Financial Alchemy in Crisis

Financial Alchemy in Crisis
The Great Liquidity Illusion
AnAstAsiA nesvetAilovA

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For Alexandre Gennady Palan .


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. 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 . 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.

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. 2002–7: the three Pillars of the Liquidity Illusion liquidity and the paradigm of self-regulating credit Playing with debt – together.

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

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

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


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

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

Joseph Stiglitz and Nouriel Roubini aside. or critical. not ‘mainstream’ economists. political economy. As a result. these scholars prefer critical historical inquiry into the dynamics of financialised capitalism. Hyman Minsky and other scholars who form the tradition of heterodox. they are rarely invited to air their views in the pages of glossy business periodicals or high-profile policy forums. Suspicious of purely econometric techniques and abstract models in their analyses. There . Intellectually. and their concerned voices were simply muffled amidst the general sense of a credit bonanza in 2002–7. If the party is so good. why listen to the killjoys who want to spoil it? This book offers an analysis of the credit crunch from the same perspective that warned about the dangers of the financial system in the first place.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. Still others ventured their prognoses on the basis of intuition and gut feeling. many of them come from the same school as John Maynard Keynes. they often sound like unenlightened sceptics of finance-led economic progress. as a rule. a few economist celebrities like Paul Krugman. Detecting historical parallels with previous socio-economic and financial crises and warning against history repeating itself.

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

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

national economy and finally. a market. an institution or even an economic system as a whole. The liquidity that was widely assumed to be abundant during the pre-crisis period was not the same liquidity that melted away during the crisis. Liquidity is a very fluid. . complex. the liquidity of an individual bank. the global financial system as a whole. Liquidity is also an intertemporal category: liquidity in good economic times is not the same as liquidity in bad times. multidimensional notion. liquidity can also comprise all these things and describe several layers of economic activity at the same time – for instance. a segment of the market. It describes a quality – of an asset. Liquidity can literally vanish overnight. To make things more complicated still. Or. 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. illiquid debt when confidence and optimism evaporate. liquidity to sell is not always the same as liquidity to buy. Liquidity also denotes a quantity – most often associated with the pool of money or credit available in a system at any given time.6 f inancial alchemy in crisis The problem is conceptual. portfolio. as economists like to stress. 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 is also about depth – of a market for a particular class of assets – and speed – with which a certain transaction can be completed.

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

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

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

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

allowing buying and selling with minimum price disturbance. As one web-based financial dictionary suggests. 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. Instead. it may seem odd to link liquidity to categories of cash. analyses of finance in the macro-economy have assumed that liquidity is no longer primarily a property of assets. a market characterised by the ability to buy and sell with relative ease’ (Farlex Free Dictionary). With money itself becoming increasingly dematerialised. The policies of financial deregulation and liberalisation reinforced this trend. liquidity has been presumed to relate . Specifically. thereby institutionalising liquidity firmly as a category and instrument of the market and its pricing mechanism. but rather an indicator of the general condition and vitality of a financial market. 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). Also. As a result. over the past few decades. After all. liquidity describes ‘a high level of trading activity. high-powered or state-backed money. the global financial system is based on credit and a multitude of economic 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.

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

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

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

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

able and willing to trade at a given point in time at a prevailing price level (Warsh 2007). liquidity is most commonly understood as ‘confidence’ of the markets. debt – has resulted in the now mainstream notion of liquidity that is divorced from any attribute of assets per se. the axiom that financial innovation and engineering have the capacity to liquefy any type of asset – or. it could take a whole weekend for computers to carry out the calculations needed to assess the risks of complex CDOs (Tett 2009). they conceive liquidity fundamentally as a property of the market or an institution. rather than as a quality of assets as such. 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). 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. At the level of financial institutions themselves. Namely. more accurately. by 2006. This conceptualisation of liquidity in turn has produced a sequence of analytical fallacies which have . And although some recent analyses have drawn a distinction between market and systemic liquidity (Large 2005).16 fina nci al alchemy in crisis Officials at Standard & Poor’s admit that. Here. or between search and funding liquidity (ECB 2006).

price and trade new financial products that creates and distributes liquidity in the markets. originates in a hollow notion of liquidity itself and. Second is the view that general market trade and turnover are synonymous with market liquidity. it is . 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. The first fallacy is the assumption that it is the market-making capacity of financial intermediaries to identify. 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 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. Altogether. consequently. Therefore. 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. 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. liquidity illusion and the Global credit crunch ‘Stability is always destabilizing’. Amidst the ostensible rehabilitation of his name. Hyman Minsky famously stated in his financial instability hypothesis. I believe. This misunderstanding.

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

this illusion can have very real – and destructive – social. economic and political consequences. Very few indeed cast a critical . In other words. fund manager or a government) has about the safety and resilience of a portfolio and/or market as a whole. While noting the risk effects of the general macroeconomic environment and investor expectations. or a situation in which markets under-price liquidity and financial institutions underestimate liquidity risks (CGFS 2001: 2). As the credit crunch revealed. essentially. the illusion of liquidity is understood as a false sense of optimism a financial actor (be that a 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. most mainstream analysts of the crisis overlook the core of Minsky’s framework. In this sense. Yet once we consider the contentious place of ‘liquidity’ in the crisis. (Brunnermeir 2009: 78) The BIS arguably went furthest in analysing the repercussions of this collective underestimation of risks for liquidity and admitted that. it appears that only a fragmented and highly selective version of Minsky’s theory resonates in current readings of the global meltdown. this phenomenon constitutes an illusion of liquidity. as now commonplace references to a ‘Minsky moment’ in finance or the crisis of Ponzi finance suggest. many emergent theories of the global credit crunch appear to have strong Minskyan undertones.

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

makes the connection between the excesses of private financial innovation and its liquidity-decreasing effects. 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. by focusing on the problem of valuations and risk mis-pricing. For instance. This has been part of a longer-term decline in banks’ holdings of liquid . indeed. Yet the evidence is abundant. unless you actually have to sell them!”’ (Kochen 2000: 112).. 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. 9 August 2008). or. most discussions of liquidity in the crisis. the Bank of England documented a depletion of sterling liquid assets relative to total asset holdings in the UK banking sector..2 However. we like the expression. “sure they’re liquid. 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. in October 2008. during more benign periods. stating that: The ongoing turmoil has revealed that.’ (The Economist. as one risk manager admitted in the wake of the crisis: ‘The possibility that liquidity could suddenly dry up was always a topic high on our list but we could only see more liquidity coming into the market – not going out of it . None of the studies.

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

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

the global credit crunch has gone through three distinct stages. causing a chain of bankruptcies and job losses in manufacturing and the services sector. However. To date. 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. the meltdown goes back earlier 24 . By the summer of 2009. It began with paralysis in the international financial markets. The Prelude: The american sub-Prime crisis Most records of the global credit crunch start at 9 August 2007. A year later. the financial meltdown had matured into one of the deepest recessions recorded in the postwar history of capitalism. Gradually. Rather than replicate these detailed records. this chapter uses the records of the crisis and traces the evolution of the global meltdown through its three distinct stages. commonly dubbed a ‘liquidity crunch’.1 the staGes of the Meltdown Since it began in the summer of 2007. the financial malaise spread to the real economy.

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

Also. crucially. The sceptics were proven right. Lewie Ranieri. thereby increasing the interest payment on the loans. Observers offered different readings of this trend: some argued that despite the notable increase in bankruptcies. Commentators explained this by the fact that in 2006 . sub-prime delinquencies more than 60 days late jumped to almost 13 per cent. for those who needed them. The trigger to the rising number of defaults was the increase in the interest rate. Some sceptics warned that against this background a default of one or two financial companies could well spark a worldwide financial crisis.26 financi al alchemy in crisis wave of mortgage delinquencies started to spread. many of whom could barely afford their mortgage payments when interest rates were low. The words of reassurance. which climbed to 5. compared to 8 per cent in 2005. who said: ‘I think [the risk] is containable … I don’t think this is going to be a cataclysm’ (in Kratz 2007). Homeowners. the trend historically was insignificant (IMF 2007: 5). According to the structure of sub-prime loans. their repayments were due to rise in a year or two. from 1 per cent in 2004. By the end of 2006. came from the architect of mortgage-backed finance himself. Others began to anticipate a bigger wave of defaults and bankruptcies: most 2006 borrowers were still in the ‘teaser rate’ period of their mortgages. in 2006 the structure of US sub-prime mortgages shifted many borrowers out of their initial (presumably favourable) fixed-rate terms.35 per cent in 2006. began to default on their mortgages and defaults on sub-prime loans rose to record levels.

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

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

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

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

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

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

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

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

part-sold to the Spanish bank . was facing bankruptcy. AIG named nearly 80 companies and municipalities that benefited most from the Fed rescue.2bn). In total.11 Merrill Lynch ($6.T he sTaG es of T he me lT doWn 35 ($12. was closed down and sold off to JP Morgan Chase. a banking and insurance giant.3bn) and Wachovia ($1.9bn). US mortgage lender Washington Mutual (whose assets were valued at $307bn). the credit crunch spread further into the European banking systems. policymakers in the US drafted a massive $700bn rescue package for the American financial system. Citigroup ($2. The major foreign banks included Société Générale and Deutsche Bank (nearly $12bn each).5bn). HBOS. Bank of America ($5. Towards the end of September. 12 In the UK at around that time. the country’s biggest mortgage lender. though many more receiving smaller payments were unnamed (Williams Walsh 2009). Fortis. Barclays ($8. Political disagreements and uncertainties over the nature of the deal continued to send shockwaves through the global financial system. The UK’s Bradford & Bingley – the largest provider of ‘buy to let’ mortgages in the country (controlling around £50bn of mortgages) – was part-nationalised.8bn). Lloyds TSB took over the ailing bank in what would soon prove to be an unwise £12bn deal. On 25 September. was nationalised. Meanwhile. It was the biggest public intervention in the markets since the Great Depression and would take weeks to be approved by Congress. The deal allowed the Treasury to buy up ‘toxic debt’ from ailing banks.5bn) and UBS ($5bn).

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

these extraordinary policy efforts appeared ineffective. reacting to weakening economic data and ever more tangible signs of economic recession on both sides of the Atlantic. Nevertheless. 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. with the major European countries following the UK in authorising massive recapitalisation plans for their financial system. as markets and economies continued to stumble. despite interest rate cuts and other state efforts to restore confidence in the economy. By early November 2008. similar action was adopted by most countries affected by the credit crunch. the committee drafted a rescue plan (later known as the Brown-Darling bank recapitalisation plan). recession trends set in and spread globally. and over the course of the following weeks. affecting economic growth in the emerging markets. (King 2008: 2) The possibility of an imminent breakdown in the UK’s payment system prompted the government to set up a COBRA13-style committee on the economic crisis (Winnett and Simpson 2008).T he sTaG es of T he me lT doWn 37 many institutions it was possible to borrow only overnight. credit to the real economy almost stopped flowing … eventually. yet as Chapter . on 6 and 7 october even overnight funding started to dry up.14 The continuing crisis and deepening recession prompted multi-level attempts to form a coordinated global policy plan to reform international financial architecture.

disagreements over the appropriate course and tone of regulatory action opened up at the transatlantic level. with developing Asia – where losses totalled $9. Official institutions adjusted their estimates of total losses to much higher levels.15 Overall. the global financial crisis had been transformed into a global recession. the Asian Development Bank (ADB) reported that the crisis had precipitated a total loss of worldwide market wealth of $50 trillion. This figure not only exceeds all previous estimates of sub-prime-related losses. By 2009. or just over one year’s GDP – suffering more than other regions of the emerging markets. over the course of its two-year history.6 trillion. the global credit crunch has transformed from a seemingly isolated sectoral crisis in the US sub-prime mortgage market into a cross-border banking and financial collapse. and eventually into a global credit crunch which has directly led to a global recession. with some believing that the financial markets would not recover their pre-crisis levels until 2012.16 The loss of stock market wealth alone amounts to $25 trillion.2 per cent year-on-year in January. but is close to a year’s world output. Diagnoses and projections of the nature and duration of the meltdown became more and more pessimistic.38 financi al alchemy in crisis 6 below shows. Data reflecting real economic losses globally are sobering. At the end of 2008. In March 2009. world manufactured output and world trade in manufactures had fallen off a cliff: Germany’s industrial output was down 19. demand for manufactures. South .

. epitomises the politics and economics of the credit crunch: the fiasco of Northern Rock. But before delving into the emergent schools of thought.6 per cent and Japan down 30. The sheer severity and scale of the global meltdown. let us take a closer look at one particular event that. as well as uncertainties over its potential effects on the economic activity and politics globally.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. as argued in this book.8 per cent (in Wolf 2009).

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

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

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

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

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

(ii) regulatory changes and the circumvention of . therefore. Any new product or practice needs a motive and a context in which to thrive. rather than structured or revolutionary.) Generally. (The only previous example of such coordinated effort dates back to the policy response to the 9/11 attacks. is. 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. For instance. Generally. economic and structural changes that prompt a wave of financial innovation include: (i) volatile inflation rates and interest rates. 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). or financialisation. character of financial globalisation. the interaction between regulation and innovation tends to bring out the evolutionary. this example of international regulatory innovation was one of the few of its kind. the most recent wave of financial globalisation. The Act was designed to compensate banks for the difference in interest rates between the European and the US financial systems. Commonly. dating back to the late 1960s. In fact. Financial innovations rarely emerge ab initio. but opted not to leave the Euromarket altogether (Palan 2003). and attract American funds back into the US economy. American banks not only failed to repatriate their investments.

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

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

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

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

5 761.413.5 436.3 210.0 1.0 71.3 28.2 2. The Powers Committee. not to achieve bona fide economic objectives or to transfer risk’ (Powers. partnerships and SPVs in order to shift debt around and make illicit payments to its directors. which investigated Enron’s collapse. 2008.1 205.691. that we do not see the two as being the same thing.164.8 773.334.5 Source: BIS.5 326. 2007 All countries Caymans Switzerland Netherlands Ireland Singapore Luxembourg Bahamas Jersey Guernsey Bahrain Isle of Man Total $29.000 . The report states that ‘[m]any of the most significant transactions [of Enron] apparently were designed to accomplish favorable financial statement results.7 0.226.8 4.2 4.3 1.6 1. International Financial Statistics.9 8.7 0. Troubb and Winokur 2002: 4).8 4. though.1 The share of ofcs in international financial flows.50 f inancial alchemy in crisis would like to stress.7bn 1.3 1.218.5 1. Enron’s fraud was organised through 3.6 2. reported that the company created complex financial arrangements. Table 2. SPVs hit the headlines following the collapse of Enron.1 0.0 % share 5.

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


f ina nci al alchemy in crisis

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

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

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

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

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

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

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

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

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

market regulators. The Global Credit Crunch as an Exogenous Shock Within this ex-post group of analyses. as argued from these perspectives. 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. low interest rates. 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. penalised. they were simply dismissed or. Ultimately. one interpretation of the crisis stands out: the reading of the global credit crunch as a ‘surprise’ event – a shock that took most financiers. four years of falling credit spreads. virtually no defaults in our loan portfolio .64 financial alchemy in crisis emphasised the destructive role of unprecedented levels of debt in the US and the global economy. the dominant mood in the markets during 2002–7 is probably best expressed in the admission of a risk manager of a global bank. 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. In most cases. political leaders and observers totally by surprise. worse. Instead. efficient and diversified. making the economy more flexible. 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.

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

yet often having minimal understanding of the ways the economic system works as a whole. finance and credit are only one facet – albeit a defining one – of the general short-termism of contemporary society as a whole. typically with excellent and highly specialised training in mathematics and physics. Langley 2008. the financial system itself has come to be defined by the paradigm and practice of scientific finance (Greenspan 2001.66 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 changed character of work and. To begin with. Second. Yet there are also reasons why long-term historical regularities and warning signs were ignored or dismissed. 2002). as a culmination. the unprecedented rise of the financial sector to a dominant position in the economy. They concern a peculiar anthropology. 2008. as we shall see in Chapter 4). Having embarked on a career in finance or banking in the past 10–20 years. The many other dimensions of such short-termism include changing patterns of production. demography and the political economy of today’s financial industry. Blackburn 2006. this process has been viewed as the financialisation of everyday life (Martin 2003. brand or logo capitalism. Montgomerie 2009). Seabrooke 2006. Academically. these professionals have no . the rise of the digital economy. The major engine of financial innovation today is in the hands of a class of young and narrowly educated geeks. Williams et al.

Indeed. Criticised for his direct role in creating the bubble of easy credit during the 1990s/early 2000s. 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 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. as far as this new generation was concerned. 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. their role was to make the sophisticated and complex financial markets work more efficiently. (in Gimson 2008) During the boom years of 2002–7. . the ‘shock’ vision of the global crisis has also been common in courtrooms and on news screens.hoW T he crisis has B een un de r s Too d 67 memory of earlier recessions or even structural financial crises. Interestingly. 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. therefore. and many might remember the collapse of Barings in 1995 or the 1998 LTCM fiasco. as one insurance broker noted: We did the south sea Bubble at school. While most of them would be familiar with the story of the 1929 Crash.

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

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

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

but largely predictable result of the operation of a type of economy that had replaced the Keynesian welfare state of the . economic. structural theorists view it as a specific. the emergent theories of the credit crunch have incorporated deeper scholarly inquiries into the nature of finance today. social. As such. Broadly.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. 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. cultural and ideological foundations of market-based capitalism. they tend to see the credit crunch as a crisis of Anglo-Saxon capitalism more generally: while it is in finance that the crisis has been most apparent. At the same time. overlapping the political. in reality the meltdown is more pervasive. Thus emphasising the historical origins of the current crisis. 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. these views can be classified as structural or cyclical explanations of the global meltdown.

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). deregulated capital markets. 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.1bn to $14. the growth of debt-financed consumption and business activity has been more pronounced in the UK. the consumer-driven pattern of recovery from previous crises and a general hedonistic basis of socioeconomic relationships that have come to define the culture of American-style capitalism (Altvater 1997. And according to Turner (2008). The ratio of debt .374.5 per cent of GDP to 227.5 trillion in debt. leaving the country more vulnerable to the effects of the credit crunch. personal debt jumped from $5.). and total private sector debt had risen from 133. The levels of borrowings. In the US over the course of the decade. Pettifor 2003. Turner 2008. higher than in any other major industrialised economy. is the key structural cause of the meltdown. minimal savings. have been growing much faster than incomes and wages in the Anglo-Saxon economies. individuals in the UK held over £1. 2002. Gamble 2009.72 f inanci al alchemy in crisis 1950s–1960s with a neoliberal model of capitalism. debt-financed consumption.5bn. both private and corporate. etc. Debt.4 per cent during the first ten years of the New Labour government. In 2007. Shiller 2008. Wade 2008. Tily 2007.547. and its role in the overall economic organisation.

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

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

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

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. The mortgagebacked security helped create a national and even an international market for mortgages … This led to securitisation of a variety of other consumer loan products.76 financial alchemy in crisis The development of a broad-based secondary market for mortgage loans also greatly expanded consumer access to credit. such as auto and credit card loans. Within this unique arrangement. 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. By reducing the risk of making long-term. fixed-rate loans and ensuring liquidity for mortgage lenders. (Greenspan 2005) At the time. 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’. the secondary market helped stimulate widespread competition in the mortgage business. 1 The bank commented that ‘conditions in the major financial markets remained calm and accommodative for much of 2005 and early 2006. which makes it attractive for . it was argued. Dollar reserves. in turn. reflecting the surprisingly strong performance of the world economy and still abundant liquidity’ (BIS 2006: 98). However ‘abnormal’ though.

hoW T he crisis has Be en un de r s To o d 77 Table 3.9 Eastern Europe and former Soviet Union –13.3 –10.2 –2.7 65.3 –30.8 –23.1 Global current account Balances.9 4.2 –342.4 21.5 205.9 17.9 –14.1 42.9 –87.4 4.8 –13.4 39.8 5.0 3.6 –23.2 88. 41.5 Statistical discrepancy Source: Bernanke 2005.0 11.5 20.1 –6.4 –39.8 3.4 12.3 –120.1 –20.1 10.7 –23.2 –530.3 8.8 7.7 47.2 –2.4 138.3 . 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 46.0 –8.4 17.3 45.6 0.6 25.5 24.5 55.5 –40.8 7.0 148.5 –15.2 –30.1 137.2 Middle East and Africa 5.9 29.


financi al alchemy in crisis

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

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


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

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


f inancial alchemy in crisis

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

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


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

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

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

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

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

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

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

and not understood by the FSA or UK Treasury’ (Ambler 2008). purpose or even the name of the products their company was trading in. 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]. this problem was apparent . those responsible for the grossly irresponsible credit derivatives trading and the ensuing risk exposure were not people who had been quantitatively trained. sales. critics argue that it was the inadequate implementation of financial policy as much as its flawed theoretical assumptions that precipitated the crisis. where senior managers often had no idea about the composition. far too often. with deal-chasing ability. they rose to their positions on other criteria. (carmona and sircar 2009) Fourth. outside the traditional set of requirements imposed by regulations) and that they generated positive earnings. and other attention-deficit-promoting activities ranking high. As Willem Buiter (2008) writes. There also emerged a peculiar state of affairs within financial companies themselves. They were mostly concerned that the company’s trading techniques provided legitimate means of raising funds off balance sheet (i. Interestingly. unseen by.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.e.

On the one hand. more and more critical voices have observed that lack of due oversight and diligence reflects a much . the crisis was aggravated by the chaotic and extremely convoluted regulatory structure for banks. while the Treasury was simply too slow to act. In the US. it fell victim to regulatory capture by Wall Street (ibid. In the Euro area. A product of the many vices of the age of ‘scientific finance’. 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 UK financial systems have suffered from a flawed tripartite arrangement between the bodies responsible for financial stability. 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.). as the crisis continued. The FSA (the market regulator) focused almost exclusively on capital adequacy and solvency. On the other hand. cyclical visions of the credit crunch emphasise that the crisis reflected a classic problem of the knowledge gap between policymakers and the financial markets. therefore.3 And while the Fed did have better access to institution-specific information. likewise. which led to a paucity of information about the financial circumstances of individual banks and other systemically important financial institutions.88 f ina nci al alchemy in crisis in all major geographical corners of the credit crunch. the central bank did not play a supervisory and regulatory role for the banking system. near-banks and financial markets.

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

and the credit crunch has its share of both. Most painfully. it has revealed that greed can be very blinding. The IMF also estimated that the present value of the fiscal cost of an ageing population is. of course. Yet it is they. on average. 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 2014.000 for every citizen. Their governments will then owe about $50.4 soMe uncoMfortaBle Puzzles of the credIt crunch Any financial crisis has its villains and fools. it has shown that those supposedly tasked with financial supervision and stability often have very little idea of what financial institutions actually do. The meltdown has exposed the ineptness of many people – in high places and elsewhere. ten times that of the financial meltdown. demographic 90 . who have rescued private financial firms through massive injections of taxpayers’ money into individual banks and financial markets. 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. and their children. If unchecked.

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

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

The group included more than a dozen bankers and City grandees. Alistair Darling. Another embarrassing revelation came in the summer of 2009. former chief executive of the fallen RBS. newly appointed deputy chairman of the FSA. Part of its remit was to examine ‘proposals to reduce administrative burdens of regulation’. 11 February 2009. the Chancellor of the Exchequer.000. Northern Rock and HBOS were at the centre of a 2004 ‘war game’ regulators held to test how banks would cope with sudden turmoil in the mortgage market and the withdrawal of money from foreign banks on which Northern Rock’s business model relied. The scandal surrounding the fiasco of HBOS-RBS was further fuelled by the revelation that Sir Fred Goodwin. . three months after quitting RBS. According to the Financial Times. Sir Fred was not asked to stand down until 28 January 2009. James Crosby. thanked him for his good service.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. the UK authorities had been informed about potential trouble at Northern Rock as early as 2004 (Cohen and Giles 2009). Kennedy 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). on an annual pension of £693. 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). In a letter.

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

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

However. 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. This is not a cyclical change. 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. the BIS pondered: . consumers cannot continue to go deeper into debt. foreigners will not continue to finance america’s excess consumption … and fiat paper money will not continue to outperform the real thing – gold – forever.96 f ina nci al alchemy in crisis 21st Century. for instance. drawing on Hyman Minsky’s work. several research publications by official financial institutions like the BIS. for it can no longer hope to spend and borrow its way to prosperity. The book’s authors.: 256). but a structural one that will take a long time’ (ibid. the dominant tone in the official understanding of financial development remained puzzlingly optimistic. More interestingly. in the run-up to the credit meltdown. concluded their study of the new. consumption cannot go down much further. (Bonner with Wiggin 2003: 276) They continued: ‘America will have to find a new economic model. In 2006. noted the dangers of overoptimistic risk assessments in the markets. published in 2003.

could withstand a variety of shocks. the success of New Labour was founded on the greater availability of credit to the population. 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. recourse to such ‘fundamentals’ does not seem adequate to explain either the extent or the duration of the unusual circumstances currently being observed. The credit and financial boom. 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. Another reason is political. even if these did arise. has been essential to the longevity of political regimes on both sides of the Atlantic. unfortunately. 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.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. the flourishing . 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. (2006: 141) Why was it. no one wants to be the one who stops the music. however. supposedly heralding a new era of prosperity. strengthened by the forces of globalisation and financial integration. In the UK during 2002–7. then. The sceptics and whistleblowers were too few to mention.

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

According to Société Générale. It appears that the Wal-Mart Walton family is wealthier than the bottom third of the US population put together – about 100 million people.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. At the peak of the credit boom. according to 2006 data. while its rivals in New York and Tokyo. the inflation-adjusted income of the highest-paid fifth of US earners has risen by 60 per cent since 1970. the financial sector provided 40 per cent of jobs in London (Caulkin 2006). London’s model historically had been much more global. reliance on finance-led growth produced its own political dynamic. during the decade of credit frenzy. 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. In both the US and the UK. Gini coefficients (a measure of income inequality) were rising steadily (Funnel 2009).) pay 25 per cent of all income tax. The financial sector’s high earners (earning £100.000+ p. for instance. while it has fallen by more than 10 per cent for the rest. financial and business services accounted for 45 per cent of UK corporate tax income. which made it a peculiarly .a.3 Domestically. tended to service domestic economies. In the UK. Under New Labour. the City dominated the economy and emerged as a unique global financial centre. At the same time.

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

more and more cases of fraud. fictitious.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. First. Third. Ponzi pyramids were exposed as the particularly nasty practice of some high-profile financiers. The securitisation boom of 2002–7 proved to be no exception. scams and pyramid schemes as legitimate investments. it transpires. venture. captures a more general tendency among financial firms to avoid true disclosure of risks and hide bad debts by using the tools of financial innovation. the notion of Ponzi finance. 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. Observing these cases. reflecting the element of deceit and fraud. they view the credit boom of 2002–7 and the process of securitisation as one massive industry of deceit and fraud. but also. As the crisis unfolded. such as Bernard Madoff and Allen Stanford. during the securitisation boom. corruption and financial machinations hit the headlines. Second. commentators often talk about the global credit crunch as the collapse of a gigantic Ponzi scheme. the principle of a pyramid scheme applied to the dynamics of the sub-prime mortgage industry in the US – the epicentre of the crisis. . In essence. 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 three types of finance mark the transitions starting with a conservative financial strategy and working towards an economic agent taking ever greater risks. Dorn 2008. turn into more risky speculative finance. this progression describes the spiral of financial innovation and the progressive underestimation of risk by financial agents. Wray 2008). Kregel 2008. where cash flows only cover interest payments. in which an economic agent can pay debts and interest only by borrowing even more. Minsky (1982. particularly during periods of economic optimism. For Minsky. 1986) used the notion of ‘Ponzi finance’ to describe a state of acute financial fragility. Broadly speaking. Ponzi finance is the ultimate phase in the evolution of a financial cycle. 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. Ee and Xiong 2008. ‘Ponzi’ is a method of financing old debt with new debt. and then into the Ponzi state.102 f inanci al alchemy in crisis Ponzi Finance and ‘Sub-Crime’ In his financial instability hypothesis. At the same time. Several facts about the structure of sub-prime lending substantiate this assertion. where even interest payments have to be financed by new debt. . where both interest and principal are repayable. the Ponzi principle implies that fraud and deception are key motives. In Minsky’s original taxonomy. which develops after hedge finance. therefore.

According to Jan Kregel (2008). IndyMac. the entire US housing market entered a bubble phase. As Black argues. Any Ponzi scheme can thrive only as long as it attracts new participants. as in any Ponzi scheme. 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. sub-prime lending was justified by the belief that the rising value of property would be sufficient to repay the loans and. it sold $80bn such loans to other companies (Black 2009). what is most worrying is that this was happening far beyond the sub-prime mortgage business: liars’ loans were securitised and. constituted a web of new markets for exotic financial products. once the bottom tier of properties was inflated through the creation of massive demand. the interest rates on their loans rose. however. Housing markets. one of the first large US mortgage houses to crumble in the global meltdown. In the US. This possibility.uncomforTaB l e Puzzles of T he cred iT c r u n c h 10 3 First. this belief proved to be self-fulfilling. specialised in making what are known as ‘liars’ loans’. For instance. was not . the practice of providing people who have uncertain credit histories. they can tumble too. along with the actual terms of the sub-prime loans. Yet from the very start it was clear that many of those sub-prime borrowers would be unable to pay their mortgages if. are notoriously cyclical. through a complex chain of financial innovations. In 2006 alone. and house prices can not only stop rising. or rather when.

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

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. accounting firms and hedge funds – as part of a wide-sweeping probe into mortgage fraud. which brings us to the next terrain of Ponzi finance: the business of securitisation itself. credit rating agencies. two major cases of pure Ponzi pyramids have come to light. insider trading and failures to disclose – with criminal intent – the proper evaluation of securitised loans and derivatives. As of June 2008.6 According to the Federal authorities. the housing and securitisation boom was in fact celebrated by many officials on both sides of the Atlantic. In the summer of 2008. The first was put together by Bernard . It is in the wake of the sub-prime fiasco that clear evidence of mortgage fraud hit the headlines. fraud was a ‘contributing factor’ to the overall credit crisis (Kirchgaessner and Weitzman 2008). Journalists following the investigations likened the instances of sub-prime fraud to the Enron and WorldCom scandals. As noted above. 406 defendants were charged in 144 cases across the US. The majority of the large corporate cases involved accounting fraud.uncomforTa B le Pu zzles of T he cred i T c r u n c h 10 5 by the expanding credit bubble. such as Bear Stearns in the US. The Ponzi Business of Securitisation To date. FBI investigators were homing in on 19 ‘large corporations’ – including investment banks.

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

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

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

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

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

politicians. for the most part they were ignored.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. it appears that the many parties to this process included financiers (large and small). Third – and much more worryingly – when warnings about the true nature of these schemes were voiced. Notwithstanding various explanations of the long-term . lawyers. The credit boom of 2002–7 and the whirlpool of new financial techniques and products made these schemes almost impossible to detect. 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. First. whose very name implied something very rotten. as the political connections of both Madoff and Stanford imply. then. How is it. bankers. as the booming industry of credit crunch studies suggests. 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. Second. regulators and. 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.

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

facilitated and encouraged a particular market-based approach to managing risks in finance. The following pages identify three interconnected forces that. 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. in its broader 113 . Even so. in turn. the global meltdown is a crisis centred on the US sub-prime mortgage industry. political and institutional developments. analytical. This chapter unpacks the role that ideas. liquidity and the Paradigm of self-regulating credit In narrow terms. emerged as a combination of historical. behaviour and the institutional organisation of financial regulation played in constructing and sustaining the illusion of liquidity. having reified the myth of efficient finance. helped disguise the deepening fragility of the North Atlantic economies. liquid markets and economic prosperity. the sub-prime lending industry was a time-bomb waiting to explode (Wray 2008).5 2002–7: the three PIllars of the lIquIdIty IllusIon Even in purely financial terms. This environment.

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

liquidity. valuing and introducing new credit instruments. while adding to a sense of greater liquidity in the markets. markets and institutions has been driven by the search for greater liquidity across the global financial markets. from Minsky onwards. rely on the liquidity of the underlying assets. Securitisation has had its own controversial effects on the idea and functioning of liquidity in the markets. in popular terminology. securitisation has been understood to be . thereby increasing market turnover and. new financial instruments. the funding of a large number of market participants involved in the securitisation process depends crucially on market liquidity being permanently sustained’ (Banque de France 2008: 11). The process of inventing. Theoretically. Securitisation. On the other hand. It ‘enhances the liquidity of underlying receivables by transforming them into tradable securities. by pricing them and then transferring them to new. critics of the financial orthodoxy. On the other hand. for instance – the latest wave of financial engineering – both relies on and enhances liquidity. financial engineers and traders have expanded the reach of the financial markets. At the same time.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. willing and able owners. 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. have argued that the relationship between new financial products and the liquidity of the economic system as a whole is far less straightforward.

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. Generally. This idea did not emerge out of the blue. by creating securities out of illiquid assets. one can design several securities (tranches) with different risk-reward profiles which appeal to different investors. securitisation has been the banking sector’s reaction to the introduction of the Basle II accord of financial regulation. Unsurprisingly. much like other important financial segments (say. thus allowing them to make more loans. 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. Historically. In simple terms. the Basle requirements made it unprofitable for banks to hold safe and liquid assets on their balance sheets (Wigan 2009). securitisation meant that risky (but profitable) assets were moved from the banks’ balance sheets into the unregulated financial system. therefore.). . the Eurodollar market which emerged almost by accident but later become widely established). securitisation was believed to increase liquidity across the financial system and the economy as a whole (ibid. By doing so. (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. In practical terms.

ultimately destructive repercussions for the stability of the financial system as a whole. but on such a scale as to change the whole manner in which banks operate (Chick 2008). securitisation reflects the way risk has been modelled. In this regard. financialised economy the ability to lengthen the debt chain leads to increasing illiquidity in the financial system as a whole: ‘to the extent that either the most liquid assets leave the banking system for the portfolios of other financial institutions or the debts of the newly grown and developed financial institutions enter the portfolios of banks. Chiefly. This shift in turn has become a major institutional transformation of the global financial system. At the heart of this process lay the transformation of the US banking system (Kregel 2007. it was transmitted through its impact on liquidity. according to Victoria Chick. As Minsky foresaw. 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.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. valued and traded by banks and financial houses since liberalisation reforms were introduced in the 1980s . As a result of the introduction of the Basle rules. in a deregulated. the liquidity of the banking system declines’ (Minsky 1982: 174). securitisation was undertaken not just as a small part of bank operations when banks needed liquidity. As noted above. the experience of the first Basle accord illustrates the law of unintended consequences. 2008).

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

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

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

the idea of ‘liquidity’ has come to describe the liquidity of the market. although seemingly only an analytical fallacy. Through the alchemy of financial engineering. liquidity as a ‘state of mind’ The popularisation of finance has had its own impact on the way liquidity is understood. Playing with debt – Together. or market turnover. The advance of financial engineering.g.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). 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. 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. the banks were assumed to optimise their own risk strategies. As contended in this book. Paralleling the rise and spread of financial markets. in both practical and analytical terms. rather that the content of those transactions (e. in popular terms liquidity has increasingly come to describe the volume and speed of financial transactions. Warburton 2000). this assumption itself is a . Put simply.

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

on an over-the-counter (OTC) basis. either on organised market platforms or. as the authors argue in their original study. in turn. 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. therefore. by grading natural products. 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. The magic of securitisation. intertemporal. is a collective and cognitive achievement: buyers. spawning theories about . for a small margin. Financial geeks were extending the range of financial products and services. The existence of market-makers who. Market liquidity. seemed to ensure that these products contain accurate information about their underlying risks and values. comprises the spatial. This standardisation in turn.: 353–4). Homogenisation and standardisation of commodities. cognitive and social processes of valuing risks. manufacturing standard products or by creating legal instruments with equal claims on an income stream. As the boom expanded. the belief in and reliance on the capacity of securitisation to optimise risks became ever greater.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. more typically. Standardisation of products and financial techniques is absolutely central to sustaining market liquidity (ibid. offering them to a host of seemingly willing buyers. 3.

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

In fact. But here is one of the many paradoxes of liquidity. the other side is the ability to sell. Standardising these securities and making them transferable in the market. First of all. the new derivative products had become so obscure that it could take days for computer programs to value them. While one side of liquidity is about finding a willing buyer and exercising one’s ability to transfer claims. As Gillian Tett (2008) notes. was absolutely pivotal both to sustaining the investment boom and to preserving the notion of a liquid market. As the techniques of securitisation became ever more complex and opaque. a liquidity boom can only be sustained as long as a collective belief in the tradability of assets persists. more and more of these newly minted securities were left on banks’ balance sheets. Confidence in turn depends on a level of transparency in the markets and knowledge about the new securities being traded. a tendency . it was increasingly difficult to shift them in the markets. so central to the sense of market liquidity. Most people understand this as ‘market confidence’. this twofold function became ever more difficult to maintain at a systemic level. and vice versa’ (McCulley 2008: 1). Tett argues. The greater the risk appetite. the greater the liquidity. Standardisation. the idea that collective reliance on financial innovation and sophistication automatically creates ‘the market’ proved to be an illusion. as noted above. From the point of view of markets as social institutions.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. proved to be dangerous. crucially.

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

Whatever the term chosen. 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. much like any other systemic financial collapse. similar investor positions are unable to diffuse the shock. in stressful periods and crises these common practices erode more values than a more diversified market would allow. it is noteworthy that while speculation. At the same time. herding and the concentration of risks . In this herd-driven process of financial innovation. and. The global credit crunch. Therefore. proved the point. As the first waves of the crisis combined with a spate of downgrades and uncertainty over valuations. warnings were voiced about the dangers of what looked like herding in the derivatives markets. the aggressive expansion of new borrowings. the conventional trends of a bubble and Minsky’s Ponzi finance prevail: the undervaluation of risks.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’. During the later years of the credit boom. the major risk posed by the growing homogeneity of market behaviour is that when distress strikes the market. they magnify it. in many cases. hordes of investors were left holding similar positions in a falling market (Madigan 2008). especially liquidity risk. Instead. There were simply too many speculators operating in one market segment. while during a boom similar attitudes and shared positions create a sense of greater vibrancy and liquidity in the market. the use of quasi-legal investment techniques and outright swindles.

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

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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

Using its exemption from brokerage regulations and oversight by the Commodities Futures Trading Commission. the company seems to have relied on old-fashioned cooking of the books: by treating routine expenses as capital investments. Arthur Andersen. The method of market-to-market accounting allowed the company instantly to book future earnings it forecast on energy deals. corporations whose executives have been convicted of serious financial fraud. the accounting violations at Enron included revenue overstatement. with the corollary of bolstering Enron’s potential return on investment and . 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 combined effect was to overstate earnings per share. The two most notorious scandals of that particular bubble were WorldCom and Enron. 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).3 Enron employed a much more elaborate scheme of financial innovation. somehow failed to see what they were doing (Kadlec 2002). Overall. WorldCom’s auditor.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. The basic idea was to represent losses as profits. involving special purpose entities (SPEs) and financial manipulations. cost understatement. In the case of WorldCom. masking of risk and overvaluation of assets.

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

much as in the bubbles of the 1980s and late 1990s. Credit rating agencies (CRAs) have been with us for a long time. 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. in the words of Timothy Sinclair (2005). Today’s CRAs are the products of their time. was needed to act as market-maker on a large scale and sustain collective belief in the liquidity of what were. 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. in order to turn sub-prime loans into liquid securities someone. 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. John Moody extended the practice to rating securities. That something was the credit rating agency (Lowenstein 2008). starting with US railroad bonds (Cantor and Packer 1994). became the ‘new masters of capital’. and make the complex structures of IOUs ‘worth – or seem to be worth – more than the sum of its parts’. in . In the age of ‘scientific’ finance and securitisation. bundles of toxic debts. when information is key to managing risks and structures of knowledge are essential for market turnover and.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. In 1909. During 2002–7. or something. in essence.

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

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


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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

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

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

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

National Recapitalisation Schemes (9 October 2008–2009) Following the government takeover of Fannie Mae and Freddie Mac and the collapse of Lehman Brothers. In the midst of the panic that paralysed the global markets in the late summer of 2007. however. This decision remains one of the most controversial policies of the global credit 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.2 Even this radical response to the crisis brought feeble results.1 it is also unclear what will happen to the billions of dollars of toxic debts now being held by the banks. decisive action. Yet as the crisis intensified and transformed into deeper problems in the national and international credit systems. Neither the exorbitant size of cash injections nor the central banks’ attempts at transatlantic regulatory coordination helped quell the turmoil. allowing little time for deep analysis or musings about the actual causes or lessons to be learnt from the crisis. the ad hoc measures proved to be insufficient. Panics require urgent. Not only does it go against the golden rule of monetary theory and the principle of a lender-of-last-resort action. the world entered the second phase of crisis management: . whether governmentsupported or not. the immediacy of political reaction was understandable.

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

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

such as AIG and Goldman Sachs in the US and RBS-HBOS in the UK. was a central forum in . The G20 summit. two key events have spurred progress on these efforts: the election of Barack Obama and the G20 London summit in April 2009. and the chain of bankruptcies expanded into the real economy. other than public commitments to bolster the global financial system and rethink existing approaches to financial governance. albeit rather too hastily. when world leaders gathered in Washington. were slow and reluctant to accept state help. International Financial Reform (15 November 2008–?) The deterioration of economic conditions worldwide has moved crisis management into its third phase: an international regulatory response. Although the summit did not bring any tangible results. even claiming that ‘they are not charity’ cases. Lending levels remained low. It did not help when it emerged that executives in the key financial institutions. In the meantime. the world financial crisis descended into a global recession. The Obama administration has been behind a radical plan for financial reform announced in June 2009. Its inception can be dated to 15 November 2008.148 financi al alchemy in crisis 2002–7. DC for a summit that was dubbed ‘Bretton Woods 2’. have received vast amounts in bonus payments. which reconvened in September 2009. it did mark the beginning of a series of efforts at the global level to reform world finance. To date. fuelling public and media fury.

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

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

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

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

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

including the European divisions of US banks. As proposals for regulatory reforms matured from initial discussions to the level of procedural planning and implementation.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. and reviewing the role and use of credit rating agencies in the financial markets. the Financial Times reported that ‘fears are rising in the City [of London] that strict new European regulation could hit the financial services . in Europe arguments have centred on the split between the UK and continental Europe. 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. 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. upgrading valuation standards. strengthening prudential frameworks and risk management in financial institutions. While the voice of American delegations in these summits has been muted due to the political changes in the US. Specific regulatory norms proposed by the EU include higher and tighter capital and liquidity requirements for all banks operating in Europe. these distinctions became ever more apparent. Over the course of 2008–9. In June 2008.

A European institution setting minimum standards would fetter the competitive drive to deregulate between countries. such as credit ratings agencies and central clearing houses. All these proposals have unnerved . as they say. Specific European proposals that trouble Britain include: • The proposal. • The proposal that EU supervisors be empowered to demand that national governments bail out banks. set out in an EC paper. for tighter regulation of hedge funds and private equity. Such a body would also be able to bully reluctant regulators elsewhere in the EU into demonstrating that their banks hold sufficient risk capital (Financial Times. • The idea that an EU ‘systemic risk council’ (a new supervisory body) would be chaired by the president of the ECB. • The proposal that supervision of entities with a pan-European reach. 11 June 2009). Financial institutions would also have to meet increased minimum capital requirements and limits on borrowing. is in the detail. But the devil. The EU directive would also require many hedge funds and private equity firms to register with regulators and disclose more about themselves and their 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). should be at the EU level.

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

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

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

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

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

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

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

• National plans to re-empower and strengthen the mandates of existing monetary and financial . 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. (These controls are mainly advocated by the EU.afT e r T h e me lTd oWn 163 reviews of the lessons of the global credit crunch. especially when these are funded by the taxpayer. • The need to license and control credit rating agencies that have disgraced themselves by assigning AAA ratings to toxic and illiquid securities. thereby making financial trades more transparent and hence accountable. • The need to change the structure of incentives.) • The need to set up organised and centralised trading platforms for products that were traded off market until recently (like OTC derivatives). 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. and on regulating what is being understood as ‘systemic risk’ in finance. they are based on the idea of rebalancing private gains and social losses. This proposal concerns financiers themselves: CEOs should not receive excessive pay and bonuses.

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

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

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

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

everyone senses it should be a good thing. 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. microeconomic indicators of financial stability. Apart from a plethora of forums and committees set up in the wake of the 1997–9 crises (the G20 forum.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. financialised capitalism. Ambitious yet vague on concrete detail. liberalisation and competition further. various Basle-centred groups. Recent history also suggests that in another important parallel to earlier attempts to deal with the legacy of the financial crises. policymakers tend to search for the same weapon. it targets qualitative parameters of financial risk – the macro-prudential approach is in a fact a big elephant in a very dark room. macro-prudential regulation risks becoming to finance what ‘good governance’ has become to politics: instinctively. NIFA remained pro-market-centred and aimed to facilitate financial innovation. . now fashionably called a macro-prudential approach to financial governance. With regard to its focus. etc. 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.). Financial Stability Forum.

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

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

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

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

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

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

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

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

Keynes likened finance to a beauty contest run by a newspaper. in 2007 HSBC was the world’s seventh largest bank in terms of shareholders’ equity (data from Euromoney). the ECB. 2. the BIS. 2. 177 . In 2004. Most notably. IKB had to be rescued with a $3. 3. 5.notes introduction 1. Voters evaluated contestants not on the basis of any objective criteria. Occasional studies of liquidity have been published by other central banks in the wake of the crisis.6 per cent in 2000.5 per cent of mortgages originating in the US were sub-prime. 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). but according to what others might consider to be ‘beautiful’. 4. Forbes ranked HSBC as the seventh largest company in the world.5bn rescue package put together by a group of public and private sector banks on 1 August 2007. for instance. The Bank of England. According to Inside Mortgage Finance. in 2006 13. According to the Mortgage Bankers Association. It filed for Chapter 11 bankruptcy on 6 August 2007. FSF and the IMF. 6. ResMae Mortgage filed for bankruptcy and Nova Star Financial reported a loss that analysts had not foreseen. compared to 2. chapter 1 1.

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

Latvia and Ukraine suffered the most. Ireland and Luxembourg. Germany’s industrial output was down 19. Among the emerging markets affected. 15. South Korea down 25. In the EU. repo transactions allow banks to post unwanted securitised bonds as collateral to borrow funds from central banks (Tett and van Duyn 2009). 14. We are grateful to Victoria Chick for highlighting this key detail. 16. chapter 2 1. The figures include the Netherlands. including Singapore.n oT es 17 9 13. the value of equity has fallen by €6 trillion. COBRA (Cabinet Office Briefing Rooms) is the UK government’s crisis response committee which deals with national crises such as pandemics and floods.6 per cent and Japan down 30.2 per cent year-on-year in January. At the end of 2008. which may be controversial. world manufactured output and world trade in manufactures shrank dramatically.2 trillion (IMF 2009: 2). Yet the banking systems in Eastern Europe – mostly controlled by European banking giants – are at a major risk of collapse. 3. Until the liquidity squeeze of autumn 2008. Granite had no employees whatsoever. 2. the IMF predicted that the total expected losses by banks and other financial institutions were in the range of $2. it has also emerged that European banks have incurred higher losses than their US counterparts. the rest. threatening in turn the stability of European banking generally. to be regulated. or more than 50 per cent from the peak reached in summer 2007 (Papademos 2009). saying that losses were out of the question (Williams Walsh 2009). Interestingly. Sale and repurchase agreements. Switzerland.8 per cent (in Wolf 2009). In March 2009. In the wake of the credit crunch. clearly attract these SPVs due . AIG officials also dismissed those who questioned its derivatives operation.

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

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

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. there is vagueness about how . 3.1bn. 4. Here. At least 22 smaller banks have been allowed to repay some or all of their taxpayer money. 3. In this regard. Kregel (2008) notes. chapter 6 1. the plan notes that ‘We will focus on reaching international consensus on four core issues: regulatory capital standards.4 million a year to certify that WorldCom’s books were honest. claims that WorldCom’s finance chief Scott Sullivan never handed over the material Andersen asked for (Kadlec 2002). 2. and crisis prevention and management.6bn and $3.182 financi al alchemy in crisis chapter 5 1. such loose ends concern technical aspects of regulatory capital and leverage ratios for financial institutions.’ 5. According to the classic doctrine of Walter Bagehot (2006 [1877]). respectively) in June 2009. $6. several financial institutions started repaying the taxpayer funds. Data from The Economist. the ongoing financial crisis differs from the context Minsky identified. Morgan Stanley. By issuing ratings downgrades. supervision of internationally active financial firms. 4. By the summer of 2009. 17 May 2007. Accepting toxic debt as central bank collateral did not give the central banks a clear ‘way out’. oversight of global financial markets. As Crook (2009) writes. which was paid $4. 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. 2. The accountancy firm Arthur Andersen.

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88. 44–8. 124. 153 Bank of England and credit crunch 21. 141 Agency debt (USA). 144. offshore. 117. 139 and fraud 94–5. 43. 164. 171. 95. 163 and liquidity (also liquid assets) 6. 79.index Accounting. 9. 106. 120–1. 94 Tripartite Agreement 31. 141. 115–16. 88. 83. 73. Ponzi. 14–15. 119 Banking crisis 2. 146 system 2.9 Agencies.2 ADB 38 Asian capitalism 160 Asset(s) Asset-backed securities (ABS) xxx. 160 investment. 94. 118 shadow 15. 116. 139 and securitisation 9. 85. 116. 96. 88. 19. 3.2 and Northern Rock. 57. 30. 158. 167 and risk 67. 133. 115. 8. 49. 177n. 31. 132 creative accounting 47. 36. 165. 78. 49. 29. 139–40. 63. 105. 125. 34. 36. 56. 48. 117. 117. 162 Banking and liquidity. 11. 78. 131. 118. 81. see also fraud. 77–8. 134 Accounting standards: 135–8. 91. 178n.14 commercial (traditional) 13. 86. 110. 129. 194 Asia – 38. 180n. 136. 74 ‘Naughty Asian exporters’. new economy. 58. regulatory arbitrage 46. 35. 147 and capital 31. 27. see also Ponzi capitalism 66 ORD model 15. 77. 133 toxic. 42. 21–2. 87. 146. 21. 161. 107. 119. 88 197 . 119. 74–5. 85. 110. see ratings agencies Arbitrage. 128 asset inflation 2. 38. 16. 35. 95. 48. 85. 24. 179n.

1. 175 Ponzi. 96. 133–4. 127–8. 30. 160–1 Anglo-Saxon 63. 44. 124. 100. 69. 28. 161–3. 124.4. 180n. 134 securitisation 20. 28. 80–3. 183n. 71–4.2 on liquidity 19. 66. 12. 76. 116–17. 68. 27. 36. 42. 103. 43.2. 18. 44. 139. 25. 92. 91–2. 99. 135. see also Ponzi 100–12 Central bank(s) 29. 167 Bubble 3. 95. 154–5. 178n12 City of London 150. 81. 156. 180n. 72. 137. 122. 144. 111. 79. 74. 157 BIS 19. 69 Credit rating 142 . 120. 145. 76 Bretton Woods system 9 ‘Bretton Woods-2’ 76. 172 varieties of 150. 157. 91. 91–2. 182n2 ECB 16. 91. 148. 29. 41. 160. 100. 114. 123.198   financial  alchemy  in  c risis Bankruptcy 24. 169. 101. 130. 48. 148. 170. 143. 31. 183n. 136 dot. 177n. 165 Capital adequacy (also norms) 88. 136.4 Basle Accord 95. 96. 168. 177n. 96. 163 committees and groups 168. 161. 174–5 financialised 3. 44. 129. 133. 155. 160. 138. 80 Capital see also recapitalisation: 1. 43. 22. 35. 127. 26. 34. 120. 178n7. 65.6 Capital markets 41. 67. 74–5. 30. 64. 105. 157.5 ‘super-bubble’ 73 Business cycle theory of. 108. 172n. 63–7. 135. 89. 71–4. 18. 70. 177n2 Federal Reserve (the Fed) 29. 63. 88. Ben 29. 179n1. 89. 42. 50.5. 114. 32. 177n2. 164 Credit derivatives 87. 53. 146. 181n3 Credit boom 3. 173. 178n12 Credit expansion 19. 171 Bernanke. 47. 126. 175 Capitalism 1. 178n7. 34. 114. 35. 171–2. 49. 172n. 88. 79. 129. 164. 167 crisis of 24.

72–5. 124. 167. 135. 95–6. see central bank Fannie Mae 33. 171. 134. 178n. 139. 36. 25. 176. 98. 74. 126–8. 55. 119. 86. 99. 69.5 Freddie Mac 33. 63–4. 101–2. 77. 150. 164. 95. dot. 33. 171 Great Depression 35. 179n. 182n. 40. 140–1 European Central Bank (ECB). 95.2 mortgage-backed. 40. 181n. 43. 145. 163 Crisis of the 1930s.3 Deregulation 11. also Eurocurrency.9 Debt culture 9–10. 144–9 Debt 2. 140 Europe 36. 165. 172 of the bubble 48. 64. 42. 16. 50. 132. 133–5. 35. 69. 135 role in the crisis 135–9. 95–6 Global 34. 105. 164 EU 32. 141. 150. 42. 163.14 response to crisis 153–6. 20. 100. 146 Eastern Europe. 52–3. 132. 179n. 87. 131. 150. eurodollar market 9.15 Euromarket. 121. 128.11.9. 37. 173–4. 145. 43. 29 public 90–1 US debt 33. 153–4. 156. see also crisis of the 1930s. 116 Enron 48. 178n. 78–9. 6. 44. 50. 95. see central banks Financial expansion 98 . 161. 128. 119. 117.2 toxic 7. 116. 171. 82.5 Federal Reserve (Fed).12.9. 138. 34–5. 105. 81. 32. 104. 170. 170 theories of. crisis. 145. 73. 102 Derivatives 10. 109. 77. 154. 180n. 178n. 162 regulation of. 178–9n. 51. 163. 178n. 62–89 structural theories 71–9 cyclical theories 80–9 policy responses to. 183n. 45.index  199 Credit rating agencies (CRAs) 22. 60. 161. 59. 175 Dot. 178n. 3. 183n. 78. 172 Depression. 32. 45.9.

47. 126–7. 150. 82. 60. 43–7 role in crisis. 55. 32. 163 institutions 182n. 37. 118. 42–3. 45. 141. 162. 52–5. see also depression and crisis. 59. see also NIFA. 109. 100–9. 95.3 Herding. 42. 174 House prices 25. 140. 156. 165. 123. 98.2 Great Depression. 146. 148. 33. 81. 128. 13–17. 167 Financialisation 12. 73.200   financial alchemy  i n crisis Financial fragility 20. financial 16. 168–70. 29. 84. 28.1 . 41 Illiquid asset 14. 94–5. 149. 181n. 47–9 and Ponzi. 118 Financial innovation 8. 116. 175 and liquidity 20 and ORD model. 59. 68. 130. 501. 68. 100. 20–3. see crises Greed 41. 120. 159–61. 152. 173. 156 Global recession. 89. in crisis 82–9 Iceland 36. 133–4. 70.3 and liquidity 129–42 crisis lessons. 175–6 controversy over. investor 95. 168. 109. 109–20 Financial liberalisation 150 Financial architecture. 142. 162. 143. 181n. 160. 179n. 103 Housing market(s) 2. 100–3. 140 Hedge fund(s) 15. 176 Greenspan. 173. 76. 105–6. 155–6. 159 Heterodox (economics. 118. 129–30. 83. 148 Global savings glut see also savings and liquidity glut 78 Gold (standard) 9. 65. 90. 82. 157. 43. 107. 166. 34. 103 Human factor. 175 Geeks. 156–7. Alan 14. 153. 22.6 and offshore. 22. finance 66. 51. 102. 166 Hedging 16. 175 Granite. 84. 164–6. 111 Galbraith. 2. 96 Governance. 66. 38. 25. 28. 181n. 89. JK 1. see also Northern Rock and Offshore 40. political economy) 3. 158 Geopolitics 149. 15. 66 Fraud 40–2. 56. 83.

10–11. 179n. 140. 78. 121–4. 127 types of. 161. 115. 79. 145 and assets 8. also debt 6.7 and subprime 103–6 Japan 39. 141 Illiquidity 117. 135 and markets 7. 182n. 29. 175.7 . 6.2 liquidity glut.15 Inflation. 5–6. 47.2. 45.6 Liquidity artificial 42 concept. 182n. 136. 129 Systemic 141 IMF 26. 159. 77. 115–16. 86. 121. 76. 174 system 20. 30. 177n. 16–17. 163. 34. 119. 179n. 6) Leverage 1. see also asset price inflation 45. 10.2 crisis. 121. 183n. 64. 104. 91. see financial innovation Interest rate 26–7. Charles 85 Lender of last resort 88. 178n. 143. 126. see also toxic debt Keynes. 73. 141–2. 115–17. 177n. 11. 36–7. 57. 126–7. 73. 113–42 paradox of. also liquidity boom. also meltdown 5. 140. 76.index  201 loans.12 illusion of 4.5. see also savings glut 7. 143. 60. 112.16. 146. John Maynard 3–4. 20. 164. 144. 176 Liquidity support in crisis 30–1. 164. 81. 137–9. 166. 167 and system 14. 180n. 125 risk 19. 75. 12. 113. 124–5. 98–9 Innovation. 159. 176 defined.1 (ch. 104–5. 12. 173–6 and regulation 57. 146.2 Junk (securities) 145. 167. 154. 173. 173. 60. 90. 107. 141. 7–8. 173. 178n. 32. 129–30. 145. 17–23 pillars of. 18. 114. 28. 174. 142. 17. 177n. 128–31. 36. 136. 179n. 143. 88. 24. 150. 97. 34. 173–4 and financial innovation 9–10. 144. 126. 125. also crunch. 112. 132.1 Keynesian welfare state 71 Kindleberger. 10–12. 177n. 30. 8. 170. 16–17.

1 taxonomy of finance. 128. Hyman Ponzi capitalism 100–2. see also Minsky. Carlo 100. 51–61 Offshore finance. 127. tulip 100 Minsky. 103. 32. 163. 166 . 104–5. 134. 60.202   financi al alchemy  in  c risis Loans. 48. 105. 30. 100. 174–5. 79. 134. see also Granite and offshore 30–2. 96.1. 121. 57. 92–4. 134. 26. 174. 65. Hyman 3. liars’ 103 LTCM 67. 44. 141. 81. 34. 102 and Ponzi finance.4 Ponzi era 96 Ponzi finance. 86. 105. 69. 112. 128. 127 Privatisation of financial risk 11.4.4 on financial innovation 115–17 Monetarism 169 Monetary policy 2. 69 Mania. 144–5. 181n. 174 Ponzi principle 59–60. also Ponzi scheme 19. 129. 102–3. 178n. 167. 167. see also Granite and Northern Rock 15. 107. 14. 181n. 128. 152.7 Mortgages. 139 Over-the-counter (OTC) 123. 100–4. 102–3. 179n. 176 Offshore. 132. 106. 78. 95. 18–19. 163 Panic 29. 13. 28. 42. 104. entities 48. 59. 174 Ponzi. 114. 168 Northern Rock. 38. 105. 56. 103. 172 New International Financial Architecture (NIFA) 165. capitalism 72 New economy 67. 17. 180n. 39. 20. 59. 113 Residential 135 Neoliberal. 182n. securitised 7. 128. 147 and Granite 40–2. 139. 102. 53–5. 101. 55. 129. 146. 59. 138. sub-prime 2. 181n. 127. 109. 22. 145 Ponzi. 41. 25. 51.2 Loans. see also Ponzi 96. 176 and securitisation 106–10.

37. 25. 159 Structured finance 13. 179n. 6. 64. 92–3. 109. 82. 133. 121. governance 9. 85. 155. 41–2. 85. 79–80. 86. 19. 148. 130. 56. 78 Speculation 73. 121–5. 81–2. 48–51. 170. 169. 13–15. 65. 153. 146. 137 and innovation. 110. 59. 14–15. 166. 59–60. 152. 50. 173 systemic 59.2 macroprudential 168–71 light-touch 89. 124. 155. 180n. 135. 172. 93–4. 6. 172. 52. 55. 65. 98–9. 24. 102. 171. 64. 81. 13. 165–6 Risk and liquidity 10. 117. 38. 18. 43. 165 paradigm of. 114 in wake of the crisis. 177n. 135. 179n. 138. 94. 119. 82. 163. 86. 113. 19–22. 8. 147 Recession 2.14 underestimation (also misunderstanding) of. 33. 87. 11. 38. see also liquidity glut 75. 86–7. 161.12 optimisation of. 65. 43–7. 37. 94. 133. 172 management of. 112. 139–40. also valuation. 21. global glut.3 Savings. 161 Real estate 14 Recapitalisation: 36. 142. 49. 127. 57. 118 . 42–3. 154. 128–30. 136. 137. 32. 148 Regulation. 64. 143. 168. 165–6 and Basle 116–17. 75. 111–12. 9. 118. 178n. 65. 78. 150–7. 127. 107. see credit ratings agencies Real economy 12.2 in the political-economic system. 15. 81. 111. 164 pricing of. 16. 76. 113. 11–12. 48.3 SIV 15. 19. 95. 124. 78. 102. 84. 131. 141–2. 89. 82. 67. 120. 28. 48. 112. 59 SPV 42. 68–9. 65. 96. 145. 105. 177n. 18. 128. 155. 83. 92–3.index  203 Rating. 116. 24. 65. 33. see also NIFA. 138–9. 67. 146. 25–6. 40. 172 global 2.

146–8. 179n. 25. 40–1. 35–7. 31. 99. 85. see debt True sale 139–40 United Kingdom 21. 18. 92–4. 112. 173–6 Welfare 13–14. 49. 2. 112. 34. 75. 17. 160 Washington Mutual 35 Wealth.13 United States 2. 71–2. 105. 182. 38. 95. 119. 12. 58. 104. 91. 73. 164. 156. 143. 33. 114. 51. 77.3 . 161. 71. 28.204   financial  a lchemy  i n  c risis Toxic debt. 22. illusion of 1. ch. 124. 97–100. 32. 43. 59. 150 Wall Street 1. 142 WorldCom 48. 150. 53–5. 88. 150. 7. 86–8.5n. 30. 154. 133–4. 34.

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