 2008. recession trends set in and spread globally. affecting economic growth in the emerging markets.T he sTaG es of T he me lT doWn 37 many institutions it was possible to borrow only overnight. (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). on 6 and 7 october even overnight funding started to dry up. and over the course of the following weeks.14 The continuing crisis and deepening recession prompted multi-level attempts to form a coordinated global policy plan to reform international financial architecture. Nevertheless. credit to the real economy almost stopped flowing … eventually. despite interest rate cuts and other state efforts to restore confidence in the economy. reacting to weakening economic data and ever more tangible signs of economic recession on both sides of the Atlantic.

the global financial crisis had been transformed into a global recession. with some believing that the financial markets would not recover their pre-crisis levels until 2012.2 per cent year-on-year in January. Diagnoses and projections of the nature and duration of the meltdown became more and more pessimistic. 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. Data reflecting real economic losses globally are sobering. South . 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. This figure not only exceeds all previous estimates of sub-prime-related losses. In March 2009. Official institutions adjusted their estimates of total losses to much higher levels. or just over one year’s GDP – suffering more than other regions of the emerging markets.38 financi al alchemy in crisis 6 below shows. and eventually into a global credit crunch which has directly led to a global recession. disagreements over the appropriate course and tone of regulatory action opened up at the transatlantic level.6 trillion. demand for manufactures. world manufactured output and world trade in manufactures had fallen off a cliff: Germany’s industrial output was down 19. over the course of its two-year history.15 Overall. but is close to a year’s world output.16 The loss of stock market wealth alone amounts to $25 trillion. At the end of 2008. By 2009.

as argued in this book. .6 per cent and Japan down 30.8 per cent (in Wolf 2009).T he sTaGes of T he me lT doWn 39 Korea was down 25. 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. The sheer severity and scale of the global meltdown. But before delving into the emergent schools of thought. as well as uncertainties over its potential effects on the economic activity and politics globally. let us take a closer look at one particular event that.

London’s Credit Magazine. congratulated Whinstone Capital Management fund – a part of the British bank Northern Rock – on winning the award for the best securitisation deal of 2005.2 the tale of northern rock: Between fInancIal InnovatIon and fraud Anastasia Nesvetailova and Ronen Palan In January 2006. The deal. In technical terms. Essentially. explained that the Whinstone transaction allowed the fifth largest UK mortgage lender to reference the reserve funds of 13 Granite transactions. it was reported. was the first European securitisation programme to transfer ‘first-loss risk’ through a credit default swap contract. one of the financial industry’s glossy periodicals. three of which were stand-alone issues and the other ten under the Master Trust programme. ‘The beauty 40 . it allowed Northern Rock to offload more risk from its balance sheet. operational director for securitisation at Northern Rock. David Johnson. the transaction represented the largest public placement of double-B risk – £117.4 million – and one of the largest subordinated debt issuances ever in the European market.

observers on the left and right started to argue. In the winter of 2007. that securitisation techniques had never discovered new ways of managing or optimising risk. On 18 February 2008. reducing the value of the company to £380 million. by February 2008.T he Tale of norT he r n ro cK 41 of it’. along with other high-profile financial collapses. ‘is in its simplicity. January 2006). greed and fraud. he declared. Bradford & Bingley in the UK. * * * 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. Fortis in Belgium and most of the Icelandic banks. they merely disguised or . such as Bear Stearns and Lehman Brothers in the US. As the securitisation boom of the decade ground to a halt in the summer of 2007. but soon paralysed the world financial system. became victims of a convoluted chain of securitisation techniques that centred on the sub-prime mortgage industry in the US. Northern Rock. quite persuasively. parcelling the reserve funds and writing a credit default swap thereby transferring the majority of Northern Rock’s first-loss risk to the international capital markets’ (Credit Magazine. Northern Rock was valued at £5bn. the UK government announced a controversial decision to nationalise the bank. the bank’s shares had dropped to 90p per share.

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

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

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

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

cited in shah 1997: 86) At the time. with some more able than others to creatively escape even harmonised regulatory restrictions. Two of these structural elements are pertinent to our focus on Northern Rock: the circumvention of the regulation and rules of taxation. without necessarily breaking the law’ (Miller 1986. Some 20 years ago. 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. (mcBarnet and Whelan 1992. academic work on market efficiency and inefficiencies (van Horne 1985: 622). Both factors have been at the epicentre of the global credit meltdown generally and of the fiasco of Northern Rock in particular. cited in Shah 1997). interestingly. 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 . (iv) technological advances. Specifically. The rules of the level playing-field themselves become obstacles to some but not all. and (vi). van Horne 1985. 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. (iii) tax changes. regulation … becomes a further stimulus for innovative use of law both to defeat unwelcome regulation and to secure advantage over competitors. (v) the level of economic activity.46 financial alchemy in crisis regulations.

they are also representative of more general trends in the financial industry. Thriving in this zone. the media and analysts were unable to expose these practices publicly and restrain such creativity: ‘practising creative accounting is not that difficult. These elements.T he Tale of norT he r n ro cK 47 the help of investment bankers and lawyers. obscured by the general euphoria of the 2002–7 credit boom and disguised by the sophisticated techniques of modern finance. Worryingly. particularly in common law countries – created a grey zone for competitive financial innovation. 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. financiers look for alternative ways to make money through commission fees. the regulators. 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. often. When interest rates are low and the traditional function of financial intermediation – taking deposits and lending – is no longer appealing. financial innovation has produced a skewed structure in the financial system itself. 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). In turn. . ‘creative accounting’ and. were at the heart of the Northern Rock fiasco. outright fraud. bankers.

The function of both SPVs and SPEs raises severe prudential problems. entities (SPEs) or investment vehicles (SIVs). WorldCom. and have a contagious effect on the entire economy. 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).com bubble. The term SPV covers a broad range of entities.48 fina ncial alchemy in crisis offshore: The uses and abuses of sPVs Most financial crises in the past two decades. Parmalat and. Northern Rock and the 2007–9 credit crunch. at least in part. The small investor is. they leave many workers without pensions and jobs. as one of the directors of Enron reputedly quipped. if not the stupidest in the room. ‘the smarter men in the room’. more recently. . by definition. as well as the scandals associated with the dot. including those in East Asia and Russia. which ultimately has to bear the resulting risk without enjoying the risk premium that created it. The offshore entities that seem to have caused most of the problems are the special purpose vehicles (SPVs). have been blamed. 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). The argument is that opacity benefits those who are. at least the one least equipped to handle complex and rapidly changing information. Enron. Refco. Tax havens have made it exceedingly easy to set up offshore SPVs. But these crises revealed a more critical dimension: scandals and frauds not only cheat investors.

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

50 f inancial alchemy in crisis would like to stress. Troubb and Winokur 2002: 4). Enron’s fraud was organised through 3.226. partnerships and SPVs in order to shift debt around and make illicit payments to its directors.691.2 4.3 28.7 0. reported that the company created complex financial arrangements.5 761. 2007 All countries Caymans Switzerland Netherlands Ireland Singapore Luxembourg Bahamas Jersey Guernsey Bahrain Isle of Man Total $29.1 205.8 4. which investigated Enron’s collapse.7bn 1. not to achieve bona fide economic objectives or to transfer risk’ (Powers. that we do not see the two as being the same thing.1 The share of ofcs in international financial flows.7 0.8 4.000 .3 210.334. International Financial Statistics.1 0.0 % share 5.5 326.0 8. SPVs hit the headlines following the collapse of Enron. The Powers Committee.0 71. 2008. The report states that ‘[m]any of the most significant transactions [of Enron] apparently were designed to accomplish favorable financial statement results.8 773.6 2.413.5 Source: BIS. though. Table 2.3 1.5 436.5 1.2 2.3 1.6 1.

It appears. on the other hand. the fifth largest mortgage lender in the UK in early 2007. Building societies typically raise the money they lend conventionally. In 1997. Banks.T he Tale of norT he r n ro cK 51 SPVs ‘with over 800 organised in well known offshore jurisdictions. In this context. by attracting it from depositors. that Enron’s offshore SPVs were set up primarily for tax avoidance purposes. neither the Powers Report nor the congressional hearings demonstrated that offshore structures were palpably more poisonous that the onshore ones in the Enron case. Northern Rock became a public limited company. and about 600 using the same post office box in the Cayman Islands’ (US Senate 2002: 23). rather. despite headline reports. began life as a building society in 1965. This was an aggressive expansion technique: the audit of Northern Rock’s accounts in 2006 showed that it raised just 22 . 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. after the wave of demutualisations of the 1990s. 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. northern rock and Granite Northern Rock. including about 120 in the Turks and Caicos. Nevertheless.


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

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


financi al alchemy in crisis

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

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

56 fina nci al alchemy in crisis several fundamental problems that financial regulators encounter in the age of thriving financial innovation. the arrangement failed in a number of ways. then Chancellor of the Exchequer. failed to compile an accurate picture of the financial . 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. formalised a division of labour between the Treasury. the FSA for prudential supervision of financial institutions and market segments. As Willem Buiter argues. the Bank of England is responsible for monetary policy and systemic financial stability. the information-gathering body. First. In 1997. According to this ‘tripartite’ arrangement. In Northern Rock’s case. the FSA.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). This division of labour was supposed to make the overall maintenance of financial stability more efficient by facilitating a clear distinction between the micro. Gordon Brown. the Bank of England and the newly established Financial Services Authority (FSA).

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. and of Northern Rock in particular. which drained much-needed cash from a bank tightly dependent on the ailing sub-prime market in the US.T he Tale of norT he r n ro cK 57 health of the bank. Northern Rock was allowed to pay out large dividends to its shareholders. Second. Probing questions about the bank’s finance model (relying on wholesale markets for funds) and its liquidity position were never asked. 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.5 Third. 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. the FSA’s implementation of the few rules on liquidity risk also raised concerns. In the midst of the unravelling crisis (July 2007). only three were reportedly dealing with Northern Rock. The supervisory reviews of the bank’s books were only conducted every three years. 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. Of the 3. The Treasury has been . other parties to the tripartite arrangement are blamed for the Northern Rock fiasco as well.000 staff working at the FSA.

Fourth. was paid $1. The Northern Rock crisis has raised many issues about how private financial gains and socialised losses are addressed by political leaders. the Treasury was told that Northern Rock might run out of money. In the midst of the collapse. the bank did just that. Northern Rock’s former CEO. In the period between those dates. imposing a political solution to nationalise the bank (Lascelles 2007). Applegarth reportedly was paid a $1. as is maintained in this book. Adam Applegarth. he cashed in shares worth more than £2 million.58 financial alchemy in crisis 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. During 2007. (In 2006. is one of the many uncomfortable puzzles of the credit crunch.36 million. by taking the initiative in the Northern Rock case. a month later. 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. on 14 September 2007. When he resigned.5 million bonus. the Treasury did nothing to prevent the collapse (Moulton 2008). Most scandalously of all. the tripartite arrangement as a whole failed in the task of passing information from the FSA to the Treasury. the bank’s senior management were . On 14 August 2007.

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

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

.T he Tale of norT he r n ro cK 61 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. in the end proved to be a dangerous and destructive myth.

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

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. conflicts of interest and profound structural dislocations). Apart from the timing. communications and finance. Here. 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. Specifically. 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. as opposed to ‘capitalism as usual’ (a system marked by periodic crises.hoW T he crisis has B een un de r s Too d 63 Within this rather broad classification. polities and cultures). the ex-ante theories originated both in a simple ‘gut-feeling’ understanding of what was happening in the financial markets. and deeper scholarly analyses of the credit system that detected profound abnormalities and tensions accumulating in the economies of ‘advanced’ Anglo-Saxon capitalism. the basic difference between these two schools of thought is their reading of the place of finance in the evolution of capitalism more broadly. Whereas more pessimistic predictions of the imminent collapse of US debt-driven consumption . the sheer sense that the Anglo-Saxon economies were overheating and asset and financial bubbles would soon burst. 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.

penalised. Ultimately. market regulators. four years of falling credit spreads. who preferred to remain anonymous: We were paid to think about the downsides but it was hard to see where the problems would come from. the dominant mood in the markets during 2002–7 is probably best expressed in the admission of a risk manager of a global bank. In most cases. efficient and diversified. as argued from these perspectives. The Global Credit Crunch as an Exogenous Shock Within this ex-post group of analyses. low interest rates. the deregulation of the financial system has popularised access to credit and finance. during the credit boom such ideas were at best taken as purely hypothetical and remote possibilities. worse.64 financial alchemy in crisis emphasised the destructive role of unprecedented levels of debt in the US and the global economy. virtually no defaults in our loan portfolio . making the economy more flexible. Instead. they were simply dismissed or. 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. 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. political leaders and observers totally by surprise. one interpretation of the crisis stands out: the reading of the global credit crunch as a ‘surprise’ event – a shock that took most financiers.

7 august 2008) As a result. whether small or large. 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. In hindsight. taking the real economy into recession. typically with a crash. The fact that house prices and the . even if risk managers did acknowledge that the history of finance offers unsettling lessons about bubbles and crises. the crisis should have been a relatively minor event in finance. eventually come to an end. reflecting a price correction in one isolated sector of the global economy – the US sub-prime mortgage sector (Dymski 2009).’ (in Gimson 2008) Moreover. All booms. everyone borrowing up to their eyeballs. We said then: ‘Well hell. they comment that complacency and collective reliance on fashionable techniques of trade and risk valuation have taken the markets into the crisis.hoW Th e crisis has B e en un de r s To o d 65 and historically low volatility levels: it was the most benign risk environment we had seen in 20 years. 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 this sense. anyone who believes things are going to go on up forever is a fool. this logic seems rather odd. and that some events in the markets in 2006 had implied that the credit boom might unravel. we went through this in the eighties and early nineties. crisis or painful recession. 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 Economist. according to his colleague at Barings.

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

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

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

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

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

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. the emergent theories of the credit crunch have incorporated deeper scholarly inquiries into the nature of finance today. cultural and ideological foundations of market-based capitalism. 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. At the same time. in reality the meltdown is more pervasive. economic. Broadly. but largely predictable result of the operation of a type of economy that had replaced the Keynesian welfare state of the . overlapping the political. social.hoW T h e crisis has B e en un de r s To o d 71 the global meltdown has become one of the dominant theories of the credit crunch in policymaking circles in both the UK and US. As such. Thus emphasising the historical origins of the current crisis. these views can be classified as structural or cyclical explanations of the global meltdown. structural theorists view it as a specific. 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.

The ratio of debt . 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). etc. 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. and total private sector debt had risen from 133. and its role in the overall economic organisation. Tily 2007. In the US over the course of the decade. debt-financed consumption.374.5bn. Turner 2008. In 2007. The levels of borrowings. 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. have been growing much faster than incomes and wages in the Anglo-Saxon economies.4 per cent during the first ten years of the New Labour government. is the key structural cause of the meltdown. deregulated capital markets. personal debt jumped from $5.547. Wade 2008. Gamble 2009.).5 per cent of GDP to 227. higher than in any other major industrialised economy. And according to Turner (2008). individuals in the UK held over £1. 2002. Pettifor 2003. the growth of debt-financed consumption and business activity has been more pronounced in the UK. leaving the country more vulnerable to the effects of the credit crunch. Shiller 2008. minimal savings. Debt.5 trillion in debt.72 f inanci al alchemy in crisis 1950s–1960s with a neoliberal model of capitalism.1bn to $14. both private and corporate.

hoW T he crisis has B een un de r s To o d 73 to disposable income went up from 93. Essentially. Many historically-oriented and systemic visions see the crisis. these economies have been affected by the credit meltdown not through their own role in the credit super-bubble but through the externalisation of the crisis from the US financial system to the global level. or what Greenspan called ‘active credit management’ (in Morris 2008: 61). In the long run.4 per cent to a post-1945 record of 139 per cent (Turner 2008: 26–7). both the credit super-bubble and debt-financed consumerism were unsustainable. 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. sparked by the fiasco of the sub-prime industry in the US. Emphasising the role of key features of such a model. it is interesting that another group of structural theories of the credit crunch takes . This vast growth of debt was evolving into what George Soros (2008) has called a ‘super-bubble’ – a concoction of a housing bubble. an explosion of leveraged buyouts and other financial excesses. therefore. 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. and thus unravelled. therefore. In this instance. as an inevitable result of the Anglo-Saxon mode of capitalist organisation.

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

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

in turn. Dollar reserves. (Greenspan 2005) At the time. 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. 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. reflecting the surprisingly strong performance of the world economy and still abundant liquidity’ (BIS 2006: 98). Within this unique arrangement. reflected ‘the exceptional depth and liquidity of the US financial markets. a similar understanding of the global liquidity glut was of fered by the BIS. 1 The bank commented that ‘conditions in the major financial markets remained calm and accommodative for much of 2005 and early 2006.76 financial alchemy in crisis The development of a broad-based secondary market for mortgage loans also greatly expanded consumer access to credit. By reducing the risk of making long-term. fixed-rate loans and ensuring liquidity for mortgage lenders. 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’. which makes it attractive for . the secondary market helped stimulate widespread competition in the mortgage business. it was argued. such as auto and credit card loans. However ‘abnormal’ though.

9 Eastern Europe and former Soviet Union –13.4 17.8 –23.6 0.9 29.8 –13.3 8.5 Statistical discrepancy Source: Bernanke 2005.1 10.2 –2.0 11.2 Middle East and Africa 5.0 –8.9 –87.7 65.9 –14.2 –530.8 3.5 –15.5 205.2 88.7 47.5 20.3 –120.4 39.1 137. 41.4 12.1 –20.4 4.2 –2.2 –342.1 –6.5 –40.hoW T he crisis has Be en un de r s To o d 77 Table 3.5 55.3 –30.0 3.8 7.0 148.3 .2 –30.7 –23.6 25.4 21.8 7.3 45.9 4. 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 46.9 17.1 Global current account Balances.3 –10.5 24.4 –39.8 5.4 138.6 –23.1 42.


financi al alchemy in crisis

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

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


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

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


f inancial alchemy in crisis

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

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


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

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

cyclical views of the credit crunch accommodate another crucial aspect of financial volatility: the human factor. including the paradigm of financial regulation and governance. securitisation and complex derivatives. importantly. one strand of interpretation stands out in particular. the crisis was caused by a combination of factors – policy-related.82 f inanci al alchemy in crisis packages. it is argued. (ambler 2008: 8) Generally. . Also. 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. As such. the crisis was the result of long-run efforts by Anglo-Saxon governments to encourage low-income people to become homeowners. which ultimately proved unsafe. The Human Factor: Greed. This socially motivated policy has relaxed lending criteria in the financial industry and pushed financial institutions into risky and opaque areas. 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. Altogether. Rather. Incompetence and Exuberance Within the range of cyclical theories of the crisis. behavioural and market-specific – that together diverted the markets away from a correct strategy and attitude to pricing risks. therefore.

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

years of it.. we went through this in the eighties and early nineties.’ Now. They’ve been lending out money on securities that are worthless.84 fina ncial alchemy in crisis With increasingly fierce competition in the markets generally and growing specialisation within financial firms themselves. ‘The trouble today is that the people . have no sense of responsibility. he said.’ In the 1940s. when he started. We said then: “Well hell. In the sea of new. The problem of unaccountability and lack of ethical standards in finance goes beyond financial dealers and . before they got to a position of responsibility. it was the younger generation of employees – and institutions more broadly – who came to shape the face of global finance. recruits were regulated: ‘They had experience. ‘scientific’ finance the traditional. 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). One anonymous 78-year-old accountant. and typically more conservative. blamed young. inexperienced traders for adopting aggressive practices from the US. 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. There was always someone overseeing someone to see things didn’t go too far.. 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. who spent 60 years working in the City.

In the wake of the global crisis. proper insight into the state of the financial sector. on the other. Some of the most staggering examples come from the UK. these schools of thought place greater emphasis on the role of policymakers and regulators in creating the crisis. As such. the failure of regulatory and supervisory bodies to read market developments accurately has come to light on many occasions. 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). their sluggish reactions to the unfolding crisis and simply not being up to the task or . it describes the institutional transformations of banking and finance that have paralleled the erosion of the function of traditional banking. and the corresponding transformations within financial institutions themselves. where the two institutions responsible for financial stability – the Bank of England and the FSA – have been exposed for their lack of vision. It also has important implications for various segments of financial practice and control. On the one hand. rather than taking on and managing the risks themselves. 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 85 institutions. the rise of institutional investors and the development of the ‘shadow banking system’. now increasingly oriented towards taking and passing on risks. as well as on the role of managerial practice and business conduct within the financial industry itself.

86 financi al alchemy in crisis ‘asleep at the wheel’. a member of the Monetary Policy Committee at the Bank of England. 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). 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. placed a large chunk of bad debt in the hands of people who are least able to hold it. and increasingly risky. according to many analysts. driven by social motives. this policy. First. David Blanchflower. Amery 2008) have pointed out that the main problem of the pre-crisis regulatory system was the classic case of moral hazard. but the Bank produced an inflation report that did not mention the word. many commentators (e. Anecdotes about the breathtaking incompetence of regulators and supervisors abound. thus prompting financial institutions to invent new. 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. ways to manage and redistribute the debt to third and fourth parties. Chris Rexworthy. As is being argued. there are those critics who argue that it was not the lack of regulation but rather the plethora of financial . admitted that he considered resigning in August 2008 at the point when the UK economy was sliding into recession. Third.g. Second. a former director of the FSA. But criticisms of the official policy stance are manifold and go beyond those directed at individuals.

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

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

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

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

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

To date. an internal risk compliance manager. In other words. 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. unfortunately. in some cases. HBOS was lending too much by relying on wholesale financial markets. warnings about the possibility of a structural financial collapse had been voiced at different levels of financial and economic analysis. as in any major financial scandal. who had warned management about the excessive risks in its loan portfolios. ABM Amro. the global credit crunch has its own whistleblowers. At the level of individual companies. the UK’s best known case is the Royal Bank of Scotland (RBS).92 f ina nci al alchemy in crisis Yet in light of the arguments outlined in Chapter 3.1 it emerged that the then chief executive of HBOS had fired Paul Moore. But in 2004 and 2005. In fact. neither HBOS nor the FSA believed that it was appropriate to assess the riskiness of its rate of growth . fired. Moore had said that this was very risky because borrowers would have difficulty repaying (though not because funding could dry up). As two member banks of the group – RBS and HBOS – came close to bankruptcy and public money was put to their rescue. they were not heard even though. It was the freezing up of these markets that pushed the bank into insolvency. these whistleblowers were routinely ignored or. this simply does not make sense. many people knew and warned that the end was imminent. Just like Northern Rock. as we learned in the wake of the crisis.

Another embarrassing revelation came in the summer of 2009. James Crosby. 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. According to the Financial Times. The scandal surrounding the fiasco of HBOS-RBS was further fuelled by the revelation that Sir Fred Goodwin. Sir Fred was not asked to stand down until 28 January 2009. newly appointed deputy chairman of the FSA. was obliged to resign in February 2009 following allegations that in his previous job as chief executive of HBOS he had fired the whistleblower and dismissed warnings about excessive risk (Kennedy 2009). 11 February 2009. In a subsequent development. served on the official committee that advises the UK Treasury on financial stability until well into the credit crunch (Hope 2009). Kennedy 2009). The group included more than a dozen bankers and City grandees. thanked him for his good service. three months after quitting RBS. In a letter. the Chancellor of the Exchequer. on an annual pension of £693. Part of its remit was to examine ‘proposals to reduce administrative burdens of regulation’.000. former chief executive of the fallen RBS. the UK authorities had been informed about potential trouble at Northern Rock as early as 2004 (Cohen and Giles 2009). .uncomforTaB le Pu zzles of T he cre di T c r u n c h 93 on the grounds that funds from wholesale sources could dry up (Peston. Alistair Darling.

though the Bank did warn of the growth in wholesale deposits repeatedly in its financial stability reports. According to the accounts. 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’. even though the exercise revealed the banks’ vulnerability. In late 2006. Madoff Securities had $1. the regulators concluded they could not force the lenders to change their practices.3bn in assets. 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. 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. In the US we learn that Bernard Madoff’s Ponzi scheme came as a surprise to his clients. highlighted the systemic risks posed by Northern Rock’s business model and its potential domino effect on HBOS.94 f inanci al alchemy in crisis As the Financial Times reported. though not to the auditors. Subsequently. According to a number of people well versed in the subject. The warnings included the fact that Madoff’s books were audited by a three-person accounting firm. the Bank of England and the Treasury. conducted by the FSA. then the UK’s largest mortgage lender. the risk simulation planning. It was felt that it was too harsh to say Northern Rock’s business model was excessively risky.

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

foreigners will not continue to finance america’s excess consumption … and fiat paper money will not continue to outperform the real thing – gold – forever. consumption cannot go down much further. noted the dangers of overoptimistic risk assessments in the markets. concluded their study of the new. in the run-up to the credit meltdown. This is not a cyclical change. However. published in 2003.96 f ina nci al alchemy in crisis 21st Century. In 2006. for it can no longer hope to spend and borrow its way to prosperity. There is also a whole current of academic work in political economy and related disciplines that had been warning about the unsustainability of the credit boom and dangers of over-inflated asset markets and mispriced risks. but a structural one that will take a long time’ (ibid.: 256). The book’s authors. for instance. the BIS pondered: . 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. More interestingly. the dominant tone in the official understanding of financial development remained puzzlingly optimistic. (Bonner with Wiggin 2003: 276) They continued: ‘America will have to find a new economic model. consumers cannot continue to go deeper into debt. several research publications by official financial institutions like the BIS. drawing on Hyman Minsky’s work.

even if these did arise. the success of New Labour was founded on the greater availability of credit to the population.uncomf orTaB l e Puzzles of T he cre diT c r u n c h 97 What grounds are there for believing that ‘imbalances’ pose a threat to the optimistic view looking forward? it is not hard to identify a large number of significant and sustained deviations from historical norms in important macroeconomic variables. 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. could withstand a variety of shocks. the flourishing . The sceptics and whistleblowers were too few to mention. however. unfortunately. Another reason is political. The credit and financial boom. In the UK during 2002–7. no one wants to be the one who stops the music. has been essential to the longevity of political regimes on both sides of the Atlantic. strengthened by the forces of globalisation and financial integration. recourse to such ‘fundamentals’ does not seem adequate to explain either the extent or the duration of the unusual circumstances currently being observed. then. (2006: 141) Why was it. 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. 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. 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. supposedly heralding a new era of prosperity.

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

According to Société Générale. Under New Labour.a.) pay 25 per cent of all income tax. In the UK. for instance. tended to service domestic economies. In both the US and the UK. the inflation-adjusted income of the highest-paid fifth of US earners has risen by 60 per cent since 1970. At the same time. which made it a peculiarly . during the decade of credit frenzy. reliance on finance-led growth produced its own political dynamic. At the peak of the credit boom. Gini coefficients (a measure of income inequality) were rising steadily (Funnel 2009). the financial sector provided 40 per cent of jobs in London (Caulkin 2006). London’s model historically had been much more global.3 Domestically. while it has fallen by more than 10 per cent for the rest. according to 2006 data. 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.000+ p. financial and business services accounted for 45 per cent of UK corporate tax income. 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.uncomforTa Bl e Puzzles of T he cre diT c r u n c h 99 So one answer to the question ‘why did politicians choose not to acknowledge the growing pyramid of debt or the risks mushrooming in the financial systems?’ is simple: debt was useful. the City dominated the economy and emerged as a unique global financial centre. while its rivals in New York and Tokyo.

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

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. but also. Observing these cases. . the notion of Ponzi finance. In essence. First. Third. scams and pyramid schemes as legitimate investments. reflecting the element of deceit and fraud. venture. it transpires. corruption and financial machinations hit the headlines. more and more cases of fraud. Ponzi pyramids were exposed as the particularly nasty practice of some high-profile financiers. fictitious. Second.uncomforTaB le Pu zzles of T he cred i T c r u n c h 101 opportunity to make a lot of money by deceiving the public by promising high returns from a new. 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 securitisation boom of 2002–7 proved to be no exception. they view the credit boom of 2002–7 and the process of securitisation as one massive industry of deceit and fraud. such as Bernard Madoff and Allen Stanford. during the securitisation boom. commentators often talk about the global credit crunch as the collapse of a gigantic Ponzi scheme. 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. the principle of a pyramid scheme applied to the dynamics of the sub-prime mortgage industry in the US – the epicentre of the crisis. As the crisis unfolded.

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

Any Ponzi scheme can thrive only as long as it attracts new participants. was not . however. the interest rates on their loans rose. once the bottom tier of properties was inflated through the creation of massive demand. and house prices can not only stop rising. 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. what is most worrying is that this was happening far beyond the sub-prime mortgage business: liars’ loans were securitised and. sub-prime lending was justified by the belief that the rising value of property would be sufficient to repay the loans and. or rather when. 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. the entire US housing market entered a bubble phase. are notoriously cyclical. the practice of providing people who have uncertain credit histories. IndyMac. For instance.uncomforTaB l e Puzzles of T he cred iT c r u n c h 10 3 First. According to Jan Kregel (2008). constituted a web of new markets for exotic financial products. In the US. This possibility. along with the actual terms of the sub-prime loans. this belief proved to be self-fulfilling. As Black argues. Housing markets. specialised in making what are known as ‘liars’ loans’. through a complex chain of financial innovations. they can tumble too. one of the first large US mortgage houses to crumble in the global meltdown. it sold $80bn such loans to other companies (Black 2009). as in any Ponzi scheme.

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

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

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

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

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

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

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

for the most part they were ignored. The credit boom of 2002–7 and the whirlpool of new financial techniques and products made these schemes almost impossible to detect. 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. politicians. Second. 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. then. bankers. First. it appears that the many parties to this process included financiers (large and small). regulators and. lawyers. as the political connections of both Madoff and Stanford imply. 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. 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. How is it. Notwithstanding various explanations of the long-term .uncomforTa B le Pu zzles of T he cre diT c r u n c h 11 1 continues – does suggest that something went terribly wrong with the business of securitisation.

economic and theoretical origins. As explained in the next chapter. They are the products. this book suggests that most of the riddles brought up by the credit crisis have a common origin. this illusion has complex socio-political. by innovating in credit instruments and techniques. they also enhance the liquidity and welfare of the economic system as a whole. Put more simply. 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.112 financial alchemy in crisis causes and short-term triggers of the global meltdown. it is the naïve belief that the financial market today creates wealth and spreads it through the economic system. thus contributing to greater and wider prosperity. both direct and indirect.

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

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

critics of the financial orthodoxy. It ‘enhances the liquidity of underlying receivables by transforming them into tradable securities. Securitisation. financial engineers and traders have expanded the reach of the financial markets. thereby increasing market turnover and. willing and able owners. liquidity. The process of inventing. 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. by pricing them and then transferring them to new. securitisation has been understood to be . 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). while adding to a sense of greater liquidity in the markets. from Minsky onwards. valuing and introducing new credit instruments. On the other hand. At the same time. rely on the liquidity of the underlying assets. in popular terminology. for instance – the latest wave of financial engineering – both relies on and enhances liquidity.T he T hree Pi llars of T he li Qu idi T y i l l u s i o n 11 5 chapters have noted. markets and institutions has been driven by the search for greater liquidity across the global financial markets. new financial instruments. Securitisation has had its own controversial effects on the idea and functioning of liquidity in the markets. have argued that the relationship between new financial products and the liquidity of the economic system as a whole is far less straightforward. Theoretically. On the other hand.

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. . Unsurprisingly. one can design several securities (tranches) with different risk-reward profiles which appeal to different investors. 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. Historically. therefore. thus allowing them to make more loans. securitisation meant that risky (but profitable) assets were moved from the banks’ balance sheets into the unregulated financial system. much like other important financial segments (say. In practical terms. by creating securities out of illiquid assets.116 f inancial alchemy in crisis a technique to create securities by reshuffling the cash flows produced by a diversified pool of assets with some common characteristics. securitisation was believed to increase liquidity across the financial system and the economy as a whole (ibid. Generally. This idea did not emerge out of the blue. By doing so. banks reacted to the new regulations by accelerating debt origination on the basis of the capacity to move assets off balance sheet by selling them. In simple terms.

As noted above. As a result of the introduction of the Basle rules. In this regard. 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 117 This trend has had its own. ultimately destructive repercussions for the stability of the financial system as a whole. Chiefly. At the heart of this process lay the transformation of the US banking system (Kregel 2007. securitisation was undertaken not just as a small part of bank operations when banks needed liquidity. the experience of the first Basle accord illustrates the law of unintended consequences. valued and traded by banks and financial houses since liberalisation reforms were introduced in the 1980s . This shift in turn has become a major institutional transformation of the global financial system. 2008). according to Victoria Chick. 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. 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. in a deregulated. it was transmitted through its impact on liquidity. securitisation reflects the way risk has been modelled. As Minsky foresaw. but on such a scale as to change the whole manner in which banks operate (Chick 2008).

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

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

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

Through the alchemy of financial engineering. the banks were assumed to optimise their own risk strategies. liquidity as a ‘state of mind’ The popularisation of finance has had its own impact on the way liquidity is understood.Th e T h ree P i llars of T h e liQ u idiT y i l l u s i o n 121 policymakers at the time was market efficiency and the efficiency of individual banks (Davies 2009).g. Playing with debt – Together. Warburton 2000). although seemingly only an analytical fallacy. As contended in this book. or market turnover. the idea of ‘liquidity’ has come to describe the liquidity of the market. The advance of financial engineering. 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. while the market as a whole – founded on financial innovation and competition – was made liquid. this assumption itself is a . 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 popular terms liquidity has increasingly come to describe the volume and speed of financial transactions. Put simply. rather that the content of those transactions (e. in both practical and analytical terms. Paralleling the rise and spread of financial markets.

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. Therefore. 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. . unfounded conceptual assumptions and beliefs constitute only one side of the liquidity illusion. But market activity is always a social process and thus constitutes a complex interactive process of information flows. and it is important to understand how social and behavioural factors shape liquidity. Continuity of trade. is a social construction. According to Carruthers and Stinchcombe (1999). or market liquidity in a more narrow sense. Assuming that anything can be bought and sold in the financial market is simply wrong. In narrow technical terms. At the same time.122 f inanci al alchemy in crisis key reason why many destabilising trends and risks in the credit bubble had been overlooked. perceptions. market fluidity. attitudes and expectations. And building a whole system of theories and regulatory principles on these two assumptions borders on something much more serious. The other important element of the illusion in the run-up to the global credit crunch lies in the dynamics of market liquidity itself.

Financial geeks were extending the range of financial products and services. intertemporal. cognitive and social processes of valuing risks. Homogenisation and standardisation of commodities. seemed to ensure that these products contain accurate information about their underlying risks and values. by grading natural products. as the authors argue in their original study. Standardisation of products and financial techniques is absolutely central to sustaining market liquidity (ibid. offering them to a host of seemingly willing buyers. This standardisation in turn. in turn. for a small margin. spawning theories about . 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. either on organised market platforms or. manufacturing standard products or by creating legal instruments with equal claims on an income stream. comprises the spatial. on an over-the-counter (OTC) basis. The existence of market-makers who. As the boom expanded. Market liquidity. The magic of securitisation. 3. the belief in and reliance on the capacity of securitisation to optimise risks became ever greater. is a collective and cognitive achievement: buyers.: 353–4). more typically.T he T hree Pi llars of T he li Qu idi T y i l l u s i o n 12 3 2. therefore. For a while during the credit boom this conviction appeared to function well. are willing to risk transferring large quantities and thus maintaining a continuous price.

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

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

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

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

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

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

however. Importantly. Lowenstein 2004). Guttman 2003.134 f inancial alchemy in crisis diminishing the firm’s cost of capital (Tinker and Carter 2003). the dot. In both these high-profile cases the companies’ auditors chose to overlook. and individual accounting firms like Arthur Andersen for lack of due diligence. in euphoria made things much less clear-cut. Yet both facts and the controversial role of financial innovation suggest that the speculative drive of the dot. Yet the bubble and the competition for markets set a general trend across the new economy: while appearing temporarily profitable and highly liquid. For the financial bubble must have been painful to the CEOs at Enron and WorldCom. and the general culture and political ideology of efficient markets (Lowenstein 2004). dominated by the five largest accounting firms in the US. both of whom have since been imprisoned for fraud. the dot. Enron was a typical Ponzi scheme. or helped disguise (Grey 2003).com boom was. the Financial Standards Accounting Board. It is tempting to blame individual executives at Enron. In essence. analysts note that this trend was supported by the standards of the private regulatory body. a giant Ponzi scheme. accounting representations set the competitive conditions for others to match if they were to survive in the marketplace (Tinker and Carter 2003: 580–1. The inevitable implosion of the dot. During the boom. Vivendi and many other firms for cooking the books and deceiving their shareholders. WorldCom. the financial crash .

In the age of ‘scientific’ finance and securitisation. During 2002–7. In 1909. in . in order to turn sub-prime loans into liquid securities someone. became the ‘new masters of capital’. 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. Credit rating agencies (CRAs) have been with us for a long time. in essence. and make the complex structures of IOUs ‘worth – or seem to be worth – more than the sum of its parts’. The first mercantile ratings guide was established in 1841 in the wake of the financial crisis of 1837 in order to rate merchants’ ability to meet their financial obligations. starting with US railroad bonds (Cantor and Packer 1994). That something was the credit rating agency (Lowenstein 2008).T he Th re e Pillars of T h e liQ u idi Ty i l l u s i o n 135 seems to have been no more than a blip in the larger trend of speculation and expansion. 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). when information is key to managing risks and structures of knowledge are essential for market turnover and. bundles of toxic debts. Today’s CRAs are the products of their time. John Moody extended the practice to rating securities. much as in the bubbles of the 1980s and late 1990s. 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.

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

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

Like most illusions. and partly by advocating the social welfare gains of new.142 financial alchemy in crisis operating in such a system. in turn. as a result. has guided this trend. . the illusion of liquidity eventually came to a destructive end. partly by capitalising on the contribution of the financial sector to the economy. the global financial architecture reflected the idea of liquidityenhancing financial innovation. arguing that this new approach to managing risks enhances market liquidity and the financial robustness of the economy. 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. ‘democratised’ finance. Institutionally. Politicians reaped the benefits. and the financial trade based on credit ratings. Mainstream finance theory.

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

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

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

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

since the latter’s acquisition of the stricken HBOS.afT e r T h e me lTd oWn 147 As a result of these bailouts. although publicly shamed by various governmental committees for their experiments during . In November 2008. subsidised loans and debt guarantees – into the failed financial institutions. the UK government is now the majority shareholder in both RBS and Lloyds TSB. Cavanagh and Redman 2008). several big banks in the US and the UK have come – either partly or totally – under state ownership. In the US. As Wigan (2010 forthcoming) writes. The reaction from the financial markets was half-hearted: although market indices stopped falling uncontrollably. 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. toxic asset purchases. Overall. 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. starting with Northern Rock. the mood in the world of finance was far from optimistic. since the funding plan effectively recognised that the insurance giant had transformed itself into a de facto investment bank through its subsidiary.42 trillion – made up of capital injections.3 In total. Oxfam (2009) estimates that governments have pumped $8. The banks in turn. Financial Products AIG. the rescue plan for AIG is of particular significance. he notes.

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

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

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

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

In this respect. and that existing market-friendly standards of governance have been unable to address them. a more .5 Moreover. In its call for a system-wide overhaul of financial supervision.152 financi al alchemy in crisis and adding to the apparatus of existing financial supervisory authorities at the Federal level. critics have pointed out that the apparent comprehensiveness of the plan is illusory. As noted above. by raising international regulatory standards and levels of coordination. 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. it is a long-needed and welcome step towards public acknowledgement that financial excesses have disastrous consequences for society and the state. Although full of good intentions. the proposal is thin on concrete initiatives and fails to address many important issues. The plan also commits the US to taking a lead in strengthening international financial reform. and as many analysts continue to reiterate. 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. nationally and internationally.4 At first glance. At the same time. calling for more regulatory bodies and extended powers in the US network of financial regulators.

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

strengthening prudential frameworks and risk management in financial institutions. Over the course of 2008–9. Specific regulatory norms proposed by the EU include higher and tighter capital and liquidity requirements for all banks operating in Europe. While the voice of American delegations in these summits has been muted due to the political changes in the US. the EU’s stronger preference for tighter financial regulation and calls for a pan-European committee of financial supervisors have been the major stumbling blocks to discussion in the November 2008 and April 2009 summits. including the European divisions of US banks. the Financial Times reported that ‘fears are rising in the City [of London] that strict new European regulation could hit the financial services . these distinctions became ever more apparent.154 f inanci al alchemy in crisis The European ‘roadmap’ for a new regulatory structure is built on four conceptual areas: improving qualitative information and transparency for investors. In June 2008. in Europe arguments have centred on the split between the UK and continental Europe. As proposals for regulatory reforms matured from initial discussions to the level of procedural planning and implementation. 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. and reviewing the role and use of credit rating agencies in the financial markets. upgrading valuation standards.

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

156 f inanci al alchemy in crisis the City. Financial Services Secretary to the UK Treasury. In July 2009. technical and political. the efforts will be too vague and hesitant. therefore. Considering the politics of financial regulation on both sides of the Atlantic. At the level of global geopolitics. But the problems with the crisis response unfortunately do not stop here. there are serious stumbling blocks. As some commentators and politicians began talking about the ‘green shoots of recovery’ in the second half of 2009. conceptual dilemmas and Traps In terms of its theoretical underpinnings. the post-crisis regulatory fallout can broadly be divided into two . the post-credit crunch financial system may not be so different from its predecessor. 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. en route to a new architecture of financial governance. conceptual level. Lord Myners. as well as the poor record of previous efforts to design a global financial architecture. 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. The plans for a new financial architecture are also riddled with opacities and conflicts at a deeper. 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).

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

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

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

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

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

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

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

as mentioned above. 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 G20 plan for strengthening the . In essence. regulators and home buyers to believe that global capitalism had entered a new era of resilience and prosperity based on deregulated credit. there are also proposals to set up a pan-European body with a similar agenda. 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. ‘scientific’ risk management and financial sophistication. It is particularly disappointing. • 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. This illusion led politicians. 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. it is difficult to predict which version of the proposals will be incorporated into concrete policy. though these ideas remain riddled with political conflicts. (The most recent negotiations have charged the IMF with this task. that in the current discussions of the future of finance. therefore. In terms of the analysis of the crisis presented in this book.) Again.164 f inancial alchemy in crisis institutions.

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

competition and liberalisation of markets. as a principle.166 f inanci al alchemy in crisis any reforms in. but for reasons specific to 2002–7. without undermining the key benefits of innovative. Moreover. privatised finance. At the same time. risk-taking is a healthy and positive part of economic activity. few seem to understand that. without killing the underlying drive for financial innovation. As a result. the emerging debate over an appropriate regulatory response concerns the fine-tuning of existing principles of financial policy and governance. 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. and adjustments to. appearances notwithstanding. confidence itself is not synonymous with liquidity. As a result. A better approach to financial regulation in the future should therefore compensate for these flaws. . 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). 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. importantly. it has been mispriced and misallocated. The logic underpinning these proposals is that.

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

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

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

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

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

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

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

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

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

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

6. the BIS.6 per cent in 2000. 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).5bn rescue package put together by a group of public and private sector banks on 1 August 2007.5 per cent of mortgages originating in the US were sub-prime. Most notably. The Bank of England. According to the Mortgage Bankers Association. the ECB. Forbes ranked HSBC as the seventh largest company in the world. compared to 2. 4. but according to what others might consider to be ‘beautiful’. According to Inside Mortgage Finance. Voters evaluated contestants not on the basis of any objective criteria. IKB had to be rescued with a $3. 2. in 2007 HSBC was the world’s seventh largest bank in terms of shareholders’ equity (data from Euromoney).notes introduction 1. for instance. 2. 5. FSF and the IMF. chapter 1 1. It filed for Chapter 11 bankruptcy on 6 August 2007. Occasional studies of liquidity have been published by other central banks in the wake of the crisis. ResMae Mortgage filed for bankruptcy and Nova Star Financial reported a loss that analysts had not foreseen. in 2006 13. In 2004. 3. Keynes likened finance to a beauty contest run by a newspaper. 177 .

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

In the EU. clearly attract these SPVs due . Switzerland. We are grateful to Victoria Chick for highlighting this key detail. or more than 50 per cent from the peak reached in summer 2007 (Papademos 2009). world manufactured output and world trade in manufactures shrank dramatically.2 per cent year-on-year in January. 15. the rest. threatening in turn the stability of European banking generally. which may be controversial. including Singapore. Germany’s industrial output was down 19. 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). In March 2009. Granite had no employees whatsoever. AIG officials also dismissed those who questioned its derivatives operation. The figures include the Netherlands. it has also emerged that European banks have incurred higher losses than their US counterparts.8 per cent (in Wolf 2009).n oT es 17 9 13. the value of equity has fallen by €6 trillion. 3. Until the liquidity squeeze of autumn 2008. Yet the banking systems in Eastern Europe – mostly controlled by European banking giants – are at a major risk of collapse. COBRA (Cabinet Office Briefing Rooms) is the UK government’s crisis response committee which deals with national crises such as pandemics and floods. In the wake of the credit crunch. chapter 2 1. Ireland and Luxembourg. 14. South Korea down 25. Among the emerging markets affected.2 trillion (IMF 2009: 2). 2. 16. Interestingly. to be regulated. At the end of 2008. saying that losses were out of the question (Williams Walsh 2009).6 per cent and Japan down 30. Sale and repurchase agreements. the IMF predicted that the total expected losses by banks and other financial institutions were in the range of $2.

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

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

In this regard. By the summer of 2009. Here. 3. respectively) in June 2009. such loose ends concern technical aspects of regulatory capital and leverage ratios for financial institutions. 17 May 2007. 2. 3. and crisis prevention and management. Observers agree that the institutions are mainly motivated by the desire to ‘get out from under US government thumb’ (Reuters 2009). US Bancorp and BB&T repaid billions of dollars ($10bn.1bn. Accepting toxic debt as central bank collateral did not give the central banks a clear ‘way out’. chapter 6 1. the ongoing financial crisis differs from the context Minsky identified. Kregel (2008) notes. According to the classic doctrine of Walter Bagehot (2006 [1877]). As Crook (2009) writes. 4. the plan notes that ‘We will focus on reaching international consensus on four core issues: regulatory capital standards.182 financi al alchemy in crisis chapter 5 1. By issuing ratings downgrades. The accountancy firm Arthur Andersen.4 million a year to certify that WorldCom’s books were honest.’ 5. there is vagueness about how . 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. $6. which was paid $4. Data from The Economist. 2. several financial institutions started repaying the taxpayer funds. Morgan Stanley. claims that WorldCom’s finance chief Scott Sullivan never handed over the material Andersen asked for (Kadlec 2002). At least 22 smaller banks have been allowed to repay some or all of their taxpayer money.6bn and $3. supervision of internationally active financial firms. oversight of global financial markets. 4.

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

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48. 115.9 Agencies. 115–16. 106. 94. 35. 74 ‘Naughty Asian exporters’. 116. 36. 78. 158. Ponzi. 30. 177n. 77. 87. 139 and fraud 94–5. 88. 43. 86. 95. see also Ponzi capitalism 66 ORD model 15. 117. 14–15. 3. 153 Bank of England and credit crunch 21. new economy. 88 197 . 16. 27. 180n. 165. 58. 167 and risk 67. 38. 79. 44–8. 110. 128 asset inflation 2. 78. 139 and securitisation 9. 124. 131. 36. 133 toxic. 21–2. 120–1. 49. 56. 77–8. 147 and capital 31. 24. 160 investment. 110. 163 and liquidity (also liquid assets) 6. 91. 117. 83.14 commercial (traditional) 13. 94 Tripartite Agreement 31. 9. 29. 139–40. 146. see also fraud. 164. 88. 118. 179n. 162 Banking and liquidity. 144. 119. 105.2 ADB 38 Asian capitalism 160 Asset(s) Asset-backed securities (ABS) xxx. 74–5. 11. 8. 161. 107.2 and Northern Rock. 19. 85. 49. 34. 134 Accounting standards: 135–8. 21. 146 system 2. 81. 119. 73.index Accounting. 63. 117. 57. 133. 96. see ratings agencies Arbitrage. 171. 85. 178n. 129. 118 shadow 15. 119 Banking crisis 2. 125. 31. 194 Asia – 38. regulatory arbitrage 46. 88. 42. 95. 85. 136. 132 creative accounting 47. 35. 116. 48. 141. 141 Agency debt (USA). offshore.

139. 101. 145. 155. 44. 79. 124. 122. 108. 178n12 Credit expansion 19. 34. 168.6 Capital markets 41. 137. 25. 96. 74–5. 111. 143. 114. 67. 172n.4 Basle Accord 95. 177n2 Federal Reserve (the Fed) 29. 165 Capital adequacy (also norms) 88. 65.2. 81. 27. 177n. 30. 171 Bernanke. 163 committees and groups 168. 63–7. 47. 22. 181n3 Credit boom 3. 91. 91–2. 91–2. 89. 174–5 financialised 3. 36. 43. 74. 177n2. 64. 99. 96. 91. 68. 173. 136. 164. 138. 44. 96. 114. 180n. 29. 31. 70. 34. 133. 135. 156. 164 Credit derivatives 87. 175 Capitalism 1. 135. 183n. 180n. 42. 157. 95. 182n2 ECB 16. 88. 161. 89. 66. 28. 26. 177n. 129. 18. 53. 50. 42. 172n. 30. 92. 41. 114. 157 BIS 19.5 ‘super-bubble’ 73 Business cycle theory of. 162. 178n12 City of London 150. 144. 161–3. 116–17. 169. 148. 69 Credit rating 142 . 79.198   financial  alchemy  in  c risis Bankruptcy 24. 157. 175 Ponzi. 127– 48. 63. 171–2. 103. 134 securitisation 20.5. 129. 76 Bretton Woods system 9 ‘Bretton Woods-2’ 76. 183n.1. 178n7. 148. 130. 18. 124. 126. 146. 69. 32. 80–3. Ben 29. 133–4. 120. 160–1 Anglo-Saxon 63.2 on liquidity 19. 49. 170. 167 crisis of 24. 120. 179n1. 127. 71–4. 100.4. see also Ponzi 100–12 Central bank(s) 29. 178n7. 123. 160. 88. 44. 72. 12. 80 Capital see also recapitalisation: 1. 71–4. 100. 154–5. 136 dot. 167 Bubble 3. 172 varieties of 150. 28. 35. 105. 76. 160. 43. 35.

dot. 104. 144–9 Debt 2. 170 theories of. 178–9n. 74. 33. 69.9 Debt culture 9–10. see central banks Financial expansion 98 . 181n. 171 Great Depression 35. 173–4.9. 50. 64. 72–5. 171. 95–6.5 Federal Reserve (Fed). 116. 183n. 179n. also Eurocurrency. 40. 69. 105. 178n. 37.2 mortgage-backed. 126–8. 140 Europe 36. 165.index  199 Credit rating agencies (CRAs) 22. 36. 167. 135 role in the crisis 135–9. 119. 128. 86. 119. 77. 42. bubble 48. 154. 95–6 Global 34. 82. 59. 105. 161. 178n. 132.11. 141. 156. 60. 171. see also crisis of the 1930s. 131. 163. 163. 150. see central bank Fannie Mae 33. 43. 77. 98. 25. 150. 178n. 51. 29 public 90–1 US debt 33. 87. 62–89 structural theories 71–9 cyclical theories 80–9 policy responses to. 95. 178n. 73. 45. 182n. 40. 45. 132. 50. 150. 100. 52–3. 42. 183n. 102 Derivatives 10. 162 regulation of. 161. 134. 78. 3. 116 Enron 48. 138. 135. 44. 133–5. 101–2. 172 of the 1990s. 128. 146 Eastern Europe. 178n. 99. 179n. 63–4. 124. 145.14 response to crisis 153–6. crisis. 176. 95. 145. 117. 81. 6. 20. 163 Crisis of the 1930s.12. 35. 172 Depression.9. 32. 16.3 Deregulation 11.15 Euromarket. 55. 109.9. 164. 139. 170. 95. 121. 180n. 164 EU 32. 145. 153–4. 78–9. 34–5. eurodollar market 9.2 toxic 7.5 Freddie Mac 33. 140–1 European Central Bank (ECB). 175 Dot. 32.

33. 174 House prices 25. 153. 164–6. 111 Galbraith. 51. 28. 143. 166 Hedging 16. 43–7 role in crisis. in crisis 82–9 Iceland 36. 43. 102. 68. 47–9 and Ponzi. 68. 130. 59. 148 Global savings glut see also savings and liquidity glut 78 Gold (standard) 9. 103 Housing market(s) 2. 157. 96 Governance. 81. 82. 2. 15. 103 Human factor.3 Herding. 34. 22.6 and offshore. 109.1 . 59. 175 Geeks. 45. 149. 84. 76. 175 and liquidity 20 and ORD model. 128. 13–17. 32. financial 16. 179n. political economy) 3. 42. 70. 148. 163 institutions 182n. 156 Global recession. 159–61. 89. 142. 156. 168–70. Alan 14. 146. 55. 118. 83. 168. 140 Hedge fund(s) 15. 94–5. investor 95. 116. 133–4. 95.200   financial alchemy  i n crisis Financial fragility 20. 84. see also NIFA. 175 Granite. 181n. 65. 66. 25. 109–20 Financial liberalisation 150 Financial architecture. 166.3 and liquidity 129–42 crisis lessons. see also Northern Rock and Offshore 40. 66 Fraud 40–2. 162. 120. 152. 156–7. 173. 175–6 controversy over. 90. 98. 118. 56. 162. see crises Greed 41. 22. 150. 140. 82. 109. 29. 100–3. 155–6. 129–30. 165. 176 Greenspan. 38. 181n. 126–7. 167 Financialisation 12. 42–3. 159 Heterodox (economics. 141. 89. 105–6. 60. 37.2 Great Depression. 47. 73. 100–9. 501. 100. 52–5. finance 66. 28. 160. 118 Financial innovation 8. 41 Illiquid asset 14. 107. 158 Geopolitics 149. 83. 20–3. 123. 181n. JK 1. 173. see also depression and crisis.

79. 163. 7–8. 177n. 159. 141. 183n. 179n. 121. 143. 135 and markets 7. 10–12. 161. 150. 142. 136. 119. 98–9 Innovation. 20. 173–4 and financial innovation 9–10. 77. 11. 12. 112. 91. 88. 28. 107.5. 24. 182n. 154. also meltdown 5. 170. 146. 73. 81. 78.7 . 164. 129 Systemic 141 IMF 26. 176 defined. 113. 36. also liquidity boom. 175. 121. 173. 144. 177n. 164. 76. 32. also crunch. 34. 136. 141–2. 125. 104. 126. 121–4. 113–42 paradox of. 90. 146. 180n. 167 and system 14. 132. 141 Illiquidity 117. 34. 140. 144.6 Liquidity artificial 42 concept. 179n.1 (ch. 137–9.2 Junk (securities) 145. John Maynard 3–4. 167. 173.index  201 loans. 174 system 20. 29. 16–17. 159. 129–30. 112. 76.2 liquidity glut. 16–17. 47. 114. 57. 177n. 17–23 pillars of.15 Inflation. 126–7. see financial innovation Interest rate 26–7. see also savings glut 7. 115–17. 140. 30. 45.16. 17.2 crisis. 166. 8. 124–5. 73. see also toxic debt Keynes. see also asset price inflation 45. 143. 125 risk 19. also debt 6. 145 and assets 8. 128–31. 18. 60. 115–16. 75. 173–6 and regulation 57. Charles 85 Lender of last resort 88. 115. 6) Leverage 1. 178n. 60. 182n. 36–7. 179n. 12. 64. 145. 10–11. 6. 104–5. 127 types of. 10. 143.12 illusion of 4. 174. 30. 97.1 Keynesian welfare state 71 Kindleberger. 177n. 126. 178n. 176 Liquidity support in crisis 30–1. 5–6.2.7 and subprime 103–6 Japan 39. 173. 86.

179n. see also Granite and offshore 30–2. 127 Privatisation of financial risk 11. 174–5. 102–3. 139 Over-the-counter (OTC) 123. 34. 163 Panic 29. 81. 128. 26. 41. 105. 65. 51. 56. 20.2 Loans.202   financi al alchemy  in  c risis Loans. 121. 59. 129. 103. 104–5. 113 Residential 135 Neoliberal. 128. 100–4. 57. 18–19. 166 . 101. 59. 44. 178n. Carlo 100. 51–61 Offshore finance. 138. 134. 22.1. 145 Ponzi. 127. 25. 100. 132. 69 Mania. 14. 32. 30. 86. 181n. 106. 174 Ponzi. see also Ponzi 96.4 on financial innovation 115–17 Monetarism 169 Monetary policy 2. capitalism 72 New economy 67. 79. securitised 7. Hyman 3. 92–4. 17. 174. 78. 105. 146. 42. 103.1 taxonomy of finance. 139. 181n. 53–5. 96. 69. 107. Hyman Ponzi capitalism 100–2. 168 Northern Rock. 28. 152. 102–3. 134. 102. 48. 176 Offshore. 102 and Ponzi finance.4 Ponzi era 96 Ponzi finance. 181n. 182n. 39. 105. 60. entities 48. 127. 172 New International Financial Architecture (NIFA) 165. sub-prime 2. 112. 114. also Ponzi scheme 19. 144–5. 104. 134. 59. 163. 176 and securitisation 106–10. see also Granite and Northern Rock 15. 129. 128. liars’ 103 LTCM 67.4. 147 and Granite 40–2. 141. see also Minsky. 167. 109.7 Mortgages. 95. 167. 180n. 128. 13. 55. tulip 100 Minsky. 174 Ponzi principle 59–60. 38.

172. 118. 24. 138. 168. 84. 67. 148 Regulation. 52. 178n. 120. 110. 155. 8. global glut. 48. 59–60. 68–9. 131. 109. 165–6 Risk and liquidity 10. 155. see also NIFA.2 macroprudential 168–71 light-touch 89. 50. governance 9. 98–9. 137 and innovation. 33. 102. 112. 95. 102. 179n. 43. 49.3 SIV 15. 14–15. 172 management of.3 Savings. 145. 19. 64. 79–80. 81–2. 143. 65. 25–6. also valuation. 172 global 2. 48. 128–30. 92–3. 111. 48–51. 173 systemic 59. 43–7. 137. 146.12 optimisation of. 81. 11. 119. 13–15. 64. 141–2. see credit ratings agencies Real economy 12. 89. 75. 139–40. 117. 127. 41–2. 21. 153. 9. 11–12. 38. 163. 165–6 and Basle 116–17. 135. 111–12. see also liquidity glut 75. 93–4. 180n. 15. 42–3. 28. 65. 152. 177n. 81. 177n. 164 pricing of. 24. 86–7. 130. 78 Speculation 73. 112. 18. 113. 76. 37. 92–3. 25. 32. 147 Recession 2. 133. 121–5. 155. 114 in wake of the crisis. 55. 65. 19–22. 127. 64. 154. 124. 6. 172. 161.index  203 Rating. 179n.2 in the political-economic system. 6. 165 paradigm of. 59. 159 Structured finance 13. 37. 65. 85. 148. 121. 169. 19. 38. 65. 135. 85. 142. 94. 40. 170. 78. 105. 18. 13. 16. 82. 171. 96. 107. 116. 150–7. 118 . 166. 124. 87. 57. 94. 67. 86. 33. 86. 133. 56. 128. 65. 136. 82. 138–9. 113. 78. 83. 161 Real estate 14 Recapitalisation: 36. 82. 59 SPV 42. 146.14 underestimation (also misunderstanding) of.

59. 156. 17. 95. 105. 119.204   financial  a lchemy  i n  c risis Toxic debt. 124. 133–4. 99. 35–7.5n. ch. 143. 73. 173–6 Welfare 13–14. 28. 2. 97–100. 58. 22. 33. 43. illusion of 1. 91. 154. 71–2. 160 Washington Mutual 35 Wealth. 85. 104. 34. 31. 18. 150. 114. 40–1. 75. 179n. 38. 12. 51. 142 WorldCom 48.13 United States 2. 71. 49. 112. 77. 34. 182. 25. 146–8. 86–8.3 . 92–4. 32. 161. 30. 53–5. see debt True sale 139–40 United Kingdom 21. 7. 150. 88. 164. 112. 150 Wall Street 1.