(So Many Important Book) (Important) Financial Alchemy in Crisis The Great Liquidity Illusion by Anastasia Nesvetailova PDF

Financial Alchemy in Crisis
Nesvetailova 00 pre 1 29/03/2010 09:12

Financial Alchemy in Crisis
The Great Liquidity Illusion
Anastasia Nesvetailova

First published 2010 by Pluto Press
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Copyright © Introduction, Chapters 2, 3–6, Conclusion

Anastasia Nesvetailova 2010
Copyright © Chapter 2 Anastasia Nesvetailova and Ronen Palan 2010
The rights of Anastasia Nesvetailova and Ronen Palen to be identified

as the authors of this work has been asserted by them in accordance
with the Copyright, Designs and Patents Act 1988.
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For Alexandre Gennady Palan

Contents
Abbreviations ix
Acknowledgements x
Introduction: The End of a Great Illusion 1

‘Liquidity’ and the crisis of invented money 4
Liquidity illusion and the global credit crunch 17
1. The Stages of the Meltdown 24

The prelude: the American sub-prime crisis 24
From sub-prime crisis to the global credit crunch 28
From global credit crunch to global recession 33
2. The Tale of Northern Rock:

Between Financial Innovation and Fraud 40
(Anastasia Nesvetailova and Ronen Palan)
The controversy over financial innovation 43
Offshore: the uses and abuses of SPVs 48
Northern Rock and Granite 51
3. How the Crisis has been Understood 62

Ex-ante and ex-post visions of the credit crunch 62
Structural theories of the credit crunch 71
Cyclical theories of the crisis 80
4. Some Uncomfortable Puzzles of the Credit Crunch 90

Dismissed: the warning signs and the
â•… whistleblowers 91
Ponzi capitalism: a crisis of fraud? 100

viiiâ•… fi nanc ial a lchemy in cr is is
5. 2002–7: The Three Pillars of the Liquidity Illusion 113

Liquidity and the paradigm of self-regulating
â•… credit 113
Playing with debt – together. Liquidity as a
â•… ‘state of mind’ 121
The alchemists: turning bad debts into ‘money’ 131
6. After the Meltdown: Rewriting the Rules of

Global Finance? 143
The three stages of the policy response 144
The crisis and geopolitics: a new special
â•… relationship? 149
Conceptual dilemmas and traps 156
Conclusion: A Very Mundane Crisis 172
Notes 177
Bibliography 184
Index 197

Abbreviations
ABSs Asset-backed securities

BIS Bank for International Settlements
CDOs Collateralised debt obligations
CEO Chief Executive Officer
CRA Credit rating agencies
ECB European Central Bank
FSA Financial Services Authority (UK)
FSF Financial Stability Forum
FSB Financial Stability Board
GDP Gross domestic product
IMF International Monetary Fund
MBAs Mortgage-backed assets
MBSs Mortgage-backed securities
NIFA New international financial architecture
OFC Offshore financial centre
ORD Originate and distribute (model of banking)
OTC Over-the-counter (trade)
SIV Special investment vehicle
SNB Swiss National Bank
SPE Special purpose entity
SPV Special purpose vehicle
VAR Value at risk (model)
ix

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

Take earth of Earth, Earth’s Mother (Water of Earth),
Fire of Earth, and Water of the Wood. These are to lie
together and then be parted. Alchemical gold is made
of three pure souls, as purged as crystal. Body, soul, and
spirit grow into a Stone, wherein there is no corruption.
This is to be cast on Mercury and it shall become most
worthy gold.
Pierce the Black Monk,
sometime in sixteenth-century Europe
Sometime in the twenty-first century, new monks, not

to be outdone by their sixteenth-century brethren,
invented a new formula. Take one part motor car debt,
add two parts credit card debt and three parts house
mortgage debt, and mix well together. Leave for six
days, and call the whole, Bond. Call in the Wizard, a
man versed in mathematics, ask him to throw the Bond
in the air. When it falls to the ground, ask for an AAA
rating, then sell to a bank.
Alchemy makes gold from base materials; today’s
experts have become as adept as their sixteenth-century
forebears in the dark arts of wealth-creation.

Introduction
The End of a Great Illusion
By now it was also evident that the investment trusts, once

considered a buttress of the high plateau and a built-in defense
against collapse were really a profound source of weakness. The
leverage, 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.
(Galbraith 1955)
Sounds familiar? John Kenneth Galbraith wrote these

words in 1955 in his celebrated text on the 1929 Wall
Street Crash. Few thought that his classic study on
economic history would be applicable to a crisis of
advanced twenty-first-century capitalism. The general
opinion among financial experts had been rather
reassuring: ‘innovative techniques of corporate finance
have led to more careful evaluation of corporate wealth
and more effective allocation of capital’ (Bernstein
2005: 2). Yet, as George Santayana famously wrote,
‘those who cannot learn from history are doomed to
repeat it’. Indeed, as is argued in this book, it is the ill-
understood process of modern financial alchemy that
has become the real cause of the global credit crunch.
The turmoil that engulfed an unsuspecting world
one Tuesday in early August 2007 has paralysed the
1
Nesvetailova 01 text 1 30/03/2010 11:40

2â•… f inancial alchemy in crisis
world of finance and, since then, the entire global

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

int roduct i on: t h e end of a gr e at i l l u s i o nâ•… 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,
as a rule, not ‘mainstream’ economists. Intellectually,
many of them come from the same school as John
Maynard Keynes, Hyman Minsky and other scholars
who form the tradition of heterodox, or critical,
political economy. Suspicious of purely econometric
techniques and abstract models in their analyses,
these scholars prefer critical historical inquiry into
the dynamics of financialised capitalism. Detecting
historical parallels with previous socio-economic and
financial crises and warning against history repeating
itself, they often sound like unenlightened sceptics
of finance-led economic progress. As a result, a few
economist celebrities like Paul Krugman, Joseph Stiglitz
and Nouriel Roubini aside, they are rarely invited to air
their views in the pages of glossy business periodicals
or high-profile policy forums. Still others ventured their
prognoses on the basis of intuition and gut feeling, 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. There

is no doubt that complex sets of factors – historical,

geopolitical, economic, social, even cultural – have
shaped the preconditions for the global malaise. Yet
as the following pages contend, the key cause of the
global credit crunch can be traced back to one pervasive
and dangerous myth. Specifically, it is the idea that by
inventing novel credit instruments and opening up new
financial markets, today’s financiers create money and
wealth. This belief had been shared by many participants
of the crisis, including its major casualties; strikingly, it
remains current in the wake of the credit crunch. During
the boom years of 2002–7 this fallacy, apparent to many
in the aftermath of the crisis, was concealed by one great
myth of today’s finance: the illusion of liquidity. As will
be argued below, the global credit crunch has shown this
idea to be a dangerous – and costly – fallacy.
‘Liquidity’ and the Crisis of Invented Money
There is a certain oddity about the realm of finance

and economics. Although apparently precise, technical,
strict, rational and calculative, 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. We all
know, for instance, what ‘price’ is, but for centuries
scholars of political economy have been arguing among
themselves about how best to define the concept of
‘value’. They have yet to reach an agreement. Keynes
famously described the financial market as a ‘beauty

in t roduct i on: t h e end of a gr e at i l l u s i o nâ•… 5
contest’1 and the metaphor stuck – albeit we know that

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

The problem is conceptual. Liquidity is a very fluid,

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

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

8 â•… f inancial alchemy in crisis
consensus, however, on what the concept of liquidity

actually implies today. As the field of credit crunch
studies expands, the diversity of views becomes ever
more apparent.
Not that long ago things were somewhat simpler. In
the brief age of Keynesian economic stability, ‘liquidity’
was generally assumed to describe a quality of an asset
and ultimately was related to the notion of money. And
even though the concept of ‘money’ remains probably
the most controversial aspect of economics and finance,
most students of finance at the time would concur
that liquidity is a property of an asset. As such, it is
conditioned by the market context, 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).
But then the real life of the financial markets
complicated matters. In 1971, the postwar system
of fixed exchange rates and financial controls was
dismantled. As a result of the financial innovations that
led to this collapse, the state lost its monopoly over the
process of credit-creation. The financial sector has been
transformed from being part of the service economy,
an intermediary between lenders and investors, into
an industry of trading and optimising risk. In parallel,
the concept of liquidity has undergone its own series
of mutations.

in t roduc ti on: t he end of a g re at i l l u s i o nâ•… 9
First, the transformation of liquidity has paralleled

the rise of private financial markets. During the
centuries of metal-based money, and later in the era of
the Gold Standard and even the fixed exchange rates
of the Bretton Woods system, liquidity was closely
associated primarily with state-generated credit money
and, second, the banking system’s ability to extend
credit. With the collapse of the Bretton Woods regime
and the rise of private financial markets, the notion of
liquidity, both functionally and conceptually, has been
gravitating towards the realm of the financial markets
themselves. A key factor in this trend was the emergence
in the late 1960s of the unregulated financial space, the
Euromarket. Created by commercial banks to avoid
national regulations, the Eurocurrency market became
the global engine of liquidity-creation and debt-financ-
ing, and became prone to overextension of credit. Most
dramatically, this trend manifested itself in the global
debt crisis of the 1980s (Guttman 2003: 32).
The second mutation of liquidity has been the
so-called securitisation revolution. Theoretically, secu-
ritisation is a technique used to create securities by
reshuffling the cash flows produced by a diversified pool
of assets with common characteristics. By doing so, one
can design several securities (tranches) with different
risk-reward profiles which appeal to different investors
(Cifuentes 2008). The idea behind this principle
is economic flexibility: by securitising previously
non-traded products and putting them on the market,
financial institutions attach a price to these assets, widen

their ownership and hence, by expanding the web of

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

in troduct i on: t h e end of a gr e at i l l u s i o nâ•… 1 1
change in the analytical approaches is to be found in the

financial developments of the post-1971 era. Specifically,
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).
The policies of financial deregulation and liberali-
sation reinforced this trend, thereby institutionalising
liquidity firmly as a category and instrument of the
market and its pricing mechanism. As a result, over
the past few decades, analyses of finance in the
macro-economy have assumed that liquidity is no
longer primarily a property of assets, but rather an
indicator of the general condition and vitality of a
financial market. As one web-based financial dictionary
suggests, liquidity describes ‘a high level of trading
activity, allowing buying and selling with minimum
price disturbance. Also, a market characterised by the
ability to buy and sell with relative ease’ (Farlex Free
Dictionary).
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. After all, the global financial
system is based on credit and a multitude of economic
transactions. With money itself becoming increasingly
dematerialised, it may seem odd to link liquidity to
categories of cash, high-powered or state-backed
money. Instead, liquidity has been presumed to relate

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

in t roduc ti on: th e end of a g re at i l l u s i o nâ•… 13
growth and, crucially, developments in the sphere of

state-backed or high-powered money.
Second, analytically, mainstream finance theory
and practice supported and guided these trends by
embedding the new credit system in a paradigm of
scientific finance. In this view, the key function of the
financial system as a whole is no longer the intermedia-
tion between savers and borrowers as such; that role has
been assigned to just one sector of the financial system
– commercial banking. Rather, 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, by pooling a bunch of sub-prime mortgages
from several mortgage lenders); (ii) by parcelling them
into specific financial vehicles (such as tranches of
mortgages or structured financial products); and (iii)
by redistributing the risk to those who are deemed most
able and willing to hold risk (i.e. by selling it on to
third and fourth parties, often institutions specialising
in trading these particular products, or placing them
off the balance sheet, as happened with many highly
risky securitisation products) (e.g. Toporowski 2009).
This complex chain of financial innovation is known
in mainstream finance theory as market completion. In
the context of the sub-prime market, for instance, risk-
optimising and market-creating financial innovations
have been seen as key to enhancing social welfare more
generally:

14â•… financial 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. By pricing the risks of different
types of credit quality, 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, even to applicants
able to qualify in a prime-only market. Those applicants obtain a
welfare gain by having more choices and flexibility. (Chinloy and
Macdonald 2005: 163–4)
Ultimately, as Alan Greenspan foresaw, ‘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, cited in
Wigan 2009). Financial innovation, therefore, by
relying on scientific approaches to risk management
and calculative practices, is believed to create new
facilities for risk optimisation and thus complete the
system of markets. As the theory holds, securitisa-
tion, for instance, transforms previously unpriced
and typically illiquid assets, such as real estate, car or
student loans and sub-prime mortgages, into tradable
and liquid financial securities, thereby optimising risks
and enhancing the liquidity of the financial system as
a whole (Cifuentes 2008). According to Greenspan,
this process – extending far beyond the sub-prime
market – symbolised ‘a new paradigm of active credit
management’ (cited in Morris 2008: 61).

int roduct i on: t h e end of a gr e at i l l u s i o nâ•… 1 5
Third, the spiral of demonetised financialisation

has been underpinned by institutional and operational
advances in financial innovation. In addition to the
structural shift towards the ‘originate and distribute’
(ORD) banking model, there has been a remarkable
rise in the number of hedge funds; the growing sophis-
tication and specialisation of offshore financial centres
and techniques (Palan 2003); the expansion of the
so-called shadow banking industry; and the spread
of new methods of risk management and trade, such
as value-at-risk (VAR) models, all leading to the
extraordinary growth of variety and complexity of
financial products themselves.
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. Indeed, as Gillian Tett writes, in 2006 and
early 2007, no less than $450bn worth of ‘collateralised
debt obligations of asset-backed securities’ (CDOs of
ABSs) were created. Yet instead of being traded, as the
principle of active credit risk management would imply,
most were sold to banks’ off-balance-sheet entities, such
as structured investment vehicles (SIVs), or simply left
on the books. Generally, she argues, 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, in ways almost nobody understood.

Officials at Standard & Poor’s admit that, by 2006, it

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

in t roduct i on: th e end of a g re at i l l u s i o nâ•… 17
contributed to the illusion that this is the real cause of the

global credit crunch. The first fallacy is the assumption
that it is the market-making capacity of financial inter-
mediaries to identify, price and trade new financial
products that creates and distributes liquidity in the
markets. Second is the view that general market trade
and turnover are synonymous with market liquidity.
The third and corresponding fallacy is the notion that
market liquidity itself – when multiplied across many
markets – ultimately is synonymous with the liquidity
(and financial robustness) of the economic system as
a whole. Altogether, 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.
This misunderstanding, I believe, originates in a
hollow notion of liquidity itself and, consequently, in
the flawed vision – academic as well as political – of the
dynamics of the relationship between private financial
innovation and the liquidity and resilience of the
financial system generally. Therefore, the hollow notion
of liquidity lies at the heart of the great illusion of wealth
and the belief in financial markets’ capacity to invent
money that are the real causes of the globalÂ€meltdown.
Liquidity Illusion and the Global Credit Crunch
‘Stability is always destabilizing’, Hyman Minsky

famously stated in his financial instability hypothesis.
Amidst the ostensible rehabilitation of his name, it is

this message that seems to attract most commentaries

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

in t roduct i on: t h e end of a g re at i l l u s i o nâ•… 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. (Brunnermeir 2009: 78)
The BIS arguably went furthest in analysing the

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

eye on the very ability of private financial intermediar-

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

in t roduct i on: t h e end of a gr e at i l l u s i o nâ•… 2 1
short-sighted and over-reliant on the market’s shared

sentiments: ‘as a guide to market discipline, we like
the expression, “sure they’re liquid, unless you actually
have to sell them!”’ (Kochen 2000: 112), or, 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 ...’ (The Economist, 9 August 2008).
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.2
However, most discussions of liquidity in the crisis,
by focusing on the problem of valuations and risk
mis-pricing, diagnose the evaporation of liquidity as
a result of market failure rather than as a systemic
tendency. None of the studies, indeed, makes the
connection between the excesses of private financial
innovation and its liquidity-decreasing effects. Yet the
evidence is abundant. For instance, in October 2008,
the Bank of England documented a depletion of sterling
liquid assets relative to total asset holdings in the UK
banking sector, stating that:
The ongoing turmoil has revealed that, during more benign periods,
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. This
has been part of a longer-term decline in banks’ holdings of liquid

assets in the United Kingdom, which has been replicated in other

countries. (2008: 39–40)
In this instance, an important question about the

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

int roduct i on: t h e end of a g r e at i l l u s i o nâ•… 2 3
economy of the credit crunch. While any economic

crisis is in a sense a crisis of belief and confidence – be it
in a national currency, a bank or a whole industry – the
concept of liquidity has played a crucial, and ultimately
destructive, role in the political economy of the credit
crunch. Not only does the idea of liquidity capture
a range of axioms and assumptions that shaped the
architecture of the unravelling global financial system,
it also encapsulates the politics of financial alchemy
today, or what is widely celebrated as a process of
financial innovation.

1
The Stages of the Meltdown
Since it began in the summer of 2007, the global credit

crunch has gone through three distinct stages. It began
with paralysis in the international financial markets,
commonly dubbed a ‘liquidity crunch’. A year later,
the meltdown turned into a cross-border banking crisis
which threatened the very viability of the financial
services in key economies. Gradually, the financial
malaise spread to the real economy, causing a chain of
bankruptcies and job losses in manufacturing and the
services sector. By the summer of 2009, the financial
meltdown had matured into one of the deepest recessions
recorded in the postwar history of capitalism. 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. 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.
The Prelude: The American Sub-Prime Crisis
Most records of the global credit crunch start at 9

August 2007. However, the meltdown goes back earlier
24

t he s tages of t he m e ltdown â•… 2 5
than that. In the United States, which has been the

epicentre of the global malaise, the prelude to the global
financial meltdown unfolded in late 2006/early 2007.
It all started with a boom. Between 2002 and 2007,
housing markets in the Anglo-Saxon economies were
booming at unprecedented levels. The great housing
boom was supported by cheap and plentiful credit
and the widely held belief that house prices would
continue to rise. In the 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. ‘Sub-prime’ designates
a category of borrowers who otherwise would be
considered ‘high-risk’ clients: they had poor or no
credit histories. But in the booming housing market,
supported by opportunities to manage the high risks
that the new financial system offered, these clients were
now granted access to credit and could own a house
on what appeared – initially at least – to be favourable
and affordable rates.1 The expansion of the mortgage-
backed securities (MBSs) market drew investors into
some of the more risky tranches of MBS debt. In 2006,
the US sub-prime market was worth $600bn, or 20
per cent of the $3 trillion mortgage market.2 In 2001,
sub-prime loans made up just 5.6 per cent of mortgage
dollars. In global terms, American MBSs became the
largest component of the global fixed income market,
accounting for a fifth of its value.
Yet it was as early as 2006 that the price increases in
the American housing market slowed down, and the first

wave of mortgage delinquencies started to spread. The

trigger to the rising number of defaults was the increase
in the interest rate, which climbed to 5.35 per cent in
2006, from 1 per cent in 2004. Also, crucially, in 2006
the structure of US sub-prime mortgages shifted many
borrowers out of their initial (presumably favourable)
fixed-rate terms, thereby increasing the interest payment
on the loans. Observers offered different readings of this
trend: some argued that despite the notable increase in
bankruptcies, the trend historically was insignificant
(IMF 2007: 5). Others began to anticipate a bigger wave
of defaults and bankruptcies: most 2006 borrowers
were still in the ‘teaser rate’ period of their mortgages.
According to the structure of sub-prime loans, their
repayments were due to rise in a year or two. Some
sceptics warned that against this background a default
of one or two financial companies could well spark a
worldwide financial crisis. The words of reassurance,
for those who needed them, came from the architect of
mortgage-backed finance himself, Lewie Ranieri, who
said: ‘I think [the risk] is containable … I don’t think
this is going to be a cataclysm’ (in Kratz 2007).
The sceptics were proven right. Homeowners,
many of whom could barely afford their mortgage
payments when interest rates were low, began to default
on their mortgages and defaults on sub-prime loans
rose to record levels. By the end of 2006, sub-prime
delinquencies more than 60 days late jumped to
almost 13 per cent, compared to 8 per cent in 2005.
Commentators explained this by the fact that in 2006

t he stag es of t he m e lt downâ•… 2 7
some of the more neglected sub-prime loans had

reached their refinancing limits, and borrowers could
no longer afford to pay the mortgage on a new, and
higher, interest rate. The number of bankruptcies and
foreclosures also rose: according to Moody’s, in 2006 it
reached almost 4 per cent, compared to 2.2 per cent for
a similar type of loan originated in 2004. 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). Eventually, the
housing boom stalled and, through the complex web of
mortgage-backed finance, started to affect the financial
and banking system more generally.
The winter of 2006–7 brought the first signs of the real
magnitude of the coming meltdown. On 22 February
2007 HSBC, the largest sub-prime lender in the US
and a leading investment bank globally,3 announced a
$10.5bn loss in its mortgage finance subsidiary, HSBC
Finance. Market sceptics immediately read this as a sign
of a greater trouble ahead: HSBC’s total annual profits
were around $15bn. Many smaller sub-prime lenders
were already facing bankruptcy.4
At the time, a giant like HSBC could write off the
$10bn loss and escape relatively unscathed from the
mounting market distress. Smaller sub-prime lenders
operating on the American markets were in a less
healthy position. In March 2007, news of heavy
losses from the ailing sub-prime market hit American
building companies. This fuelled fears of bankruptcy in
several sub-prime lenders, most notably New Century

Finance Corporation, at the time the largest American

independent sub-prime mortgage lender. In just a
few weeks, on 2 April 2007, New Century Financial
Corporation filed for Chapter 11 bankruptcy. The fall
of the company marks the point when tensions in the
sub-prime mortgage markets started to affect Wall
Street directly.
Interestingly, even as the prospects for the housing
market and financial boom darkened, commentary at
the time viewed the unfolding downturn as no more
than a cyclical adjustment to the otherwise normal
trend of rising house prices, rather than as a systemic
breakdown in finance and the economy. The IMF, for
instance, explained the downturn as a combination of
regional economic factors and a shift in the US mortgage
market. Specifically, 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). According
to the BIS, this reflected a ‘seemingly orderly re-pricing
of credit risk’, conditioned by changing economic and
policy factors in the US economy (Borio 2008: 5).
From Sub-Prime Crisis to the Global Credit Crunch
Notwithstanding the optimism in the markets, over the

following few months the sub-prime crisis escalated
as more and more high-ranking companies, including
UBS and the investment bank Bear Stearns, announced
write-downs. In July 2007, Bear Stearns told investors

they would get little, if any, of the money invested

in two of its hedge funds after rival banks refused to
help it bail them out. Federal Reserve chairman Ben
Bernanke estimated that the sub-prime crisis could cost
up to $100bn.
As large financial houses were calculating their losses
from sub-prime loans, the credit ratings agencies were
downgrading asset-backed securities (ABSs), sub-
prime-backed bonds and collateralised debt obligations
(CDOs). By early August 2007, the list of casualties
of the implosion included the hedge fund run by Bear
Stearns, Countrywide Financial, a US home loan lender,
American Home Mortgage Investment Corporation,5
and the German bank IKB.6
The fateful date 9 August 2007 became the official
anniversary of the global credit crunch. On that day,
the largest French bank, BNP Paribas, 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. Reacting to the news, the world’s financial
indices went into free-fall and pretty much remained
there over the following months. Central banks around
the world immediately offered liquidity support in
an attempt to stem the panic. On 9 August 2007,
the European Central Bank (ECB) injected €95bn
into the overnight markets and the Federal Reserve
injected $38bn; other central banks followed with
similar actions over the following weeks. In the space
of just a few days in mid-August 2007, the world’s

central banks pumped an extraordinary $240bn into

the ailing markets. Aside from liquidity injections,
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.7
Despite these collective and unprecedented efforts to
restore optimism in the markets, the first stage of the
global meltdown – the sub-prime crisis in the US – had
not been brought under control. Through its effects on
the financial markets worldwide and, in particular, by
harming those financial institutions that relied heavily
on wholesale credit markets, it was transformed from a
crisis in one segment of the market into an international
banking crisis and global credit crunch. The best known
of the casualties during this second phase was the
British bank Northern Rock, which went bankrupt in
August–September 2007 and had to be nationalised.
Northern Rock
Just days into the unfolding malaise in the financial

markets, on 13 August 2007, the Financial Services
Authority (FSA), the UK financial watchdog, was
reportedly informed that the country’s fifth largest
mortgage lender, Northern Rock, might be facing a
liquidity crisis. With this, the first run on a bank in the
UK for a century, and a subsequent political scandal,
started to unfold.

t he s tages of t he m e ltdown â•… 31
In 2006–early 2007, Northern Rock had a portfolio

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

conditions, rather than a serious structural problem.

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

th e stage s of th e m e ltd own â•… 3 3
the crisis continued to accelerate into the summer and

autumn of 2008.
The next dark moment in the crisis chain came in
mid-summer 2008. On 14 July, the two largest lenders
in the US – Fannie Mae and Freddie Mac – appealed
for help from the US government. They had been the
drivers of the mortgage securities markets, owning
or guaranteeing $5 trillion worth of home loans, or
nearly half of the US’s $12 trillion mortgage market.
On the other side of the Atlantic, signs of recession were
becoming more visible. In late August 2008, the UK
Chancellor, Alistair Darling, warned that the economy
was facing its worst crisis in 60 years and added that the
downturn would be more ‘profound and long-lasting’
than most had feared.
From Global Credit Crunch to Global Recession
The week of 7–15 September 2008 was the darkest to

date in the history of the credit crunch. On 7 September,
Fannie Mae and Freddie Mac were taken over by the US
government in one of the largest bailouts in US financial
history. The pressure, according to market consensus
and common sense, came from China, the largest holder
of US debt.9 Although the Chinese government made
no official comment at the time, 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.

Three days later, Lehman Brothers – one of the

largest Wall Street banks – posted a loss of $3.9bn for
the three months to August 2008. On 15 September
2008, after several futile attempts to find a buyer or
secure governmental rescue, Lehman Brothers filed for
bankruptcy protection under Chapter 11. 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. Alan Greenspan described the
fall of Lehmans as ‘probably a once in a century type
of event’. Markets went into free-fall for weeks in a
row, representing the biggest erosion of financial wealth
since the 1930s. Direct comparisons with the 1930s
crisis and projections of a global depression became
commonplace. The situation worsened as another
high-profile US bank, Merrill Lynch, agreed to be taken
over by Bank of America for $50bn (BBC 2009).
The second half of September 2008 witnessed
several attempts by governments to tame the panic
in the markets and save individual institutions from
bankruptcy. In the US, the Federal Reserve authorised
an $85bn rescue package for the country’s biggest
insurance firm, AIG, in return for an 80 per cent stake
in the company.10 Several months later, it would emerge
that having received the bailout, AIG paid out hundreds
of millions of dollars in bonuses to its senior executives.
Under pressure from an angry Congress, AIG eventually
had to list the firms to which the money was actually
paid. These included top US firms Goldman Sachs

($12.9bn),11 Merrill Lynch ($6.8bn), Bank of America

($5.2bn), Citigroup ($2.3bn) and Wachovia ($1.5bn).
The major foreign banks included Société Générale and
Deutsche Bank (nearly $12bn each); Barclays ($8.5bn)
and UBS ($5bn). In total, AIG named nearly 80
companies and municipalities that benefited most from
the Fed rescue, though many more receiving smaller
payments were unnamed (Williams Walsh 2009). 12
In the UK at around that time, HBOS, the country’s
biggest mortgage lender, was facing bankruptcy. Lloyds
TSB took over the ailing bank in what would soon
prove to be an unwise £12bn deal. On 25 September,
US mortgage lender Washington Mutual (whose assets
were valued at $307bn), was closed down and sold off
to JP Morgan Chase.
Towards the end of September, policymakers in
the US drafted a massive $700bn rescue package for
the American financial system. The deal allowed the
Treasury to buy up ‘toxic debt’ from ailing banks.
It was the biggest public intervention in the markets
since the Great Depression and would take weeks to
be approved by Congress. Political disagreements and
uncertainties over the nature of the deal continued to
send shockwaves through the global financial system.
Meanwhile, the credit crunch spread further into
the European banking systems. Fortis, a banking and
insurance giant, was nationalised. The UK’s Bradford &
Bingley – the largest provider of ‘buy to let’ mortgages
in the country (controlling around £50bn of mortgages)
– was part-nationalised, part-sold to the Spanish bank

Santander. Meanwhile, facing a currency attack and

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

institutions accelerated their withdrawal from even short-term
funding of banks, and banks increasingly lost confidence in the
safety of lending to each other. Funding costs rose sharply and for

t he stag es of t he m e lt downâ•… 37
many institutions it was possible to borrow only overnight. Credit

to the real economy almost stopped flowing … Eventually, on 6 and
7 October even overnight funding started to dry up. (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). Over the weekend of
4–5 October 2008, the committee drafted a rescue plan
(later known as the Brown-Darling bank recapitalisa-
tion plan), and over the course of the following weeks,
similar action was adopted by most countries affected
by the credit crunch, with the major European countries
following the UK in authorising massive recapitalisation
plans for their financial system. The US government
unveiled a $250bn (£143bn) plan to purchase a stake
in a number of banks in an effort to restore confidence
in the sector.
Nevertheless, these extraordinary policy efforts
appeared ineffective, as markets and economies
continued to stumble, reacting to weakening economic
data and ever more tangible signs of economic recession
on both sides of the Atlantic. By early November
2008, despite interest rate cuts and other state efforts
to restore confidence in the economy, recession trends
set in and spread globally, affecting economic growth
in the emerging markets.14 The continuing crisis and
deepening recession prompted multi-level attempts
to form a coordinated global policy plan to reform
international financial architecture, yet as Chapter

6 below shows, disagreements over the appropriate

course and tone of regulatory action opened up at the
transatlantic level.
By 2009, the global financial crisis had been
transformed into a global recession. Diagnoses and
projections of the nature and duration of the meltdown
became more and more pessimistic, with some believing
that the financial markets would not recover their
pre-crisis levels until 2012. Official institutions adjusted
their estimates of total losses to much higher levels.15
Overall, over the course of its two-year history, 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. Data
reflecting real economic losses globally are sobering.
In March 2009, the Asian Development Bank (ADB)
reported that the crisis had precipitated a total loss
of worldwide market wealth of $50 trillion, with
developing Asia – where losses totalled $9.6 trillion,
or just over one year’s GDP – suffering more than other
regions of the emerging markets. This figure not only
exceeds all previous estimates of sub-prime-related
losses, but is close to a year’s world output.16 The loss
of stock market wealth alone amounts to $25 trillion.
At the end of 2008, demand for manufactures, world
manufactured output and world trade in manufactures
had fallen off a cliff: Germany’s industrial output was
down 19.2 per cent year-on-year in January, South

t he stages of t he m e lt down â•… 3 9
Korea was down 25.6 per cent and Japan down 30.8
per cent (in Wolf 2009).
The sheer severity and scale of the global meltdown,
as well as uncertainties over its potential effects on the
economic activity and politics globally, have spawned a
rash of explanations and theories of the credit crisis and
its major lessons. But before delving into the emergent
schools of thought, let us take a closer look at one
particular event that, as argued in this book, epitomises
the politics and economics of the credit crunch: the
fiasco of Northern Rock.

2
The Tale of Northern Rock:
Between Financial Innovation
and Fraud
Anastasia Nesvetailova and Ronen Palan
In January 2006, London’s Credit Magazine, one of the

financial industry’s glossy periodicals, congratulated
Whinstone Capital Management fund – a part of the
British bank Northern Rock – on winning the award
for the best securitisation deal of 2005. The deal,
it was reported, was the first European securitisa-
tion programme to transfer ‘first-loss risk’ through a
credit default swap contract. In technical terms, the
transaction represented the largest public placement of
double-B risk – £117.4 million – and one of the largest
subordinated debt issuances ever in the European
market. Essentially, it allowed Northern Rock to offload
more risk from its balance sheet.
David Johnson, operational director for securitisa-
tion at Northern Rock, explained that the Whinstone
transaction allowed the fifth largest UK mortgage lender
to reference the reserve funds of 13 Granite transactions,
three of which were stand-alone issues and the other
ten under the Master Trust programme. ‘The beauty
40

t he tale of nort he r n ro ckâ•… 4 1
of it’, he declared, ‘is in its simplicity, 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, January 2006).
*â•… *â•… *
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, greed and fraud.
In the winter of 2007, Northern Rock was valued
at £5bn; by February 2008, the bank’s shares had
dropped to 90p per share, reducing the value of the
company to £380 million. On 18 February 2008, the
UK government announced a controversial decision to
nationalise the bank. Northern Rock, along with other
high-profile financial collapses, such as Bear Stearns
and Lehman Brothers in the US, Bradford & Bingley
in the UK, Fortis in Belgium and most of the Icelandic
banks, became victims of a convoluted chain of secu-
ritisation techniques that centred on the sub-prime
mortgage industry in the US, but soon paralysed the
world financial system.
As the securitisation boom of the decade ground to
a halt in the summer of 2007, observers on the left and
right started to argue, quite persuasively, that securi-
tisation techniques had never discovered new ways of
managing or optimising risk; they merely disguised or

reparcelled it. But if the real foundations of financial

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

th e ta le of nort h e r n ro ckâ•… 4 3
The Controversy Over Financial Innovation
For the past three decades, financial innovation has

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

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

critics at the time said that the measure was neither

well coordinated nor justified by the market’s need
(Buiter 2007), this example of international regulatory
innovation was one of the few of its kind. (The only
previous example of such coordinated effort dates back
to the policy response to the 9/11 attacks.)
Generally, the most recent wave of financial
globalisation, dating back to the late 1960s, is,
according to many critics, an outcome of the complex
interplay of incentives and governmental controls over
finance. For instance, 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. The Act was designed
to compensate banks for the difference in interest rates
between the European and the US financial systems, and
attract American funds back into the US economy. In
fact, American banks not only failed to repatriate their
investments, but opted not to leave the Euromarket
altogether (Palan 2003). Generally, therefore, the
interaction between regulation and innovation tends
to bring out the evolutionary, rather than structured
or revolutionary, character of financial globalisation,
or financialisation.
Financial innovations rarely emerge ab initio. Any
new product or practice needs a motive and a context
in which to thrive. Commonly, economic and structural
changes that prompt a wave of financial innovation
include: (i) volatile inflation rates and interest rates;
(ii) regulatory changes and the circumvention of

regulations; (iii) tax changes; (iv) technological

advances; (v) the level of economic activity; and (vi),
interestingly, 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. 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, 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, without necessarily breaking the
law’ (Miller 1986; van Horne 1985, cited in Shah
1997). Specifically, the ability to avoid regulation
may provide competitive advantage to firms in the
deregulatedÂ€market:
A legally based level playing-field opens up new sources of competitive
advantage, with some more able than others to creatively escape
even harmonised regulatory restrictions. The rules of the level
playing-field themselves become obstacles to some but not all.
Regulation … becomes a further stimulus for innovative use of law
both to defeat unwelcome regulation and to secure advantage over
competitors. (McBarnet and Whelan 1992, cited in Shah 1997: 86)
At the time, 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

t he tale of nort he r n ro ckâ•… 47
the help of investment bankers and lawyers. In turn,

the regulators, 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-compli-
ance or evasion … The collusion between management,
bankers, 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).
The nexus between these two elements – self-
regulation of the financial industry itself and the
ambiguity that exists at the juncture between law and
new financial practices, particularly in common law
countries – created a grey zone for competitive financial
innovation. Thriving in this zone, financial innovation
has produced a skewed structure in the financial system
itself. When interest rates are low and the traditional
function of financial intermediation – taking deposits
and lending – is no longer appealing, financiers look for
alternative ways to make money through commission
fees, tax avoidance and evasion, ‘creative accounting’
and, often, outright fraud. These elements, obscured by
the general euphoria of the 2002–7 credit boom and
disguised by the sophisticated techniques of modern
finance, were at the heart of the Northern Rock fiasco.
Worryingly, they are also representative of more general
trends in the financial industry.

Offshore: The Uses and Abuses of SPVs
Most financial crises in the past two decades, including

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

yet crucially they do not have the resources, especially in

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

would like to stress, though, that we do not see the two

as being the same thing.
Table 2.1â•… The Share of OFCs in International Financial Flows,

2007
All countries $29,164.7bn % share
Caymans 1,691.3 5.8

Switzerland 1,413.0 4.8
Netherlands 1,226.3 4.2
Ireland 1,218.8 4.2
Singapore 773.5 2.6
Luxembourg 761.5 2.6
Bahamas 436.5 1.5
Jersey 326.3 1.1
Guernsey 210.1 0.7
Bahrain 205.0 0.7
Isle of Man 71.9 0.3
Total 8,334.0 28.5
Source: BIS, International Financial Statistics, 2008.
SPVs hit the headlines following the collapse of

Enron. The Powers Committee, which investigated
Enron’s collapse, reported that the company created
complex financial arrangements, partnerships and SPVs
in order to shift debt around and make illicit payments
to its directors. The report states that ‘[m]any of the
most significant transactions [of Enron] apparently were
designed to accomplish favorable financial statement
results, not to achieve bona fide economic objectives
or to transfer risk’ (Powers, Troubb and Winokur
2002: 4). Enron’s fraud was organised through 3,000

SPVs ‘with over 800 organised in well known offshore

jurisdictions, including about 120 in the Turks and
Caicos, and about 600 using the same post office box
in the Cayman Islands’ (US Senate 2002: 23).
Nevertheless, despite headline reports, neither
the Powers Report nor the congressional hearings
demonstrated that offshore structures were palpably
more poisonous that the onshore ones in the Enron
case. It appears, rather, that Enron’s offshore SPVs were
set up primarily for tax avoidance purposes.
In this context, 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.
Northern Rock and Granite
Northern Rock, the fifth largest mortgage lender in the

UK in early 2007, began life as a building society in
1965. Building societies typically raise the money they
lend conventionally, by attracting it from depositors.
Banks, on the other hand, can get ready access to
larger sums from the money markets. In 1997, after
the wave of demutualisations of the 1990s, Northern
Rock became a public limited company. Northern Rock
was different from conventional commercial banks in
that it had a small deposit base and relied heavily on
wholesale money markets for its funds. This was an
aggressive expansion technique: the audit of Northern
Rock’s accounts in 2006 showed that it raised just 22

per cent of its funds from retail depositors and at least

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

th e ta le of nort h e r n ro ckâ•… 5 3
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

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

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

several fundamental problems that financial regulators

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

health of the bank. It transpires that the FSA had

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

faulted for overriding the terms of the agreement and,

by taking the initiative in the Northern Rock case,
imposing a political solution to nationalise the bank
(Lascelles 2007).
Fourth, the tripartite arrangement as a whole failed
in the task of passing information from the FSA to
the Treasury. On 14 August 2007, the Treasury was
told that Northern Rock might run out of money; a
month later, on 14 September 2007, the bank did just
that. In the period between those dates, the Treasury
did nothing to prevent the collapse (Moulton 2008).
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. 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, as is maintained in
this book, is one of the many uncomfortable puzzles
of the credit crunch.
The Northern Rock crisis has raised many issues
about how private financial gains and socialised losses
are addressed by political leaders. (In 2006, Northern
Rock’s former CEO, Adam Applegarth, was paid
$1.36 million. During 2007, he cashed in shares worth
more than £2 million. When he resigned, Applegarth
reportedly was paid a $1.5 million bonus. In the midst
of the collapse, the bank’s senior management were

offered £100,000 in compensation pay.) But apart from

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

it found itself in. Private investors are not as forgiving.

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

profitable, in the end proved to be a dangerous and

destructive myth.
But before we turn to this part of the story, it is
worth examining how the crisis has been understood so
far and what questions about the global credit crunch
remain unanswered.

3
How the Crisis Has
Been Understood
The continuing economic malaise has produced a

whole industry of credit crunch analytics. These range
from popular commentary, blogs on crisis-related
issues and journalistic investigations, to high-profile
policy discussions commissioned by official bodies and
academic analyses. Focusing mainly on the latter, this
chapter aims to systematise the spectrum of emerging
views on the nature and implications of the financial
meltdown. Whilst readings of the crisis do overlap,
broadly there are two ways to differentiate and classify
the rapidly evolving theorisations of the credit crunch:
on the basis of time and on their theoretical grounding.
Ex-Ante and Ex-Post Visions of the Credit Crunch
At first cut, credit crunch theories can be divided into

ex-ante and ex-post explanations. The ex-ante theories,
as the term suggests, are those that warned about the
possibility of such a collapse – and eventually predicted
it – before the events of 2007 engulfed world markets.
Ex-post explanations were put forward once the crisis
started to engulf world markets.
62

how t he crisis has b een u n d e r s too d â•… 63
Within this rather broad classification, the ex-ante

theories originated both in a simple ‘gut-feeling’
understanding of what was happening in the financial
markets, the sheer sense that the Anglo-Saxon economies
were overheating and asset and financial bubbles would
soon burst, and deeper scholarly analyses of the credit
system that detected profound abnormalities and
tensions accumulating in the economies of ‘advanced’
Anglo-Saxon capitalism. 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
structuralÂ€crisis.
Apart from the timing, the basic difference between
these two schools of thought is their reading of the place
of finance in the evolution of capitalism more broadly.
Specifically, the distinction focuses on what is ‘normal’
and what is ‘abnormal’ in the structure and functioning
of the economic system, 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, communications and finance, as well as
globalising trends across markets, polities and cultures),
as opposed to ‘capitalism as usual’ (a system marked
by periodic crises, conflicts of interest and profound
structural dislocations).
Here, 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. Whereas more pessimistic predictions of
the imminent collapse of US debt-driven consumption

emphasised the destructive role of unprecedented

levels of debt in the US and the global economy, many
ex-post theories of the credit crunch interpret the rise of
debt and consumption as sustainable and constructive
features of the new type of economy. Ultimately, as
argued from these perspectives, the deregulation of the
financial system has popularised access to credit and
finance, making the economy more flexible, efficient
and diversified.
The Global Credit Crunch as an Exogenous Shock
Within this ex-post group of analyses, one interpreta-

tion of the crisis stands out: the reading of the global
credit crunch as a ‘surprise’ event – a shock that took
most financiers, market regulators, political leaders and
observers totally by surprise. 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, during the credit boom
such ideas were at best taken as purely hypothetical and
remote possibilities. In most cases, they were simply
dismissed or, worse, penalised. Instead, the dominant
mood in the markets during 2002–7 is probably best
expressed in the admission of a risk manager of a global
bank, who preferred to remain anonymous:
We were paid to think about the downsides but it was hard to see
where the problems would come from. Four years of falling credit
spreads, low interest rates, virtually no defaults in our loan portfolio

how th e crisis has b e en u n d e r s to o dâ•… 65
and historically low volatility levels: it was the most benign risk
environment we had seen in 20 years. (The Economist, 7 August 2008)
As a result, according to his colleague at Barings,

the air of general optimism translated into pervasive
short-termism and lack of basic foresight and account-
ability among market players:
… things go in cycles. Anyone who believes things are going to go
on up forever is a fool. Everyone borrowing up to their eyeballs, we
went through this in the eighties and early nineties. We said then:
‘Well hell, it doesn’t matter if I’m running up the money on my credit
cards because next year I’m going to earn more.’ (in Gimson 2008)
Moreover, even if risk managers did acknowledge that

the history of finance offers unsettling lessons about
bubbles and crises, and that some events in the markets
in 2006 had implied that the credit boom might unravel,
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, the crisis should have been a relatively
minor event in finance, reflecting a price correction in
one isolated sector of the global economy – the US
sub-prime mortgage sector (Dymski 2009). 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, taking the
real economy into recession. In hindsight, this logic
seems rather odd. All booms, whether small or large,
eventually come to an end, typically with a crash, crisis
or painful recession. The fact that house prices and the

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

memory of earlier recessions or even structural financial

crises. While most of them would be familiar with the
story of the 1929 Crash, and many might remember the
collapse of Barings in 1995 or the 1998 LTCM fiasco,
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. Indeed, as one insurance
broker noted:
We did the South Sea Bubble at school, so we know how it works
… It was clear that the property bubble was going to burst but it
would have been nice if it had deflated slowly rather than popped.
(in Gimson 2008)
During the boom years of 2002–7, therefore, as

far as this new generation was concerned, their role
was to make the sophisticated and complex financial
markets work more efficiently, 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. 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.
Interestingly, the ‘shock’ vision of the global crisis
has also been common in courtrooms and on news
screens. Criticised for his direct role in creating the
bubble of easy credit during the 1990s/early 2000s,

Alan Greenspan called the crisis a ‘once-in-a-century

phenomenon’ (Greenspan 2008b). Defending Ralf
Cioffi, 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, including the Fed and the
Treasury. Dozens of the largest financial institutions in
the world have lost over $300 billion to date on the
same investments’ (Kelly 2008).
Baffled and incapacitated by the scope of the
meltdown, regulators and policymakers also tend to
emphasise the extraordinary character of the crisis
and the fact that it took most people by surprise. In
October 2008, Lord Turner, a newly appointed boss of
the FSA, noted: ‘In April of this year everybody knew
that something pretty big had happened to the world’s
financial system. What we had no idea, bluntly, was
how extreme it was going to be …’ (Financial Times,
17 October 2008). The British prime minister, Gordon
Brown, 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. But sometimes the reality is that defining moments of history
come suddenly and without warning … An economic hurricane has
swept the world, creating a crisis of credit and of confidence. (Brown,
4 March 2009)
Outside the courtroom, however, it simply does not

make sense to view the crisis as a surprise or shock.
Indeed, the risks unleashed and accentuated by the

securitisation process, 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. To
take just one example, William White of BIS observed
in 2006:
… the opacity and complexity of the financial system today shrouds
in secrecy who finally bears the risks, and increases the likelihood of
operational problems. More broadly, the reliance of banks in many
countries on revenues from dealing with the household sector,
already heavily indebted, 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. (White 2006: 5–6)
So what should one make of ‘shock’ explanations of

the credit crunch? On the one hand, it is understand-
able why many market practitioners and politicians
view the global crisis as a once-in-a-lifetime, certainly
a once-in-a-career, event. According to the philosophy
of self-regulating and self-correcting markets, the global
financial system seemed to have worked smoothly and
efficiently for several decades. When it did experience
breakdowns (in 1982, 1987, 1994–5, 1997–8 and
2000), they were easily dismissed as problems specific
to the financial structure of the emerging market
economies, or – in the case of the crises of the LTCM,
Enron, Parmalat, etc. – as isolated episodes reflecting
troubles in individual firms. Either way, none of the
financial crises of the past 30 years was understood

to require a global response, essentially because it did

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

how t h e crisis has b e en u n d e r s to o dâ•… 7 1
the global meltdown has become one of the dominant

theories of the credit crunch in policymaking circles in
both the UK and US.
The ‘exogenous shock’ readings of the global
meltdown therefore appear opportune to those who are
reluctant to question the underlying belief in the self-
correcting forces of the market and interpret all major
disruptions – however frequent – as extraordinary
events. At the same time, the emergent theories of
the credit crunch have incorporated deeper scholarly
inquiries into the nature of finance today. Broadly,
these views can be classified as structural or cyclical
explanations of the global meltdown.
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.
As such, 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, in
reality the meltdown is more pervasive, overlapping
the political, social, economic, cultural and ideological
foundations of market-based capitalism. Thus
emphasising the historical origins of the current crisis,
structural theorists view it as a specific, but largely
predictable result of the operation of a type of economy
that had replaced the Keynesian welfare state of the

1950s–1960s with a neoliberal model of capitalism. 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, debt-financed
consumption, minimal savings, deregulated capital
markets, the consumer-driven pattern of recovery from
previous crises and a general hedonistic basis of socio-
economic relationships that have come to define the
culture of American-style capitalism (Altvater 1997,
2002; Pettifor 2003; Tily 2007; Shiller 2008; Turner
2008; Wade 2008; Gamble 2009; etc.).
Debt, and its role in the overall economic organisation,
is the key structural cause of the meltdown. The levels
of borrowings, both private and corporate, have been
growing much faster than incomes and wages in the
Anglo-Saxon economies. And according to Turner
(2008), the growth of debt-financed consumption and
business activity has been more pronounced in the UK,
leaving the country more vulnerable to the effects of the
credit crunch. 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). In 2007, individuals in the UK held over £1.5
trillion in debt, and total private sector debt had risen
from 133.5 per cent of GDP to 227.4 per cent during the
first ten years of the New Labour government, higher
than in any other major industrialised economy. In the
US over the course of the decade, personal debt jumped
from $5,547.1bn to $14,374.5bn. The ratio of debt

how t he crisis has b een u n d e r s to o d â•… 7 3
to disposable income went up from 93.4 per cent to a

post-1945 record of 139 per cent (Turner 2008: 26–7).
This vast growth of debt was evolving into what
George Soros (2008) has called a ‘super-bubble’ – a
concoction of a housing bubble, an explosion of
leveraged buyouts and other financial excesses. 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, or what
Greenspan called ‘active credit management’ (in Morris
2008: 61). In the long run, both the credit super-bubble
and debt-financed consumerism were unsustainable,
and thus unravelled, sparked by the fiasco of the
sub-prime industry in the US.
Many historically-oriented and systemic visions
see the crisis, therefore, as an inevitable result of
the Anglo-Saxon mode of capitalist organisation.
Emphasising the role of key features of such a model,
they also point out that economies that have followed a
different trajectory – such as the ‘welfare’ capitalism of
continental European states or the Asian developmental
economies – have escaped the excesses of financial
speculation and debt-dependent growth. Essentially,
therefore, 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. In this instance, it is interesting that another
group of structural theories of the credit crunch takes

a diametrically opposite view, effectively blaming the

crisis on the role of emerging markets – mainly East
Asian exporters – in skewing the balance in the world
macro-economy.
International Imbalances: Naughty Asian Exporters
This school of thought views the credit crunch as a

result of a structural discrepancy at the international
level. Essentially, so the argument goes, the crisis is the
unwitting outcome of an abnormal state of affairs in
world financial flows. The abnormality has been noted
by many, not least by the economist Ben Bernanke,
who in 2005 explained the huge increase of US current
account deficit by ‘a remarkable reversal in the flows of
credit to developing and emerging-market economies,
a 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.
Trying to rebuild their economies in the wake of the
1990s crises, the governments of these countries
have acted as financial intermediaries, channeling domestic saving

away from local uses and into international capital markets. A related
strategy has focused on reducing the burden of external debt by
attempting to pay down those obligations, with the funds coming
from a combination of reduced fiscal deficits and increased domestic

debt issuance. Of necessity, this strategy also pushed emerging-

market economies toward current account surpluses. (ibid.)
6 6
4 Emerging Asia 4
2 2
0 0
–2 –2
–4 –4
–6 United States –6
–8 –8
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
Figure 3.1â•…Current Account Imbalances as a Percentage of GDP

(1975 Q1–2006 Q4)
Source: Bracke and Fidora 2008.
Overall, Bernanke argued, this shift by developing

nations, together with the high saving propensities of
Germany, Japan and some of the other major industrial
nations, resulted in a ‘global savings glut’. 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, reducing US national
savings and contributing to the nation’s rising current
account deficit.
Within the US, widening homeownership was
supported and facilitated by securitisation – the ability
of financiers to price the risk in mortgages and other
loans, and to diffuse it effiÂ�cientÂ�ly through the advanced
system of financial intermediation to those who were
assumed to be best placed to bear it:

The development of a broad-based secondary market for mortgage

loans also greatly expanded consumer access to credit. By reducing
the risk of making long-term, fixed-rate loans and enÂ�surÂ�ing liquidity
for mortgage lenders, the secondary market helped stimulate
widespread competition in the mortgage business. The mortgage-
backed security helped create a national and even an interÂ�Â�national
market for mortgages … This led to securitisation of a variety of
other consumer loan products, such as auto and credit card loans.
(Greenspan 2005)
At the time, a similar understanding of the global

liquidity glut was ofÂ�fered by the BIS. 1 The bank
commented that ‘conditions in the major finÂ�anÂ�cial
markets remained calm and accommodative for much
of 2005 and early 2006, reflecting the surprisingly
strong performance of the world economy and still
abundant liquidity’ (BIS 2006: 98).
However ‘abnormal’ though, 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’. Within this unique
arrangement, it was argued, 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. Dollar reserves, in
turn, reflected ‘the exceptional depth and liquidity of
the US financial markets, which makes it attractive for

how t he crisis has be en u n d e r s to o d â•… 7 7
Table 3.1â•… Global Current Account Balances, 1996 and 2003

(billions of US dollars)
Countries 1996 2003
Industrial 46.2 –342.3

United States –120.2 –530.7
Japan 65.4 138.2
Euro Area 88.5 24.9
France 20.8 4.5
Germany –13.4 55.1
Italy 39.6 –20.7
Spain 0.4 –23.6
Other 12.5 25.3
Australia –15.8 –30.4
Canada 3.4 17.1
Switzerland 21.3 42.2
United Kingdom –10.9 –30.5
Developing –87.5 205.0
Asia –40.8 148.3
China 7.2 45.9
Hong Kong –2.6 17.0
Korea –23.1 11.9
Taiwan 10.9 29.3
Thailand –14.4 8.0
Latin America –39.1 3.8
Argentina –6.8 7.4
Brazil –23.2 4.0
Mexico –2.5 –8.7
Middle East and Africa 5.9 47.8
Eastern Europe and former Soviet Union –13.5 5.1
Statistical discrepancy 41.3 137.2
Source: Bernanke 2005.

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 under-
developed and shallow: ‘Large Asian holdings of U.S.
debt are usually attributed to the region’s penchant for
undervalued home curÂ�rencies, 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 u n d e r s to o d â•… 7 9
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.

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 polit-
ical-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 u n d e r s to o d â•… 8 1
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

packages, securitisation and complex derivatives, which ultimately

proved unsafe. (Ambler 2008: 8)
Generally, it is argued, the crisis was the result of

long-run efforts by Anglo-Saxon governments to
encourage low-income people to become homeowners.
This socially motivated policy has relaxed lending
criteria in the financial industry and pushed financial
institutions into risky and opaque areas.
Altogether, therefore, 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. Rather,
the crisis was caused by a combination of factors –
policy-related, behavioural and market-specific – that
together diverted the markets away from a correct
strategy and attitude to pricing risks. As such, the
cyclical theory stands in stark contrast to those views
which emphasise that the sheer magnitude of the crisis
calls for an overhaul of the entire edifice of finance,
including the paradigm of financial regulation and
governance. Also, importantly, cyclical views of the
credit crunch accommodate another crucial aspect of
financial volatility: the human factor.
The Human Factor: Greed, Incompetence and

Exuberance
Within the range of cyclical theories of the crisis,

one strand of interpretation stands out in particular.

how th e crisis has b e en u n d e r s to o dâ•… 8 3
Broadly, it can be called the ‘greed, incompetence and

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

With increasingly fierce competition in the markets

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

how t he crisis has be en u n d e r s to o d â•… 8 5
institutions. It also has important implications for

various segments of financial practice and control. On
the one hand, it captures the inherent conflict between
financial market developments and the reach of the
regulatory oversight; on the other, it describes the
institutional transformations of banking and finance
that have paralleled the erosion of the function of
traditional banking, the rise of institutional investors
and the development of the ‘shadow banking system’,
and the corresponding transformations within financial
institutions themselves, now increasingly oriented
towards taking and passing on risks, rather than taking
on and managing the risks themselves. As such, these
schools of thought place greater emphasis on the role
of policymakers and regulators in creating the crisis, as
well as on the role of managerial practice and business
conduct within the financial industry itself.
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).
In the wake of the global crisis, the failure of regulatory
and supervisory bodies to read market developments
accurately has come to light on many occasions. Some of
the most staggering examples come from the UK, 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, their sluggish reactions to the
unfolding crisis and simply not being up to the task or

‘asleep at the wheel’. Anecdotes about the breathtaking

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

how t h e crisis has b e en u n d e r s to o dâ•… 8 7
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, unseen by, and not understood by the FSA or UK
Treasury’ (Ambler 2008).
There also emerged a peculiar state of affairs within
financial companies themselves, where senior managers
often had no idea about the composition, purpose or
even the name of the products their company was
trading in. They were mostly concerned that the
company’s trading techniques provided legitimate
means of raising funds off balance sheet (i.e. outside the
traditional set of requirements imposed by regulations)
and that they generated positive earnings. Interestingly,
in this instance financial engineers themselves were keen
to focus blame on the decision-making processes within
banks and financial companies:
As we have learned [in 2008], those responsible for the grossly
irresponsible credit derivatives trading and the ensuing risk exposure
were not people who had been quantitatively trained. Far too often,
they rose to their positions on other criteria, with deal-chasing ability,
sales, and other attention-deficit-promoting activities ranking high.
(Carmona and Sircar 2009)
Fourth, critics argue that it was the inadequate imple-

mentation of financial policy as much as its flawed
theoretical assumptions that precipitated the crisis. As
Willem Buiter (2008) writes, this problem was apparent

in all major geographical corners of the credit crunch.

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

bigger trend in Anglo-Saxon financial capitalism –

namely, the paradigm of soft-touch (or light-touch)
regulation advocated by the political regimes on both
sides of the Atlantic for the past three decades.
Altogether, the emergent schools of thought on the
global meltdown, individually and collectively, raise
many important questions about the structure, politics,
operation and governance of the financial system
today. Yet while analysing the many tentacles of the
highly complex crisis, they leave a host of concerns
about the crisis unaddressed. What, for instance, 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, wasn’t the securi-
tisation bubble one giant fraudulent scheme? In what
follows, this book addresses these questions.

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

uncomf ortab l e p uzzles of th e cre d i t c r u n c hâ•… 9 1
pressures will increase the combined public debt of

the wealthy economies to 200 per cent of GDP by
2030 (The Economist, 11 June 2009). Generations of
taxpayers, therefore, are destined to pay for the vagaries
of the credit boom.
These are just some of the long-term concerns
raised by the burst of the credit bubble. They centre
on the ethics of financial industry and the question
of social justice in financial capitalism. But the crisis
has also posed somewhat smaller, yet important,
questions about today’s finance which, so far, remain
unanswered.
Dismissed: The Warning Signs and the Whistleblowers
The first puzzle is the timing and the apparent

unÂ�predictability of the meltdown. As the markets
imploded, eroding the values of many companies and
individuals, many market players, including traders in
big investment banks, analysts and brokers, baffled by
the scale of the unfolding turmoil, have admitted that
nobody anticipated that a devastating collapse could
take place in the twenty-first century. Indeed, despite
occasional corrections to the markets, the West has
been enjoying a decade of unprecedented prosperity,
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,
globalised economy.

Yet in light of the arguments outlined in Chapter 3,

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

uncomfortab le pu zzles of t he cre d i t c r u n c h â•… 9 3
on the grounds that funds from wholesale sources could

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

As the Financial Times reported, the risk simulation

planning, conducted by the FSA, the Bank of England
and the Treasury, highlighted the systemic risks posed
by Northern Rock’s business model and its potential
domino effect on HBOS, then the UK’s largest mortgage
lender. According to a number of people well versed in
the subject, even though the exercise revealed the banks’
vulnerability, the regulators concluded they could not
force the lenders to change their practices. It was felt
that it was too harsh to say Northern Rock’s business
model was excessively risky, and in any case banks
following that strategy were profitable and growing,
though the Bank did warn of the growth in wholesale
deposits repeatedly in its financial stability reports.
Subsequently, 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.
In the US we learn that Bernard Madoff’s Ponzi
scheme came as a surprise to his clients, though not
to the auditors. In late 2006, 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, 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’. According to the accounts, Madoff Securities
had $1.3bn in assets, including $711m in marketable

uncomfortab l e p uzzles of th e cre d i t c r u n c hâ•… 9 5
securities and $67m in US debt. Members’ equity, the

firm’s net worth, was $604m. Such a ratio of debt to
equity made Madoff’s company a classic pyramid scheme
(Bloomberg News, 13 December 2008). In the winter
of 2008, Madoff confessed that his fund was indeed a
Ponzi pyramid. In the summer of 2009 he was sentenced
to 150 years’ imprisonment for financial fraud.
In circles closer to academic commentary, warnings
about the crisis were formulated more systematically.
In 2002 Avinash Persaud, an academic and market
practitioner advising many policymaking bodies,
published an article in the Financial Times warning
that the Basle II accord would be inadequate to prevent
a systemic banking failure and that the banks, typically
herding in the markets, were likely to suffer from
systemic collapse:
Large banks with their sophisticated internal risk systems have been
caught up in every market cycle. They lost considerable amounts
during the dotcom bubble and on companies with crooked accounting.
They may be about to do so again on their syndication of collater-
alised debt obligations – the next bubble to burst. (Persaud 2002)
In the same year, Warren Buffet, himself a successful

market player, famously described derivatives as
‘financial weapons of mass destruction’. 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. Let us take as an example Financial
Reckoning Day. Surviving the Soft Depression of the

21st Century, published in 2003. The book’s authors,

drawing on Hyman Minsky’s work, concluded
their study of the new, Ponzi-style era of consumer
borrowing and credit excesses in the US with a rather
pessimisticÂ€prognosis:
American consumer capitalism is doomed … The trends that could

not last forever seem to be coming to an end. Consumers cannot
continue to go deeper into debt. Consumption cannot go down
much further. Foreigners will not continue to finance America’s
excess consumption … And fiat paper money will not continue to
outperform the real thing – gold – forever. (Bonner with Wiggin
2003: 276)
They continued: ‘America will have to find a new

economic model, for it can no longer hope to spend
and borrow its way to prosperity. This is not a cyclical
change, but a structural one that will take a long time’
(ibid.: 256). There is also a whole current of academic
work in political economy and related disciplines that
had been warning about the unsustainability of the
credit boom and dangers of over-inflated asset markets
and mispriced risks. More interestingly, several research
publications by official financial institutions like the
BIS, in the run-up to the credit meltdown, noted the
dangers of overoptimistic risk assessments in the
markets. However, the dominant tone in the official
understanding of financial development remained
puzzlingly optimistic. In 2006, for instance, the
BISÂ€pondered:

uncomf ortab l e puzzles of t he cre d it c r u n c hâ•… 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. However, 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. Unfortunately, recourse to
such ‘fundamentals’ does not seem adequate to explain either the
extent or the duration of the unusual circumstances currently being
observed. This leaves room for a complementary explanation: these
phenomena might be linked to there having been such abundant
global liquidity over such a long period. (2006: 141)
Why was it, then, 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, no one wants to be the one who
stops the music. The sceptics and whistleblowers were
too few to mention, 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, strengthened by the forces of globalisation
and financial integration, could withstand a variety of
shocks, even if these did arise.
Another reason is political. The credit and financial
boom, supposedly heralding a new era of prosperity,
has been essential to the longevity of political regimes
on both sides of the Atlantic. In the UK during 2002–7,
the success of New Labour was founded on the greater
availability of credit to the population, the flourishing

position of London as a financial centre and the new

nature of economic growth which, as Gordon Brown
liked to repeat, meant ‘the end of the boom-and-bust’
character of the inflation-prone economic cycle with
which the Conservative Party was associated. 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.
In the US, on the other hand, the economy was never
a priority for President Bush and his administration. As
a result, the signs of growing economic fragility were
missed or simply ignored (Galbraith 2006). Indeed, in
2007, overlooking evidence of the deterioration in the
housing market and the growing risks of the debt-driven
financial expansion, it was observed in the Economic
Report of the President that:
The expansion of the U.S. economy continued for the fifth consecutive
year in 2006. Economic growth was strong, with real gross domestic
product (GDP) growing at 3.4 percent during the four quarters of
2006. This strong economic growth comes in the face of numerous
headwinds and resulted from the inherent strengths of the U.S.
economy and pro-growth policies such as tax relief, regulatory
restraint, and opening foreign markets to U.S. goods and servicesÂ€...
The Administration forecast calls for the economic expansion to
continue in 2007, but we must continue to pursue pro-growth policies
such as those designed to keep tax relief in place, restrain government
spending, slow the rate of health care inflation, enhance national
energy security, and expand free and fair trade. (2007: 23)

uncomforta bl e puzzles of t he cre d it c r u n c hâ•… 9 9
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. 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. According to Société Générale,
the inflation-adjusted income of the highest-paid fifth
of US earners has risen by 60 per cent since 1970, while
it has fallen by more than 10 per cent for the rest. It
appears that the Wal-Mart Walton family is wealthier
than the bottom third of the US population put together
– about 100 million people. In both the US and the
UK, during the decade of credit frenzy, Gini coefficients
(a measure of income inequality) were rising steadily
(Funnel 2009).
In the UK, reliance on finance-led growth produced
its own political dynamic. Under New Labour, the City
dominated the economy and emerged as a unique global
financial centre.3 Domestically, according to 2006 data,
financial and business services accounted for 45 per
cent of UK corporate tax income. The financial sector’s
high earners (earning £100,000+ p.a.) pay 25 per cent
of all income tax. At the peak of the credit boom, the
financial sector provided 40 per cent of jobs in London
(Caulkin 2006). At the same time, while its rivals in
New York and Tokyo, for instance, tended to service
domestic economies, London’s model historically had
been much more global, which made it a peculiarly

unregulated, offshore financial space where financial

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

uncomfortab le pu zzles of t he cred i t c r u n c h â•… 1 0 1
opportunity to make a lot of money by deceiving the

public by promising high returns from a new, fictitious,
venture. The securitisation boom of 2002–7 proved to
be no exception. As the crisis unfolded, more and more
cases of fraud, corruption and financial machinations
hit the headlines. Observing these cases, commentators
often talk about the global credit crunch as the collapse
of a gigantic Ponzi scheme. In essence, they view the
credit boom of 2002–7 and the process of securiÂ�
tisation as one massive industry of deceit and fraud.
Sophisticated financial means of trading and packaging
highly obscure financial instruments employed in securi-
tisation and re-securitisation deals were instrumental in
concealing not only bad lending and business practice,
but also, it transpires, scams and pyramid schemes as
legitimate investments.
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. First, the principle
of a pyramid scheme applied to the dynamics of the
sub-prime mortgage industry in the US – the epicentre
of the crisis. Second, Ponzi pyramids were exposed
as the particularly nasty practice of some high-profile
financiers, such as Bernard Madoff and Allen Stanford,
during the securitisation boom. Third, the notion of
Ponzi finance, reflecting the element of deceit and fraud,
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.

Ponzi Finance and ‘Sub-Crime’
In his financial instability hypothesis, Minsky (1982,

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

uncomfortab l e puzzles of t he cred it c r u n c hâ•… 10 3
First, the practice of providing people who have

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

mentioned by the scores of financial advisers who sold

the products to their clients.
In retrospect, the terms of borrowing and the
conditions for repayment appear to have been the
key block in the Ponzi pyramid of sub-prime loans.
Ponzi-type methods employed by lendÂ�ing institutions
included large pre-payment penalties, 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).5 In the aftermath of
the crisis, it also transpired that many lenders, enticed
by commission fees, were deliberately diverting clients
to more expensive sub-prime products, even when the
applicant could have qualified for a ‘prime’ loan.
The reasons why the sub-prime industry flourished
for so long go beyond economics. On the one hand,
sub-prime lending flourished in the US (and to a lesser
extent in other Anglo-Saxon countries such as the UK,
Australia and New Zealand) due to historically low
interest rates in the 1990s and 2000s which offered
ample opportunities for borrowers. On the other hand,
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. This
suggests that the Ponzi pyramid of sub-prime finance,
and the related securitisation boom, was facilitated by
the political climate in the Anglo-Saxon econÂ�omies and,
correspondingly, by the benign and ill-informed view of
the financial and monetary authorities of the risks posed

uncomforta b le pu zzles of t he cred i t c r u n c h â•… 10 5
by the expanding credit bubble. As noted above, the

housing and securitisation boom was in fact celebrated
by many officials on both sides of the Atlantic.
It is in the wake of the sub-prime fiasco that clear
evidence of mortgage fraud hit the headlines. 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, such as
Bear Stearns in the US. In the summer of 2008, FBI
investigators were homing in on 19 ‘large corporations’
– including investment banks, credit rating agencies,
accounting firms and hedge funds – as part of a
wide-sweeping probe into mortgage fraud. The majority
of the large corporate cases involved accounting
fraud, insider trading and failures to disclose – with
criminal intent – the proper evaluation of securitised
loans and derivatives. Journalists following the inves-
tigations likened the instances of sub-prime fraud to
the Enron and WorldCom scandals. As of June 2008,
406 defendants were charged in 144 cases across
the US.6 According to the Federal authorities, fraud
was a ‘contributing factor’ to the overall credit crisis
(Kirchgaessner and Weitzman 2008), which brings us
to the next terrain of Ponzi finance: the business of
securitisation itself.
The Ponzi Business of Securitisation
To date, two major cases of pure Ponzi pyramids have

come to light. The first was put together by Bernard

Madoff, a New York-based financier. For several

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

uncomfortab l e p uzzles of th e cred i t c r u n c hâ•… 10 7
Madoff’s books, nobody in a senior position in the US

regulatory system seems to have suspected the massive
pyramid scheme. If Madoff himself had not confessed,
who knows how many more billions of dollars would
have disappeared into fictitious books.
The second now notorious case of a Ponzi scheme
involves Sir Allen Stanford, another well-known
financier. Accused of an $8bn fraud, Stanford, unlike
Madoff, continues to deny any Ponzi element in
his business (Ishmael 2009). Regulators allege that
Stanford’s pyramid operated primarily through Stanford
International, an Antigua-based bank, which sold about
$8bn of certificates of deposit to investors by promising
improbable and unsubstantiated high interest rates.
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). Stanford ran
institutions that are alleged to have misled investors
about their exposure to risky illiquid assets (Financial
Times, 20 February 2009). 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.
What is most astonishing is that there were real
warning signs about both men. In both cases, analysts
grew suspicious of the returns the two financiers were
offering. In both cases, Madoff and Stanford dominated
their companies and used peculiarly inconspicuous
auditing firms to check them. Yet while they continued

to post astronomic returns, they evaded any serious

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

uncomfortab l e p uzzles of th e cred i t c r u n c hâ•… 1 0 9
– dwarf what was uncovered in any recent recession.

According to historians, the last time the US saw
anything like this was during the 1920s, when Ponzi’s
original postage scam flourished. The Ponzi web has
spread beyond America’s shores. In Italy, Milan has lost
millions on a derivatives deal. In the spring of 2009 four
big banks – UBS, JP Morgan Chase, Deutsche Bank
and Hypo Real Estate – came under investigation for
what prosecutors believe may have been fraudulent or
‘illicit’ profits amounting to €100 million. In Germany,
as many as 700 local authorities may have lost money
on similar deals (ibid.).
As many critics argue, the institutional foundations
of the securitisation industry, including the regulatory
framework in which it flourished, have helped entrench
fraud as a legitimate practice of financial innovation.
The growth of hedge funds and offshore finance made
secrecy and high returns seem more common (Picciotto
2009). According to one former SEC official, ‘the beauty
of these recent cases is that very little money ever went
out. It was all on paper.’ At the same time, regulators
were hampered by political pressure to leave hedge
funds alone on the one hand, and a lack of resources to
inspect more than 11,000 registered investment advisers
on the other (Chung and Masters 2009). It is very likely
that in the aftermath of the crisis more such revelations
will surface.
But what does one make of all this? It is contentious
to allege that the securitisation industry was in fact
one giant Ponzi scheme. After all, securitisation has

existed for decades and its economic purpose had been

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

uncomforta b le pu zzles of t he cre d it c r u n c hâ•… 11 1
continues – does suggest that something went terribly

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

causes and short-term triggers of the global meltdown,

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

5
2002–7: The Three Pillars
of the Liquidity Illusion
Even in purely financial terms, the sub-prime lending

industry was a time-bomb waiting to explode (Wray
2008). Even so, it would have played an important yet
relatively minor role in sustaining the 2002–7 boom
had there not been a broader international political-
economic environment that supported, facilitated and
encouraged a particular market-based approach to
managing risks in finance. This environment, in turn,
emerged as a combination of historical, analytical,
political and institutional developments. The following
pages identify three interconnected forces that, having
reified the myth of efficient finance, liquid markets and
economic prosperity, helped disguise the deepening
fragility of the North Atlantic economies. This
chapter unpacks the role that ideas, behaviour and the
institutional organisation of financial regulation played
in constructing and sustaining the illusion of liquidity.
Liquidity and the Paradigm of Self-Regulating Credit

In narrow terms, the global meltdown is a crisis centred
on the US sub-prime mortgage industry; in its broader
113

international dimension, it is a crisis of securitisation. It

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

t he t hree pi llars of t he li qu idi t y i l l u s i o nâ•… 11 5
chapters have noted, most financial innovations have

for a long time been perceived to be liquidity-enhanc-
ing: by pooling a greater variety of assets in the market
exchange, by pricing them and then transferring them
to new, willing and able owners, financial engineers
and traders have expanded the reach of the financial
markets, thereby increasing market turnover and, in
popular terminology, liquidity.
On the other hand, critics of the financial orthodoxy,
from Minsky onwards, have argued that the relationship
between new financial products and the liquidity of
the economic system as a whole is far less straightfor-
ward. The process of inventing, valuing and introducing
new credit instruments, markets and institutions has
been driven by the search for greater liquidity across
the global financial markets. At the same time, new
financial instruments, while adding to a sense of
greater liquidity in the markets, rely on the liquidity
of the underlying assets. Securitisation, for instance –
the latest wave of financial engineering – both relies
on and enhances liquidity. It ‘enhances the liquidity
of underlying receivables by transforming them into
tradable securities. On the other hand, 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).
Securitisation has had its own controversial effects
on the idea and functioning of liquidity in the markets.
Theoretically, securitisation has been understood to be

a technique to create securities by reshuffling the cash flows

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

t he th ree pi llars of t h e liq u idi ty i l l u s i o nâ•… 1 1 7
This trend has had its own, ultimately destructive

repercussions for the stability of the financial system as
a whole. Chiefly, it was transmitted through its impact
on liquidity. As Minsky foresaw, in a deregulated,
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, the liquidity of the banking system
declines’ (Minsky 1982: 174).
In this regard, according to Victoria Chick, the
experience of the first Basle accord illustrates the law
of unintended consequences. Regulations intended to
strengthen the balance sheets of banks by weighting their
assets on the basis of their riskiness and thus rewarding
the holding of safe assets actually drove risky assets
off the balance sheet. As a result of the introduction of
the Basle rules, securitisation was undertaken not just
as a small part of bank operations when banks needed
liquidity, but on such a scale as to change the whole
manner in which banks operate (Chick 2008).
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, 2008). As noted above,
securitisation reflects the way risk has been modelled,
valued and traded by banks and financial houses since
liberalisation reforms were introduced in the 1980s

in the US and elsewhere.1 These reforms led to the

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

t he th ree p i llars of t h e liq u idi ty i l l u s i o nâ•… 1 1 9
trading in derivatives and capital market-related

activities at the top ten global investment banks rose
by almost two-thirds, from $55bn in 2004 to $90bn
in 2006.2 Reflecting these changes, profits from sales
and trading operations had not only been growing, but
also assuming a greater share of the investment banks’
revenues (over 90 per cent for the Americas, over 80
per cent for Europe, Middle East and Africa, and just
over 40 per cent for Asia Pacific).
The concern with creating new markets for their
products prompted financial institutions – both in
the official, 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. The resulting series of
financial innovations created a sense, though not a
guarantee, of abundant liquidity in the sub-prime-
related financial markets and of financial wealth being
created and spread. Politically, this trend has been
commonly viewed as an indication of a more efficient
financial system and foundation for economic stability.
In 2006, the Bank of England, for instance, noted that
while the ORD model ‘does not alter the financial
sector’s aggregate credit exposure to the non-financial
sector’, it promises to ‘improve systemic stability if risk
is held by those with the greatest capacity to absorb
losses’ (Bank of England 2006, cited in Langley 2009).
In the wake of the global meltdown, it seems naïve
and short-sighted to draw a straightforward, linear
link between securitisation and systemic stability. At

the peak of the credit boom, however, things were much

murkier. Here again it is the idea of, or more accurately
the illusion of, liquidity that disguised many fallacies
– both conceptual and political – at the time. As Paul
Langley writes, the mainstream political discourse that
paralleled the expanding credit boom invariably
represented the markets as efficient … and liquid. Such representa-
tions of finance meant that a ‘liquid’ market became an object that
investors increasingly regarded as a given fact, external to them.
Since the sub-prime industry seemed to exemplify what was possible
in an era of liquid finance, there was little to suggest that markets
for assets named ‘liquid’ would be any different from the norm.
(Langley 2009)
With regard to how liquidity has been approached

within the regulatory architecture, a particular emphasis
in the Basle II accord proved fatal in the lead-up to
the global credit crunch. Basle II has been built on the
assumption that a well-functioning financial market
is always liquid. As a result, the accord established a
system of regulatory principles that delegated to the
individual institutions themselves the management
of their portfolio of risks. Specifically, the central
parameters of international financial governance were
founded on regulatory developments in the private
sector: when the first Basle accord proved ineffective,
the solution was sought in private risk management
tools (Wigan 2009). With the assumption of an infinitely
liquid market there was no need to install a systemic
provision to guarantee its liquidity. The key concern for

th e t h ree p i llars of t h e liq u idit y i l l u s i o nâ•… 1 2 1
policymakers at the time was market efficiency and the

efficiency of individual banks (Davies 2009). Through
the alchemy of financial engineering, the banks were
assumed to optimise their own risk strategies; while the
market as a whole – founded on financial innovation
and competition – was made liquid. 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.
Playing with Debt – Together. Liquidity as a

‘State of Mind’
The popularisation of finance has had its own impact

on the way liquidity is understood. Paralleling the rise
and spread of financial markets, the idea of ‘liquidity’
has come to describe the liquidity of the market. The
advance of financial engineering, in both practical
and analytical terms, 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. Put simply,
in popular terms liquidity has increasingly come to
describe the volume and speed of financial transactions,
or market turnover, rather that the content of those
transactions (e.g. Warburton 2000).
As contended in this book, although seemingly
only an analytical fallacy, this assumption itself is a

key reason why many destabilising trends and risks

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

of knowledgeable buyers meets a crowd of
knowledgeable sellers.

2. The existence of market-makers who, for a small

margin, are willing to risk transferring large
quantities and thus maintaining a continuous price.
3. Homogenisation and standardisation of commodities,
by grading natural products, manufacturing standard
products or by creating legal instruments with equal
claims on an income stream.
Market liquidity, therefore, comprises the spatial, inter-

temporal, cognitive and social processes of valuing risks.
Standardisation of products and financial techniques is
absolutely central to sustaining market liquidity (ibid.:
353–4). This standardisation in turn, as the authors
argue in their original study, is a collective and cognitive
achievement: buyers, 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.
For a while during the credit boom this conviction
appeared to function well. Financial geeks were
extending the range of financial products and services,
offering them to a host of seemingly willing buyers,
either on organised market platforms or, more typically,
on an over-the-counter (OTC) basis. The magic of secu-
ritisation, in turn, seemed to ensure that these products
contain accurate information about their underlying
risks and values. As the boom expanded, the belief in
and reliance on the capacity of securitisation to optimise
risks became ever greater, spawning theories about

‘abundant market liquidity’ and a ‘global liquidity glut’.

In June 2007, for instance, the BIS observed:
the prevailing view that the world was awash with liquidity – that
is, credit was both cheap and commonly available with weaker
conditionality than had previously been the case. 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,
and changes in attitude altered what people wanted to do. Examples
of new practices abound, not least in the area of credit to households.
Mortgage credit has become available on easier terms to borrowers
almost everywhere, thanks both to deregulation in many countries
and to the global extension of the mortgage scoring techniques
pioneered in the United States. Indeed, 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. Until quite late in the period under review, this was generally
considered to be a healthy development supporting owner-occupied
housing. Only in recent months … has the downside to these new
practices become more apparent. (BIS 2007: 7–8)
Optimism during the global credit boom had its

own, peculiar impact on the construction of liquidity.
Stripped of its relation to the underlying assets, market
liquidity was increasingly taken to be synonymous with
the shared appetite for financial trading – or put bluntly,
speculation. According to one market player, liquidity
was no longer about the available pool of money or
even credit more generally. Rather, it is ‘the result of the
appetite of investors to underwrite risk and the appetite

th e t h ree p i llars of t h e liq u idit y i l l u s i o nâ•… 1 2 5
of savers to provide leverage to investors who want

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

that was overlooked by most financial supervisors and

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

t he t hree pi llars of th e liq u idi t y i l l u s i o nâ•… 12 7
and ‘crowded trades’. In this herd-driven process of

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

tend to be generic features of any financial crisis, the

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

t he th ree pi llars of th e liq u idi t y i l l u s i o nâ•… 1 2 9
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 securitisa-
tion-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

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 sustain-
ability of market turnover depended crucially on the
collective actions and expectations of financial players.

t he t hree pi llars of t he li q uidi t y i l l u s i o nâ•… 131
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

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
ownÂ€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

th e t h ree p illars of t h e liq u idit y i l l u s i o nâ•… 1 3 3
liquidity for the shares of those companies. The two

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

diminishing the firm’s cost of capital (Tinker and Carter

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

t he th ree pillars of t h e liq u idi ty i l l u s i o nâ•… 1 3 5
seems to have been no more than a blip in the larger

trend of speculation and expansion. 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.
During 2002–7, much as in the bubbles of the 1980s
and late 1990s, in order to turn sub-prime loans into
liquid securities someone, or something, was needed
to act as market-maker on a large scale and sustain
collective belief in the liquidity of what were, in essence,
bundles of toxic debts, and make the complex structures
of IOUs ‘worth – or seem to be worth – more than the
sum of its parts’. That something was the credit rating
agency (Lowenstein 2008).
Credit rating agencies (CRAs) have been with us
for a long time. The first mercantile ratings guide
was established in 1841 in the wake of the financial
crisis of 1837 in order to rate merchants’ ability to
meet their financial obligations. In 1909, John Moody
extended the practice to rating securities, starting with
US railroad bonds (Cantor and Packer 1994). 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 the words of Timothy Sinclair
(2005), became the ‘new masters of capital’.
Today’s CRAs are the products of their time. In
the age of ‘scientific’ finance and securitisation, when
information is key to managing risks and structures of
knowledge are essential for market turnover and, in

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

t he th ree pillars of th e liq u idi t y i l l u s i o nâ•… 1 37
CRAs performed well, but it is the methodological

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

aggravated the securitisation bubble by creating the

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

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

the mortgages. Thereafter, monthly payments from the

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

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

operating in such a system. Institutionally, the global

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

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

was built on these three pillars of modern finance. Now

that the global credit meltdown has passed its second
anniversary, one question naturally arises: What has
been done? At first glance, the answer is, 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, central banks

rushed to put out the fire with massive injections of
cash. The amounts set the tone for how the crisis would
be handled for the year ahead. Essentially, the first phase
was about pumping money into the frozen markets and
was defined by the efforts of the national monetary
authorities, often coordinated internationally, to restore
confidence (understood as liquidity) in the financial
markets. Hence the efforts of the regulators centred on
opening up the markets, unblocking credit lines through
monetary injections that were quite unprecedented in
their scale, cutting interest rates and trying to make the
financial institutions lend to each other.
As the crisis progressed, several central banks agreed
to offer their guarantees in exchange for toxic assets
from financial institutions. Effectively, with this move,
governments validated the experiments of private
financiers by offering state-backed, high-powered

af t er t he m e lt dow nâ•… 14 5
liquidity to individual institutions which could no longer

shift their junk paper in the markets. This decision
remains one of the most controversial policies of the
global credit meltdown. Not only does it go against
the golden rule of monetary theory and the principle
of a lender-of-last-resort action;1 it is also unclear what
will happen to the billions of dollars of toxic debts
now being held by the banks, whether government-
supported or not.2
Even this radical response to the crisis brought feeble
results, however.
In the midst of the panic that paralysed the global
markets in the late summer of 2007, the immediacy of
political reaction was understandable. Panics require
urgent, decisive action, allowing little time for deep
analysis or musings about the actual causes or lessons
to be learnt from the crisis. Yet as the crisis intensified
and transformed into deeper problems in the national
and international credit systems, the ad hoc measures
proved to be insufficient. Neither the exorbitant size
of cash injections nor the central banks’ attempts at
transatlantic regulatory coordination helped quell
theÂ€turmoil.
National Recapitalisation Schemes

(9 October 2008–2009)
Following the government takeover of Fannie Mae and

Freddie Mac and the collapse of Lehman Brothers, the
world entered the second phase of crisis management:

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

aft e r t h e m e ltd own â•… 1 4 7
As a result of these bailouts, several big banks

in the US and the UK have come – either partly or
totally – under state ownership. As Wigan (2010
forthcoming) writes, starting with Northern Rock, the
UK government is now the majority shareholder in both
RBS and Lloyds TSB, since the latter’s acquisition of
the stricken HBOS. In the US, he notes, the rescue plan
for AIG is of particular significance, since the funding
plan effectively recognised that the insurance giant
had transformed itself into a de facto investment bank
through its subsidiary, Financial Products AIG. Overall,
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.3
In total, Oxfam (2009) estimates that governments
have pumped $8.42 trillion – made up of capital
injections, toxic asset purchases, subsidised loans and
debt guarantees – into the failed financial institutions.
In November 2008, 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,
Cavanagh and Redman 2008).
The bailout plans met with little success. The reaction
from the financial markets was half-hearted: although
market indices stopped falling uncontrollably, the mood
in the world of finance was far from optimistic. The
banks in turn, although publicly shamed by various
governmental committees for their experiments during

2002–7, were slow and reluctant to accept state help,

even claiming that ‘they are not charity’ cases. Lending
levels remained low, and the chain of bankruptcies
expanded into the real economy. It did not help
when it emerged that executives in the key financial
institutions, such as AIG and Goldman Sachs in the US
and RBS-HBOS in the UK, have received vast amounts
in bonus payments, fuelling public and media fury. In
the meantime, the world financial crisis descended into
a global recession.
International Financial Reform (15 November 2008–?)
The deterioration of economic conditions worldwide

has moved crisis management into its third phase: an
international regulatory response. Its inception can
be dated to 15 November 2008, when world leaders
gathered in Washington, DC for a summit that was
dubbed ‘Bretton Woods 2’, albeit rather too hastily.
Although the summit did not bring any tangible results,
other than public commitments to bolster the global
financial system and rethink existing approaches to
financial governance, it did mark the beginning of a series
of efforts at the global level to reform worldÂ€finance.
To date, two key events have spurred progress on
these efforts: the election of Barack Obama and the G20
London summit in April 2009. The Obama administra-
tion has been behind a radical plan for financial reform
announced in June 2009. The G20 summit, which
reconvened in September 2009, was a central forum in

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

to the crisis is geopolitical. Put in somewhat crude
terms, it can be understood as a reflection of the

long-running differences between the Anglo-Saxon and

continental models of capitalism. In the age of financial
capitalism, the line cuts in two ways: between London
and Wall Street on the one hand and Brussels on the
other; within the EU itself, where there is a sharp divide
between the UK and other EU members, most notably
France and Germany.
Both sides of the conflict centre on how national (and
supranational) authorities view the process of financial
liberalisation. Whereas the EU has traditionally been
more in favour of closer regulation of the financial
industry, the UK has built its economic strength on
the power of the City of London as the world centre
for financial innovation. The US, for its part, has been
opposed to the idea of preventing market progress by
administrative or political interference since the 1970s.
In the context of the global credit crunch, 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 United States
As noted above, in the US until the nationalisation

of Freddie Mac and Fannie Mae and the collapse of
Lehman Brothers, the political response to the credit
crunch was simply an attempt to restore confidence
by pumping liquidity into the markets. Here, one
important conceptual detail of the US bailout plan
stands out. Originally, the official reflection on the

aft e r t h e m e ltd own â•… 1 51
lessons from the crisis, as articulated by the US Treasury

Secretary in the March 2008 blueprint for a new system
of regulation (Paulson, Steel and Nason 2008), stressed
that innovation and market competition remain the
priority for the US economy. Specifically, the blueprint,
or ‘objectives-based’ plan, was designed to address
individual market and business failures rather than
question the core principles of the functioning of the
financial system.
The version of the reform proposal launched by the
Obama administration in early summer 2009 takes
things much further. The plan aims to build ‘a new
foundation’ for financial regulation and supervision
that is simpler and more effectively enforced, protects
consumers and investors, rewards innovation and is
able to adapt and evolve in line with changes in the
financial markets (US Treasury 2009: 2). The proposal
targets financial regulation at four key levels:
1. Oversight and close supervision of financial

firms, including the establishment of several new
institutions that would undertake the task at the
federal level.
2. Comprehensive supervision of the financial markets,
installing, in particular, new requirements for
regulation of the financial products that previously
were traded in unregulated exchanges.
3. Stronger regulatory potential by the government,
extending the scope of regulation to non-banks

and adding to the apparatus of existing financial

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

aft e r th e m e ltd own â•… 1 5 3
effective mechanism of crisis resolution would need

to be much more transparent and simple, rather than
complex. A more complicated domestic regulatory
framework would also undermine the effectiveness of
any international coordination in terms of cross-border
supervision, which has been a key problem in the global
meltdown (Crook 2009). Therefore, notwithstanding
its radical tone, the Obama administration’s proposals
for a better governed financial system have left many
questions about the credit crisis unanswered. To
complicate matters, the plan has yet to gain congressional
approval and it is unclear which version, if any, of the
proposals is likely to make it to the final policy act.
Europe
Things in Europe have been somewhat different, though

not decisively so. On the face of it, the EU’s initial
regulatory response to the crisis echoed the themes
of the US March 2008 blueprint. In spring 2008, the
EU followed the US in acknowledging the need for
international policy coordination, not least because the
risk of a cross-border banking crisis was deemed high.
Yet, significant divisions, both conceptual and policy-
related, between the US and Europe gradually surfaced.
Fundamentally, they centre on the differences between
American and European officials in drawing lessons
about the risks and benefits of financial innovation
andÂ€liberalisation.

The European ‘roadmap’ for a new regulatory

structure is built on four conceptual areas: improving
qualitative information and transparency for investors;
upgrading valuation standards; strengthening
prudential frameworks and risk management in
financial institutions; and reviewing the role and use of
credit rating agencies in the financial markets. Specific
regulatory norms proposed by the EU include higher
and tighter capital and liquidity requirements for all
banks operating in Europe, including the European
divisions of US banks. These measures would make it
more expensive to package and sell obscure products
such as mortgage-backed securities (MBSs) in Europe
and thus erect a barrier in the way of the further
evolution of securitisation.
Over the course of 2008–9, 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. While the
voice of American delegations in these summits has
been muted due to the political changes in the US, in
Europe arguments have centred on the split between the
UK and continental Europe. As proposals for regulatory
reforms matured from initial discussions to the level
of procedural planning and implementation, these
distinctions became ever more apparent.
In June 2008, the Financial Times reported that
‘fears are rising in the City [of London] that strict new
European regulation could hit the financial services

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

the City. In July 2009, 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, Lord Myners, Financial
Services Secretary to the UK Treasury, 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).
At the level of global geopolitics, therefore, there
are serious stumbling blocks, technical and political,
en route to a new architecture of financial governance.
Considering the politics of financial regulation on both
sides of the Atlantic, as well as the poor record of
previous efforts to design a global financial architecture,
the post-credit crunch financial system may not be so
different from its predecessor. As some commentators
and politicians began talking about the ‘green shoots
of recovery’ in the second half of 2009, the real danger
is that despite the severity of the crisis and ostensible
determination of a number of policymakers to rewrite
the rules of global finance, the efforts will be too vague
and hesitant. But the problems with the crisis response
unfortunately do not stop here. The plans for a new
financial architecture are also riddled with opacities
and conflicts at a deeper, conceptual level.
Conceptual Dilemmas and Traps
In terms of its theoretical underpinnings, the post-crisis

regulatory fallout can broadly be divided into two

distinct paradigms of finance. The first, quite radical

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

A notable distinction between the two groups lies in

their intellectual origins. While the first school of thought
is informed by considerations of the place of finance
and money in society, the second is mostly built on the
idea of improving the current practice of investment,
trading, valuation and supervision techniques. Intellec-
tually, the ‘traditionalists’ frequently draw their insights
from history and non-economic academic disciplines
and they often appeal to a wider audience. The latter
approaches, on the contrary, are dominated by expert
forums, are couched in the specialised financial language
of today and are formulated by a range of financial
practitioners, specialists in academic finance theory,
observers and, on occasion, private financiers.
The Traditionalist School: Return to Prudence and

Old Values
You have forgotten the basics of what finance and banking are for.
In your financial experiments, you have carried your institutions
into abyss, at the expense of all of us. It is time to return to some
old-fashioned banking.
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. The audience – comprising
mostly young finance geeks – was clearly not impressed.
The banker, who started his career in the 1950s at a
desk in a provincial bank, was asked only one question
from the audience at the end of his address: ‘So has

your bank avoided all the losses then?’ Later, it emerged

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

and ‘pro-prudence’ regulatory camp calls for the return

of old-fashioned, boring banking and conservative
finance – in terms of both size and aspirations: ‘The
market will reward you for safe, long-term profits even
though they happen to be lower than your rivals’ in any
given year’, as an executive of a medium-sized lender
argued (in Guerrera 2009). Specifically, to ensure a
better financial system in the future, the traditional-
ists argue, the world needs to make a clear distinction
between socially useful banking (retail and commercial)
and the more parasitic, speculative investment banking.
We have a very conservative business model not by luck but by design.

‘We see ourselves as retailers. Our goal is not to maximise earnings
in any given year but to have a profitable business for centuries,’
says an executive of a medium-size bank commenting on the role
of the culture of big-bank aggressive competition in the crisis. (ibid.)
Crucially, a new financial order, one that is more

prudent and long-term in its orientation, 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, at the expense of us all.
Accordingly, the vision of a better capitalist system of
finance tends to be charted either along Keynesian lines
of the regulatory state or, at some extreme, by drawing
on the virtues of a more ‘Asian’ type of capitalism, based
on a culture of thrift rather than spending, hierarchies
of power and coordination rather than horizontal

af t er t he m e lt downâ•… 161
networks, paternalistic loyalty rather than aggressive

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

pooling their assets with those of other clients into

a securitisation vehicle large enough to be rated by a
credit rating agency. With a decent rating, such a vehicle
would require a lower level of capital to be held against
it (Tett and van Duyn 2009). Sounds familiar, doesn’t it?
Making Financial Innovation Work
The second, much wider group of post-crisis reflections

encompasses policy discussion at various levels and is
unfolding along with the dialogue with private financial
actors. With some variation, 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-securiti-
sation’. These practices, it is argued, have made the
system as a whole less transparent and more obscure,
not only widening the gap between the regulators and
financiers, but also creating opacity within the financial
markets. It is this gap, and the obscurity of finance, that
needs to be addressed by the new regulatory paradigm
in the post-crisis environment. According to Francesco
Papadia, director-general of market operations at the
ECB, ‘securitisations have become ridiculously complex.
Structures should become simpler, plain-vanilla deals’
(in Tett and van Duyn 2009).
To these ends, various improvements to the current
self-regulating financial system are being proposed.
Highlighted by the G20 statement on financial
architecture in April 2009 as well as several high-profile

reviews of the lessons of the global credit crunch, they

are based on the idea of rebalancing private gains
and social losses, and on regulating what is being
understood as ‘systemic risk’ in finance. Measures being
proposed include:
• A ‘Basle III’ accord on capital and liquidity norms

that would be counter-cyclical and require financial
firms to hold more liquid assets.
• The need to license and control credit rating
agencies that have disgraced themselves by
assigning AAA ratings to toxic and illiquid
securities. (These controls are mainly advocated
by the EU.)
• The need to set up organised and centralised
trading platforms for products that were traded
off market until recently (like OTC derivatives),
thereby making financial trades more transparent
and hence accountable.
• The need to change the structure of incentives.
This proposal concerns financiers themselves:
CEOs should not receive excessive pay and
bonuses, especially when these are funded by the
taxpayer; 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.
• National plans to re-empower and strengthen
the mandates of existing monetary and financial

institutions, 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; as mentioned above, there are also
proposals to set up a pan-European body with a
similar agenda.)
Again, it is difficult to predict which version of the

proposals will be incorporated into concrete policy.
In terms of the analysis of the crisis presented in this
book, 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.
In essence, 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. This
illusion led politicians, regulators and home buyers to
believe that global capitalism had entered a new era of
resilience and prosperity based on deregulated credit,
‘scientific’ risk management and financial sophistication.
It is particularly disappointing, therefore, that in the
current discussions of the future of finance, the process
at the core of the crisis – the ability of financial engineers
to transform obscure debts into ‘liquid’ assets – is not
being questioned. The G20 plan for strengthening the

af te r t he m e lt dow nâ•… 16 5
global financial system, for instance, is disappoint-

ingly 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.
Indeed, as stressed in the G20 communiqué: ‘Regulators
and supervisors must protect consumers and investors,
support market discipline, avoid adverse impacts
on other countries, reduce the scope for regulatory
arbitrage, support competition and dynamism, and
keep pace with innovation in the marketplace’ (G20
2009: paragraph 14).
The authors of the Geneva report, one of the
high-profile policy reports on the crisis, 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 …). In general, restrictive control
of financial intermediation stifles innovation and, especially if
government starts to intervene with direct controls over bank
lending, interferes with the appropriate allocation of capital.
(Brunnermeier et al. 2009: 10)
Generally, therefore, the mainstream solution to the

global crisis is based on the cyclical theory of financial
crisis and on the belief that the market mechanism, with
appropriate assistance from the state, can re-balance
itself in the event of failure. The regulatory and policy
adjustments necessary for stabilisation and recovery in
turn should not compromise the abiding principles of
free competition: ‘It is important, indeed crucial, that

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

aft e r t h e m e lt d own â•… 1 6 7
however, restoring market liquidity without questioning

the essence of financial trade today, the nature of assets
being created and traded, and the very meaning of
what ‘liquidity’ is, has led the financial system into the
gigantic hole it finds itself in today. It is thus likely to
lead us into another one in the not-too-distant future.
In this instance, history is a useful indicator of
how effective, and stringent, attempts to re-regulate
finance can aim to be. Since the late 1970s, every
crisis – economic and financial – almost invariably
rekindled the calls for a ‘new Bretton Woods’ system,
while more recently, the injustices of globalising
markets fuelled anti-globalisation movements across
the world. Despite the waves of financial disasters and
growing tensions within the economies of advanced
capitalism, the paradigm of market-driven progress
has not been seriously challenged and, up to now, has
firmly shaped the ‘constitution of global capitalism’
(Gill 2002; Vestergaard 2009). Even if critics like
Minsky appear to be taken seriously during crises, few
heed their warnings once the financial cycle and market
‘liquidity’ are restored.
Moreover, 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, very few of the ideas
being put forward are essentially new. Indeed, the wave
of financial crises of the late 1990s has given rise to
what has been dubbed a New International Financial
Architecture (NIFA). NIFA was briefly in vogue from

1999 until the 9/11 attacks diverted the attention of

policymakers from finance-related problems to other
areas. Apart from a plethora of forums and committees
set up in the wake of the 1997–9 crises (the G20 forum,
Financial Stability Forum, various Basle-centred groups,
etc.), NIFA remained pro-market-centred and aimed
to facilitate financial innovation, liberalisation and
competition further. The bodies and committees that
were set up under the NIFA umbrella remained poorly
coordinated and impotent in terms of their juridical
status. With regard to its focus, 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,
financialised capitalism.
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, now fashionably called a macro-pru-
dential approach to financial governance. Apparently
radical in its tone – unlike conventional quantitative,
microeconomic indicators of financial stability, it
targets qualitative parameters of financial risk – the
macro-prudential approach is in a fact a big elephant
in a very dark room. Ambitious yet vague on concrete
detail, macro-prudential regulation risks becoming to
finance what ‘good governance’ has become to politics:
instinctively, everyone senses it should be a good thing,

but no one knows precisely how best to define, measure

or control it.
One positive thing about calls for a closer macro-
prudential focus is that they are based on the apparently
serious realisation that the micro-prudential institution-
by-institution supervision undertaken by the FSA has
not been sufficient. It certainly has not. But macro-pru-
dential regulation – whatever form it might eventually
take (and there are serious doubts as to how feasible,
politically and economically, current proposals are) –
is not a panacea which will necessarily save us from
financial instability and crises. There are several reasons
for saying this.
First, at the core of the macro-prudential approach
is the idea of better management of ‘systemic risk’ in
finance. Yet again, aside from an intuitive understanding
that ‘systemic risk’ is widespread, contagious and quite
dangerous for the system, there is currently very little
understanding, least so at the international level, as
to what ‘systemic’ risk might be and, crucially, how it
evolves (Davies 2009).
Second, the macro-prudential approach, as John
Plender (2009) argues, derives from the assumption
that, had macroeconomic analysis played a larger role
in governing finance during the bubble, the crisis might
have been averted. Under closer scrutiny, this argument
appears quite naïve: for a while now, macroeconomic
governance has been based on obsolete, national-based
statistics and the assumptions of monetarism. The
world of finance, however, has moved economies far

beyond national boundaries, making macroeconomic

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

suggests that, aside from installing new jargon in the

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

Conclusion:
A Very Mundane Crisis
The global financial meltdown wrought havoc in the

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

conclusion: a ve ry munda n e c r i s i sâ•… 1 7 3
insight into – the nature of ‘investment’ today. Like

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

political dynamics of the modern financial system.

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

conclusion: a v ery munda n e c r i s i s â•… 1 7 5
of Anglo-Saxon capitalism had been assumed to be

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

greed, unaccountability and lack of transparency, and

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

NOTES
Introduction
â•‡ 1. Keynes likened finance to a beauty contest run by a
newspaper. Voters evaluated contestants not on the basis
of any objective criteria, but according to what others
might consider to be ‘beautiful’.
â•‡ 2. Most notably, the BIS, the ECB, FSF and the IMF.
Occasional studies of liquidity have been published
by other central banks in the wake of the crisis. The
Bank of England, for instance, noted in October 2008
that liquidity regulation ‘can play an important role in
requiring banks to build larger defences against crystal-
lisation of rollover risk’ (2008: 39).
Chapter 1
â•‡ 1. According to the Mortgage Bankers Association, in 2006
13.5 per cent of mortgages originating in the US were
sub-prime, compared to 2.6 per cent in 2000.
â•‡ 2. According to Inside Mortgage Finance.
â•‡ 3. In 2004, Forbes ranked HSBC as the seventh largest
company in the world; in 2007 HSBC was the world’s
seventh largest bank in terms of shareholders’ equity
(data from Euromoney).
â•‡ 4. ResMae Mortgage filed for bankruptcy and Nova Star
Financial reported a loss that analysts had not foreseen.
â•‡ 5. It filed for Chapter 11 bankruptcy on 6 August 2007.
â•‡ 6. IKB had to be rescued with a $3.5bn rescue package put
together by a group of public and private sector banks
on 1 August 2007.
177

â•‡ 7. In the autumn of 2007, reacting to falling market

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

n ot es â•… 17 9
to be regulated. Until the liquidity squeeze of autumn

2008, AIG officials also dismissed those who questioned
its derivatives operation, saying that losses were out of
the question (Williams Walsh 2009).
13. COBRA (Cabinet Office Briefing Rooms) is the UK
government’s crisis response committee which deals
with national crises such as pandemics and floods.
14. Among the emerging markets affected, Latvia and
Ukraine suffered the most. Yet the banking systems in
Eastern Europe – mostly controlled by European banking
giants – are at a major risk of collapse, threatening in
turn the stability of European banking generally.
15. In March 2009, the IMF predicted that the total expected
losses by banks and other financial institutionsÂ€were in
the range of $2.2 trillion (IMF 2009: 2). Interestingly,
it has also emerged that European banks have incurred
higher losses than their US counterparts. In the EU, the
value of equity has fallen by €6Â€trillion, or more than
50 per cent from the peak reached in summer 2007
(Papademos 2009).
16. At the end of 2008, world manufactured output and
world trade in manufactures shrank dramatically.
Germany’s industrial output was down 19.2 per cent
year-on-year in January, South Korea down 25.6 per
cent and Japan down 30.8 per cent (in Wolf 2009).
Chapter 2
â•‡ 1. Sale and repurchase agreements. In the wake of the credit
crunch, repo transactions allow banks to post unwanted
securitised bonds as collateral to borrow funds from
central banks (Tett and van Duyn 2009).
â•‡ 2. Granite had no employees whatsoever. We are grateful
to Victoria Chick for highlighting this key detail.
â•‡ 3. The figures include the Netherlands, which may be
controversial; the rest, including Singapore, Switzerland,
Ireland and Luxembourg, clearly attract these SPVs due

to their very low tax regimes and because they offer a

high degree of opacity and secrecy.
â•‡ 4. Renamed the Financial Stability Board in the wake of
the global credit crunch.
â•‡ 5. Based on interviews and analysis by Jon Moulton, ‘How
the Banks Bet Your Money’, Dispatches, Channel 4,
18Â€February 2008.
Chapter 3
â•‡ 1. According to the BIS, by early 2006 the combined
holdings of China and other large emerging markets
had increased to an estimated $1.25 trillion, from just
over $800bn at end of 2004 (2006: 103–4).
â•‡ 2. As of April 2007, the Asian sovereign bond market
(valued at $830bn) was less than a tenth the size of its US
and Japanese counterparts. 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’. According
to the BIS, in Hong Kong, India and South Korea, only
1 per cent of housing loans were securitised, while in
Japan and Malaysia the ratio was between 5 and 6 per
cent. This compared with 68 per cent in the US.
â•‡ 3. As Buiter explains, at the Federal level commercial
banks are supervised by the Federal Deposit Insurance
Corporation, the Federal Reserve Board and the Office
of the Comptroller of the Currency. Other depositary
institutions are supervised at the Federal level by the
Office of Thrift Supervision and the National Credit
Union Administration. Investment banks fall under the
Securities and Exchange Commission (SEC). Financial
markets are supervised by the SEC or by the Commodity
Futures Trading Commission. Insurance, which played
a key role in the crisis through the credit risk insurance
industry, is not supervised at the Federal level at all
(Buiter 2008).

n ot e sâ•… 1 8 1
Chapter 4
â•‡ 1. As a result of the bailout, 68 per cent of the bank is
currently owned by the state.
â•‡ 2. Bernard L. Madoff Investment Securities LLC used
Friehling & Horowitz, an auditor operating out of a
13 × 18 foot location in a business park in New York
City’s northern suburbs.
â•‡ 3. In 2006, the City of London was global No. 1 in
foreign equity, derivatives and foreign exchange trading,
cross-border bank lending and as a secondary market
for international bonds. It was the fastest-growing
hedge fund market, and has been the leading hub of
financial innovation globally. In 2004, financial services
incurred £19bn in trade surplus, up 9 per cent from 2003
(Caulkin 2006; IFSL 2007).
â•‡ 4. Employed in analytical terms by Minsky, the term
actually commemorates the life of a scandalous crook,
Carlo Ponzi, who made millions of dollars by fleecing
Americans during the 1920s economic boom, but was
ultimately caught and died in poverty. In the context of
the credit crunch, the scandals of pyramid schemes run
by Madoff and Stanford made the notion ever more
widespread.
â•‡ 5. Often, borrowers were persuaded to take a mortgage
without being told that they would be unable to pay
it off early or change the terms, 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, they were ensnared in the
sub-prime net (Kregel 2008).
â•‡ 6. The 144 cases, which involved roughly $1bn (£510m) in
losses, targeted anyone involved in fraudulent mortgage
loans, from estate agents and appraisers to underwriters,
developers, lenders and lawyers.

Chapter 5
â•‡ 1. In this regard, Kregel (2008) notes, the ongoing financial
crisis differs from the context Minsky identified.
â•‡ 2. Data from The Economist, 17 May 2007.
â•‡ 3. The accountancy firm Arthur Andersen, which was paid
$4.4 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).
â•‡ 4. By issuing ratings downgrades.
Chapter 6
â•‡ 1. According to the classic doctrine of Walter Bagehot
(2006 [1877]), 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.
â•‡ 2. Accepting toxic debt as central bank collateral did not
give the central banks a clear ‘way out’.
â•‡ 3. By the summer of 2009, several financial institutions
started repaying the taxpayer funds. Morgan Stanley, US
Bancorp and BB&T repaid billions of dollars ($10bn;
$6.6bn and $3.1bn, respectively) in June 2009. At least
22 smaller banks have been allowed to repay some or
all of their taxpayer money. Observers agree that the
institutions are mainly motivated by the desire to ‘get
out from under US government thumb’ (Reuters 2009).
â•‡ 4. Here, the plan notes that ‘We will focus on reaching
international consensus on four core issues: regulatory
capital standards; oversight of global financial markets;
supervision of internationally active financial firms; and
crisis prevention and management.’
â•‡ 5. As Crook (2009) writes, such loose ends concern
technical aspects of regulatory capital and leverage ratios
for financial institutions; there is vagueness about how

n ote s â•… 18 3
Fannie Mae and Freddie Mac – central to the mortgage

securities bubble – will be regulated under the new rules.
â•‡ 6. The paper includes tighter capital and leverage
requirements, and new norms of consumer protection
in the country.
â•‡ 7. I thank Victoria Chick for highlighting this important
point to me.

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index
Accounting, see also fraud, 21–2, 42, 77–8, 107,

new economy, offshore, 110, 115, 117, 120–1,
Ponzi, 44–8, 132 124, 125, 131, 164, 167
creative accounting 47, and risk 67, 81, 139
139 and securitisation 9,
and fraud 94–5, 105, 14–15, 78, 110, 115–16,
106, 133, 134 118, 136, 139–40, 162
Accounting standards:
135–8, 141 Banking
Agency debt (USA), 178n.9 and liquidity, 117, 146
Agencies, see ratings system 2, 9, 19, 21, 27,
agencies 49, 83, 88, 116, 161,
Arbitrage, regulatory 171, 179n.14
arbitrage 46, 87, 165, commercial (traditional)
194 13, 85, 158, 160
Asia – 38, 48, 73, 74 investment, see also Ponzi
‘Naughty Asian capitalism 66
exporters’, 74–5, 77, ORD model 15, 116,
78, 79, 119, 180n.2 117, 118
ADB 38 shadow 15, 85, 119
Asian capitalism 160 Banking crisis 2, 24, 30, 34,
Asset(s) 35, 36, 38, 91, 95, 129,
Asset-backed securities 153
(ABS) xxx, 29, 43, 128 Bank of England
asset inflation 2, 3, 63, and credit crunch 21, 36,
96, 133 57, 58, 85, 86, 88, 94,
toxic, 144, 146, 147 119, 177n.2
and capital 31, 35, 48, and Northern Rock, 31,
49, 95, 141, 163 88, 94
and liquidity (also liquid Tripartite Agreement 31,
assets) 6, 8, 11, 16, 56, 88
197
Nesvetailova 02 index 197 30/03/2010 11:40

198 financial alchemy in c risis
Bankruptcy 24, 26, 27, 28, Capitalism 1, 67, 76, 100,

30, 34, 35, 92, 129, 114, 160, 164, 167
139, 148, 177n.4 crisis of 24, 63, 70, 71–4,
Basle Accord 95, 116–17, 79, 91–2, 96, 171–2,
120, 137, 163 174–5
committees and groups financialised 3, 12, 91–2,
168, 171 114, 168, 172
Bernanke, Ben 29, 74–5, varieties of 150, 160–1
81, 129, 157 Anglo-Saxon 63, 66,
BIS 19, 28, 49, 50, 69, 96, 71–4, 89, 157, 161,
124, 177n.2, 180n.1, 175
180n.2 Ponzi, see also Ponzi
on liquidity 19, 42, 76 100–12
Bretton Woods system 9
Central bank(s) 29, 30, 32,
‘Bretton Woods-2’ 76, 148,
36, 44, 88, 144, 145,
167
177n2, 178n7, 179n1,
Bubble 3, 18, 63–7, 79, 91,
182n2
100, 103, 105, 122,
ECB 16, 29, 44, 130,
127, 135, 136
155, 162, 177n2
dot.com 48, 95, 133, 134
Federal Reserve (the Fed)
securitisation 20, 89, 138,
29, 34, 35, 44, 68, 88,
160, 169, 173, 183n.5
‘super-bubble’ 73 146, 157, 178n7,
Business cycle 178n12
theory of, 80 City of London 150, 156,
170, 181n3
Capital see also Credit boom 3, 22, 25, 31,
recapitalisation: 1, 18, 42, 47, 53, 64, 65,
41, 43, 114, 133–4, 80–3, 91, 96, 99,
135, 165 101, 108, 111, 120,
Capital adequacy (also 123, 124, 127–8, 143,
norms) 88, 154–5, 164
161–3, 172n.4, 172n.5, Credit derivatives 87, 126,
183n.6 178n12
Capital markets 41, 43, 72, Credit expansion 19, 69
74, 136, 175 Credit rating 142

index 199
Credit rating agencies Deregulation 11, 43, 64,

(CRAs) 22, 81, 105, 78, 124, 128, 172
135 Depression, see also crisis
role in the crisis 135–9, of the 1930s, 32, 95–6
162 Global 34, 171
regulation of, 154, 163 Great Depression 35,
Crisis 171, 175
of the 1930s, 34–5, 171, Dot.com crisis, dot.com
172 bubble 48, 95, 100,
of the 1990s, 74, 165, 132, 134, 138, 140
167, 170
theories of, 62–89 Europe 36, 37, 40, 45, 73,
structural theories 71–9 77, 104, 119, 146
cyclical theories 80–9 Eastern Europe, 77,
policy responses to, 32, 179n.14
144–9 response to crisis 153–6,
161, 164
Debt 2, 3, 6, 16, 20, 33, 40, EU 32, 36, 150, 153–4,
50, 52–3, 55, 95, 99, 156, 161, 163, 170,
101–2, 116, 117, 121, 179n.15
173–4, 176, 178n.9, Euromarket, also
178n.11, 180n.2 Eurocurrency,
toxic 7, 35, 42, 59, 60, eurodollar market 9,
86, 128, 131, 135, 139, 45, 116
141, 145, 164, 182n.2 Enron 48, 50, 51, 69,
mortgage-backed, 25, 29 133–5, 140–1
public 90–1 European Central Bank
US debt 33, 42, 95, (ECB), see central bank
178n.9
Debt culture 9–10, 63–4, Fannie Mae 33, 132, 145,
69, 72–5, 78–9, 95–6, 150, 178n.9, 183n.5
98, 102 Freddie Mac 33, 145, 150,
Derivatives 10, 43, 44, 82, 178n.9, 183n.5
87, 95, 105, 109, 119, Federal Reserve (Fed), see
126–8, 163, central banks
178–9n.12, 181n.3 Financial expansion 98

200 financial alchemy i n crisis
Financial fragility 20, 102, Gold (standard) 9, 96

118, 175 Governance, financial 16,
and liquidity 20 55, 82, 89, 120, 143,
and ORD model, 118 148, 152, 156–7, 166,
Financial innovation 8, 168–70, 175
13–17, 20–3, 42–3, 51, Granite, see also Northern
56, 59, 60, 83, 100–3, Rock and Offshore 40,
109, 181n.3 42, 501, 52–5, 59, 141,
and liquidity 129–42 179n.2
crisis lessons, 150, 153, Great Depression, see crises
157, 162, 164–6, 168, Greed 41, 82, 83, 84, 90,
173, 175–6 159–61, 176
controversy over, 43–7 Greenspan, Alan 14, 22,
role in crisis, 109–20 34, 66, 68, 70, 73, 76,
Financial liberalisation 150 166
Financial architecture, see
also NIFA, 37, 142, Hedging 16, 140
149, 156, 162, 165, Hedge fund(s) 15, 29, 43,
167 94–5, 105–6, 109, 118,
Financialisation 12, 15, 45, 129–30, 155–6, 181n.3
66 Herding, investor 95,
Fraud 40–2, 47, 68, 89, 126–7, 130, 159
100, 128, 133–4, 140, Heterodox (economics,
160, 173, 181n.6 political economy) 3,
and offshore, 47–9 22, 95, 174
and Ponzi, 100–9, 111 House prices 25, 28, 65,
103
Galbraith, JK 1, 175 Housing market(s) 2, 25,
Geeks, finance 66, 84, 123, 28, 32, 81, 98, 103
158 Human factor, in crisis
Geopolitics 149, 156 82–9
Global recession, see also
depression and crisis, 2, Iceland 36, 41
33, 38, 148 Illiquid
Global savings glut see also asset 14, 107, 116, 146,
savings and liquidity 163
glut 78 institutions 182n.1

index 201
loans, also debt 6, 12, concept, 5–6, 7–8, 10–12,

174 16–17, 60, 114, 121,
system 20, 141 126, 136, 167, 173,
Illiquidity 117, 129 177n.2
Systemic 141 crisis, also crunch, also
IMF 26, 28, 32, 36, 90, 91, meltdown 5, 24, 29,
140, 164, 170, 177n.2, 30, 34, 126, 128–31,
179n.15 179n.12
Inflation, see also asset illusion of 4, 60, 113,
price inflation 45, 73, 143, 164, 173, 176
81, 86, 98–9 defined, 17–23
Innovation, see financial pillars of, 113–42
innovation paradox of, 125
Interest rate 26–7, 30, risk 19, 20, 57, 127
36–7, 45, 47, 64, types of, 6, 145
104–5, 107, 140, 144,
and assets 8, 121, 135
178n.7
and markets 7, 10–11,
and subprime 103–6
12, 16–17, 34, 88, 115,
119, 121–4, 126–7,
Japan 39, 75, 77, 104,
132, 136, 141, 143,
179n.16, 180n.2
144, 159, 167
Junk (securities) 145, see
also toxic debt and system 14, 17, 112,
115–17, 141–2, 143,
Keynes, John Maynard 3–4, 173–4
8, 10, 161, 175, 177n.1 and financial innovation
Keynesian welfare state 9–10, 11, 76, 112,
71 115–16, 137–9, 142,
Kindleberger, Charles 85 159, 166, 173–6
and regulation 57, 154,
Lender of last resort 88, 163, 177n.2
145, 182n.1 (ch. 6) liquidity glut, also liquidity
Leverage 1, 18, 73, 125, boom, see also savings
129–30, 146, 173, glut 7, 76, 78, 79, 97,
182n.5, 183n.6 124–5, 174, 176
Liquidity Liquidity support in crisis
artificial 42 30–1, 146, 150, 178n.7

202 financial alchemy in c risis
Loans, securitised 7, 57, 78, Northern Rock, see also

103, 105, 114, 128, Granite and offshore
139, 146, 179n.1, 30–2, 39, 92–4, 128,
180n.2 141, 147
Loans, liars’ 103 and Granite 40–2,
LTCM 67, 69 51–61
Mania, tulip 100 Offshore finance, see also

Minsky, Hyman 3, 17, Granite and Northern
18–19, 20, 96, 102, Rock 15, 42, 48, 51,
127, 129, 167, 174–5, 53–5, 59, 100, 107,
181n.4, 182n.1 109, 128, 176
taxonomy of finance, Offshore, entities 48, 60,
102 128, 139
and Ponzi finance, see Over-the-counter (OTC)
also Ponzi 96, 102–3, 123, 163
181n.4
on financial innovation Panic 29, 32, 34, 145
115–17 Ponzi, see also Minsky,
Monetarism 169 Hyman
Monetary policy 2, 30, 44, Ponzi capitalism 100–2,
56, 69, 81, 86, 105, 104–5, 134, 174
144–5, 152, 163, Ponzi, Carlo 100,
178n.7 181n.4
Mortgages, sub-prime 2, Ponzi era 96
13, 14, 25, 26, 28, 38, Ponzi finance, also Ponzi
41, 55, 65, 79, 101, scheme 19, 22, 59, 95,
103, 113 100–4, 105, 106, 121,
Residential 135 127, 129, 134, 174,
176
Neoliberal, capitalism 72 and securitisation
New economy 67, 112, 106–10, 174
132, 134, 138, 172 Ponzi principle 59–60,
New International Financial 102–3, 104, 127
Architecture (NIFA) Privatisation of financial
165, 167, 168 risk 11, 59, 166

index 203
Rating, see credit ratings management of, 6, 9,

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

204 financial a lchemy i n c risis
Toxic debt, see debt Wall Street 1, 28, 32, 34,

True sale 139–40 88, 150, 160
Washington Mutual 35
United Kingdom 21, 30, 31, Wealth, illusion of 1, 2, 12,
33, 35–7, 40–1, 49, 51, 17, 22, 34, 38, 91, 99,
53–5, 58, 59, 71–2, 85, 112, 114, 119, 143,
86–8, 92–4, 97–100, 164, 173–6
104, 146–8, 150, 154, Welfare 13–14, 43, 71, 73,
156, 161, 179n.13 112, 142
United States 2, 7, 18, 25, WorldCom 48, 105, 133–4,
75, 77, 95, 124, 150 182, ch.5n.3

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Financial Alchemy in Crisis

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Distributed in the United States of America exclusively by

Copyright © Introduction, Chapters 2, 3–6, Conclusion

The rights of Anastasia Nesvetailova and Ronen Palen to be identified

British Library Cataloguing in Publication Data

ISBN 978 0 7453 2878 2 Hardback

Library of Congress Cataloging in Publication Data applied for

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Designed and produced for Pluto Press by

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Nesvetailova 00 pre 5 29/03/2010 09:12

Introduction: The End of a Great Illusion 1

1. The Stages of the Meltdown 24

2. The Tale of Northern Rock:

3. How the Crisis has been Understood 62

4. Some Uncomfortable Puzzles of the Credit Crunch 90

Nesvetailova 00 pre 7 29/03/2010 09:12

5. 2002–7: The Three Pillars of the Liquidity Illusion 113

6. After the Meltdown: Rewriting the Rules of

Conclusion: A Very Mundane Crisis 172

Nesvetailova 00 pre 8 29/03/2010 09:12

ABSs Asset-backed securities

Nesvetailova 00 pre 9 29/03/2010 09:12

The booming industry of credit crunch analysis is

Nesvetailova 00 pre 10 29/03/2010 09:12

Sometime in the twenty-first century, new monks, not

Nesvetailova 00 pre 11 29/03/2010 09:12

By now it was also evident that the investment trusts, once

Sounds familiar? John Kenneth Galbraith wrote these

Nesvetailova 01 text 1 30/03/2010 11:40

world of finance and, since then, the entire global

Nesvetailova 01 text 2 30/03/2010 11:40

Nesvetailova 01 text 3 30/03/2010 11:40

is no doubt that complex sets of factors – historical,

‘Liquidity’ and the Crisis of Invented Money

There is a certain oddity about the realm of finance

Nesvetailova 01 text 4 30/03/2010 11:40

contest’1 and the metaphor stuck – albeit we know that

Nesvetailova 01 text 5 30/03/2010 11:40

The problem is conceptual. Liquidity is a very fluid,

Nesvetailova 01 text 6 30/03/2010 11:40

This is exactly what happened to trillions of

Nesvetailova 01 text 7 30/03/2010 11:40

consensus, however, on what the concept of liquidity

Nesvetailova 01 text 8 30/03/2010 11:40

First, the transformation of liquidity has paralleled

Nesvetailova 01 text 9 30/03/2010 11:40

their ownership and hence, by expanding the web of

Nesvetailova 01 text 10 30/03/2010 11:40

change in the analytical approaches is to be found in the

Nesvetailova 01 text 11 30/03/2010 11:40

to the complex mechanism of financial transactions

Nesvetailova 01 text 12 30/03/2010 11:40

growth and, crucially, developments in the sphere of

Nesvetailova 01 text 13 30/03/2010 11:40

The subprime market provides a market-opening and -completing

Ultimately, as Alan Greenspan foresaw, ‘financial

Nesvetailova 01 text 14 30/03/2010 11:40

Third, the spiral of demonetised financialisation

Nesvetailova 01 text 15 30/03/2010 11:40

Officials at Standard & Poor’s admit that, by 2006, it

2. The Tale of Northern Rock:

4. Some Uncomfortable Puzzles of the Credit Crunch 90

5. 2002–7: The Three Pillars of the Liquidity Illusion 113

6. After the Meltdown: Rewriting the Rules of