0745328776

Financial Alchemy in Crisis
Financial Alchemy in Crisis

The Great Liquidity Illusion
AnAstAsiA nesvetAilovA
First published 2010 by Pluto Press 345 Archway Road, london n6 5AA and 175 Fifth Avenue, new York, nY 10010 www.plutobooks.com Distributed in the United states of America exclusively by Palgrave Macmillan, a division of st. Martins Press llC, 175 Fifth Avenue, new York, nY 10010 Copyright introduction, Chapters 2, 36, 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. British library Cataloguing in Publication Data A catalogue record for this book is available from the British library isBn isBn 978 0 7453 2878 2 978 0 7453 2877 5 Hardback Paperback
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For Alexandre Gennady Palan
Contents
Abbreviations Acknowledgements Introduction: the end of a Great Illusion liquidity and the crisis of invented money liquidity illusion and the global credit crunch 1. the stages of the Meltdown the prelude: the American sub-prime crisis From sub-prime crisis to the global credit crunch From global credit crunch to global recession 2. the tale of northern Rock: Between Financial Innovation and Fraud (Anastasia nesvetailova and Ronen Palan) the controversy over financial innovation offshore: the uses and abuses of sPvs northern Rock and Granite 3. How the Crisis has been Understood Ex-ante and ex-post visions of the credit crunch structural theories of the credit crunch Cyclical theories of the crisis 4. some Uncomfortable Puzzles of the Credit Crunch Dismissed: the warning signs and the whistleblowers Ponzi capitalism: a crisis of fraud?
ix x 1 4 17 24 24 28 33 40 43 48 51 62 62 71 80 90 91 100
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5. 20027: the three Pillars of the Liquidity Illusion liquidity and the paradigm of self-regulating credit Playing with debt together. liquidity as a state of mind the alchemists: turning bad debts into money 6. After the Meltdown: Rewriting the Rules of Global Finance? the three stages of the policy response the crisis and geopolitics: a new special relationship? Conceptual dilemmas and traps Conclusion: A Very Mundane Crisis Notes Bibliography Index
113 113 121 131 143 144 149 156 172 177 184 197
Abbreviations
ABss Bis CDos Ceo CRA eCB FsA FsF FsB GDP iMF MBAs MBss niFA oFC oRD otC siv snB sPe sPv vAR
Asset-backed securities Bank for international settlements Collateralised debt obligations Chief executive officer Credit rating agencies european Central Bank Financial services Authority (UK) Financial stability Forum Financial stability Board Gross domestic product international Monetary Fund Mortgage-backed assets Mortgage-backed securities new international financial architecture offshore financial centre originate and distribute (model of banking) over-the-counter (trade) special investment vehicle swiss national Bank special purpose entity special purpose vehicle value at risk (model)
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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, earths 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; todays 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 illunderstood 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
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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,
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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 20027. 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
f inanci al alchemy in crisis
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, todays 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 20027 this fallacy, apparent to many in the aftermath of the crisis, was concealed by one great myth of todays 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
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contest1 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 20079, 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 aint 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 intertemporal 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.
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This is exactly what happened to trillions of dollars of securitised loans and a plethora of highly sophisticated and opaque financial instruments during 20079. At the height of the 20027 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
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 assets 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.
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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 systems 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-financing, 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, securitisation 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
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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 securitisation 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.: 401). With banks rapidly becoming major players in this global financial market, and with their greater reliance on securitisation techniques in managing their portfolios, the notion of liquidity as tied to the pure credit intermediation mechanism or a state-administered monetary pool began to fade away. Indeed, the earlier political-economic conceptualisations 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
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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 liberalisation 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
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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 financialisation, therefore have been progressively abstracted from the dynamics of productivity, trade, real economic
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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 intermediation 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, riskoptimising and market-creating financial innovations have been seen as key to enhancing social welfare more generally:
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financi al alchemy in crisis
The subprime market provides a market-opening and -completing opportunity The subprime market allows funding to those who would otherwise not be homeowners. 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: 1634)
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, securitisation, 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).
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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 sophistication 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.
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Officials at Standard & Poors 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: 1317). 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
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contributed to the illusion that this is the real cause of the global credit crunch. The first fallacy is the assumption that it is the market-making capacity of financial intermediaries to identify, 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 global 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
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this message that seems to attract most commentaries on the credit crunch. According to Minsky, good times breed complacency, exuberance and optimism about ones position in the market and lead to greater reliance on leverage and underestimation of risks. Indeed, as stated famously by Citis 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, youve 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 underestimation, 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 2007September 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
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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 Minskys 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 Minskys framework. Very few indeed cast a critical
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eye on the very ability of private financial intermediaries 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 systems 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 firms securitisation strategy had been based on the assumption that collateralised mortgage obligations (CMOs) would be more liquid than their underlying collateral the properties he warned that this assumption was far too
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short-sighted and over-reliant on the markets shared sentiments: as a guide to market discipline, we like the expression, sure theyre 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
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assets in the united Kingdom, which has been replicated in other countries. (2008: 3940)
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 20027. 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 n
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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
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T he s TaGes of T he me lTdoWn
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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 mortgagebacked 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
26
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 dont 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
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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 Moodys, 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 20067 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: HSBCs 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
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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
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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), subprime-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 worlds 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 worlds
30
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 AugustSeptember 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 countrys 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.
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In 2006early 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 government (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
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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 Streets 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 me lTd oWn
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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 USs $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 715 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.
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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 countrys 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
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($12.9bn),11 Merrill Lynch ($6.8bn), Bank of America ($5.2bn), Citigroup ($2.3bn) and Wachovia ($1.5bn). The major foreign banks included Socit Gnrale 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 countrys 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 UKs 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
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f ina ncial alchemy in crisis
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 countrys 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 industrialised 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
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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 UKs payment system prompted the government to set up a COBRA13-style committee on the economic crisis (Winnett and Simpson 2008). Over the weekend of 45 October 2008, the committee drafted a rescue plan (later known as the Brown-Darling bank recapitalisation 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
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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 years 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 years 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: Germanys industrial output was down 19.2 per cent year-on-year in January, South
T he sTaGes of T he me lT doWn
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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, Londons Credit Magazine, one of the financial industrys 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 securitisation 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 securitisation at Northern Rock, explained that the Whinstone transaction allowed the fifth largest UK mortgage lender to reference the reserve funds of 13 Granite transactions, three of which were stand-alone issues and the other ten under the Master Trust programme. The beauty
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T he Tale of norT he r n ro cK
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of it, he declared, is in its simplicity, parcelling the reserve funds and writing a credit default swap thereby transferring the majority of Northern Rocks first-loss risk to the international capital markets (Credit Magazine, January 2006). * * * 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 banks 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 securitisation 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 securitisation techniques had never discovered new ways of managing or optimising risk; they merely disguised or
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reparcelled it. But if the real foundations of financial health in the 20027 credit boom never existed, as many analysts now seem to agree, how was the securitisation boom sustained for those five years? Why and how were so many dubious debts transformed into liquid assets? We believe that there were three factors supporting the boom of what Claudio Borio, 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 cK
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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.
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fin anci al 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 todays 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 worlds 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
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critics at the time said that the measure was neither well coordinated nor justified by the markets 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
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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 deregulated market:
a legally based level playing-field opens up new sources of competitive advantage, with some more able than others to creatively escape even harmonised regulatory restrictions. 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, Shahs 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
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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-compliance 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 selfregulation 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 20027 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.
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fina ncial alchemy in crisis
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 20079 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,
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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 UKs 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 worlds SPVs. We have no way of knowing, however, exactly how many of the worlds 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
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would like to stress, though, that we do not see the two as being the same thing.
Table 2.1 The share of ofcs in international financial flows, 2007 All countries Caymans Switzerland Netherlands Ireland Singapore Luxembourg Bahamas Jersey Guernsey Bahrain Isle of Man Total $29,164.7bn 1,691.3 1,413.0 1,226.3 1,218.8 773.5 761.5 436.5 326.3 210.1 205.0 71.9 8,334.0 % share 5.8 4.8 4.2 4.2 2.6 2.6 1.5 1.1 0.7 0.7 0.3 28.5
Source: BIS, International Financial Statistics, 2008.
SPVs hit the headlines following the collapse of Enron. The Powers Committee, which investigated Enrons 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). Enrons fraud was organised through 3,000
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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 Enrons offshore SPVs were set up primarily for tax avoidance purposes. In this context, the fall of Northern Rock in 20078 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 Rocks accounts in 2006 showed that it raised just 22
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per cent of its funds from retail depositors and at least 46 per cent from bonds. It was this risky financing technique that gained Northern Rock its award for the best securitisation deal of the year in January 2006. Crucially, the bonds that were so instrumental in Northern Rocks 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 Rocks 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 Granites accounts showed it had no employees at all, despite having nearly 50bn of debt. The entire structure was acknowledged to be managed by Northern Rock and, unusually, was treated as being on balance sheet of Northern Rock and thus included in its consolidated accounts.
Th e Ta le of norT h e r n ro cK
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As the credit boom unravelled, Northern Rock faced a dilemma. Granite was used to securitise parcels of mortgages on the money market through bond issues. When in August 2007 the money market lost its appetite for that debt, Northern Rocks 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 banks balance sheet (ibid.). So how could Granite be part of the Northern Rocks funding mechanism and yet be a separate entity? The precise ownership structure of Granite companies
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and its financial relationship with Northern Rock are murky. Because Granite is a Jersey-incorporated vehicle and protected under the secrecy laws of Jersey (generally considered an offshore financial centre), there is no way of knowing who really is the trustee of Granite. Consequently, the issue was never resolved. No one seemed to know whether a company wholly managed by a state-owned enterprise but notionally owned by a charitable trust was under state control or not. Despite that, the government had little choice but to extend its guarantee to the Granite bondholders. The consensus is that the Jersey-based offshore structure was used as a securitisation vehicle for mortgages issued by Northern Rock. It is suspected that Granite served as an equivalent of a price transfer channel for the bank, a means by which it could transfer profits earned in the UK to Jerseys 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 banks obligations to Granite, which in turn, may be owned by Northern Rock. In the winter of 2008 some MPs raised questions about the precise links between Northern Rock and Granite, but no clear
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answers have been forthcoming. In the meantime, the unfolding financial malaise shifted political concerns to the UKs increasingly shaky financial system. The confusion created by Granites 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 banks failure was handled by the tripartite structure of financial governance in the UK highlights
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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 Banks 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: 1718). In Northern Rocks 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
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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 banks 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 FSAs 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 banks 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
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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 Rocks 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 banks senior management were
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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 worlds 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
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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 others 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
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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.
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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 structural 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
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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 interpretation 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 20027 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
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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 accountability 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 doesnt matter if im running up the money on my credit cards because next year im 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
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financial sectors 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 todays 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 financialisation 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 1020 years, these professionals have no
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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 20027, 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,
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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 worlds 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
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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: 56)
So what should one make of shock explanations of the credit crunch? On the one hand, it is understandable 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, 19945, 19978 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
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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 interpretations 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
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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 selfcorrecting 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
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1950s1960s with a neoliberal model of capitalism. The financial meltdown of 20079 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 socioeconomic 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
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to disposable income went up from 93.4 per cent to a post-1945 record of 139 per cent (Turner 2008: 267). 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
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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
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debt issuance. of necessity, this strategy also pushed emergingmarket economies toward current account surpluses. (ibid.)
6 4 2 0 2 4 6 8 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 6 4 2 0 2 4 6 8
Emerging Asia
United States 1995 1997 1999 2001 2003 2005
Figure 3.1 current account imbalances as a Percentage of GdP (1975 Q12006 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 nations 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 efficiently through the advanced system of financial intermediation to those who were assumed to be best placed to bear it:
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The development of a broad-based secondary market for mortgage loans also greatly expanded consumer access to credit. By reducing the risk of making long-term, fixed-rate loans and ensuring liquidity for mortgage lenders, the secondary market helped stimulate widespread competition in the mortgage business. The mortgagebacked security helped create a national and even an international market for mortgages This led to securitisation of a variety of other consumer loan products, such as auto and credit card loans. (Greenspan 2005)
At the time, a similar understanding of the global liquidity glut was of fered by the BIS. 1 The bank commented that conditions in the major financial markets remained calm and accommodative for much of 2005 and early 2006, 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
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Table 3.1 Global current account Balances, 1996 and 2003 (billions of us dollars) Countries Industrial United States Japan Euro Area France Germany Italy Spain Other Australia Canada Switzerland United Kingdom Developing Asia China Hong Kong Korea Taiwan Thailand Latin America Argentina Brazil Mexico 1996 2003
46.2 342.3 120.2 530.7 65.4 138.2 88.5 20.8 13.4 39.6 0.4 12.5 15.8 3.4 21.3 10.9 87.5 40.8 7.2 2.6 23.1 10.9 14.4 39.1 6.8 23.2 2.5 24.9 4.5 55.1 20.7 23.6 25.3 30.4 17.1 42.2 30.5 205.0 148.3 45.9 17.0 11.9 29.3 8.0 3.8 7.4 4.0 8.7 47.8 5.1 137.2
Middle East and Africa 5.9 Eastern Europe and former Soviet Union 13.5 Statistical discrepancy
Source: Bernanke 2005.
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other countries to hold assets in this form (Eichengreen 2007: 24). In the meantime, the Asian exporting countries were criticised for keeping their debt markets underdeveloped and shallow: Large Asian holdings of U.S. debt are usually attributed to the regions penchant for undervalued home currencies, which lead to chronic trade surpluses and a buildup of foreign reserves. Such excess liquidity, or savings glut, according to observers, was stunting their growth.2 The explanation was found to be in the nature of market openness and competition: according to market commentators, Asian savings tend to sit in savings accounts, creating vast pools of liquidity that enable banks to offer mortgages and loans at rates with which the originators of securitised loans cannot compete. Analysts at the time concluded that a liquidity glut is mitigating against Asias 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
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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 20027 financial bubble. In order to understand such trends and their role in the crisis, we turn next to the cyclical explanations of the credit crunch.
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cyclical Theories of the crisis

The End of the 20027 Credit Boom Chronologically, the global credit crunch came as the end of the preceding housing and credit boom centred on the North Atlantic economies. This boom-and-bust sequence led to a common reading of the crisis that has its origins in the business cycle theory of finance and economy. At its core, the theory derives from the Austrian school of political economy and is based on the assumption that in the long run any economic system necessarily goes through periods of boom and bust, expansion and contraction. Crises therefore are cyclical or transient events, marking the natural bottoming out points of economic activity between the two major phases of the cycle expansion (boom) and contraction (bust). In this view, any crisis is caused by, and reflects, the dynamics specific to the expansionary period in question, as opposed to being the outcome of a more inherent structural disruption to the political-economic system as whole. This vision, therefore, makes crises appear natural, normalising events in the course of the economic cycle. In the context of the global credit crunch, the business cycle approach to crisis is built on the argument that the crisis originates in a problem specific to the 20027 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
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to under-price financial risks during the boom years of 20027. 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 sectors 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
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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 20027 and it subsequent bust in 20079 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.
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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 financial markets.
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fina ncial alchemy in crisis
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 unaccountability 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. Theyve 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 didnt go too far. Now, he said, they entered straight from university and were allowed to take extraordinary risks: Theyve been doing it for years but its 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 doesnt matter if Im running up the money on my credit cards because next year Im going to earn more (in Gimson 2008). The problem of unaccountability and lack of ethical standards in finance goes beyond financial dealers and
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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
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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
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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 companys 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 implementation of financial policy as much as its flawed theoretical assumptions that precipitated the crisis. As Willem Buiter (2008) writes, this problem was apparent
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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 institution-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
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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, wasnt the securitisation 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
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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 todays finance which, so far, remain unanswered.
dismissed: The Warning signs and the Whistleblowers

The first puzzle is the timing and the apparent unpredictability 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 todays financialised, globalised economy.
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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 UKs best known case is the Royal Bank of Scotland (RBS). The bank reached the brink owing to an extremely aggressive financial strategy during 20008 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
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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 Rocks business model relied.
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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 Rocks business model and its potential domino effect on HBOS, then the UKs 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 Rocks 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 Madoffs 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 Madoffs books were audited by a three-person accounting firm, 2 which in late 2006 affirmed that the financial statements of Madoffs 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
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securities and $67m in US debt. Members equity, the firms net worth, was $604m. Such a ratio of debt to equity made Madoffs 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 collateralised 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
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21st Century, published in 2003. The books authors, drawing on Hyman Minskys work, concluded their study of the new, Ponzi-style era of consumer borrowing and credit excesses in the US with a rather pessimistic prognosis:
american consumer capitalism is doomed The trends that could not last forever seem to be coming to an end. consumers cannot continue to go deeper into debt. consumption cannot go down much further. foreigners will not continue to finance americas 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 BIS pondered:
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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 20027, the success of New Labour was founded on the greater availability of credit to the population, the flourishing
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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 Partys position and appeal fatally damaged by the deeply unpopular war in Iraq, the economic argument remained one of the few things supporting Labours 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 services ... 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)
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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 Socit Gnrale, 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 sectors 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, Londons model historically had been much more global, which made it a peculiarly
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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
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opportunity to make a lot of money by deceiving the public by promising high returns from a new, fictitious, venture. The securitisation boom of 20027 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 20027 and the process of securitisation as one massive industry of deceit and fraud. Sophisticated financial means of trading and packaging highly obscure financial instruments employed in securitisation and re-securitisation deals were instrumental in concealing not only bad lending and business practice, 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.
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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 Minskys 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.
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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 sometimes 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 attracts 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-fulfilling. 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
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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 lending 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 economies and, correspondingly, by the benign and ill-informed view of the financial and monetary authorities of the risks posed
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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 investigations 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
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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 20089, 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 Madoffs 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
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Madoffs 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 Stanfords 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 Stanfords 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
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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 superprofitable. But according to prosecutors and regulators the money simply filled the two mens 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
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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 Ponzis original postage scam flourished. The Ponzi web has spread beyond Americas 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
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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 Socit Gnrale 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
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continues does suggest that something went terribly wrong with the business of securitisation. First, it transpires that the proliferation of scientifically calculated but opaque financial techniques in the self-regulated financial markets has made it easier for individuals and institutions to conceal fraud and deception under the wide umbrella of financial innovation. The credit boom of 20027 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
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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 nave 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 20027: 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 20027 boom had there not been a broader international politicaleconomic 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
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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 ones 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
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chapters have noted, most financial innovations have for a long time been perceived to be liquidity-enhancing: by pooling a greater variety of assets in the market exchange, by pricing them and then transferring them to new, 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 straightforward. 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
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a technique to create securities by reshuffling the cash flows produced by a diversified pool of assets with some common characteristics. 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 sectors 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.
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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
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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: 323), 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 banks 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
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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-primerelated 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 sectors 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 nave and short-sighted to draw a straightforward, linear link between securitisation and systemic stability. At
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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 representations 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
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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 20027 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
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key reason why many destabilising trends and risks in the credit bubble had been overlooked. Assuming that anything can be bought and sold in the financial market is simply wrong. 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.
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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, intertemporal, cognitive and social processes of valuing risks. Standardisation of products and financial techniques is absolutely central to sustaining market liquidity (ibid.: 3534). 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 securitisation, 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
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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: 78)
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
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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 ones 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
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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 Nuge (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 20027. 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
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and crowded trades. In this herd-driven process of financial innovation, the conventional trends of a bubble and Minskys Ponzi finance prevail: the undervaluation 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
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tend to be generic features of any financial crisis, the credit boom of 20007 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
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security (Thomson 2009: 911). This not only triggered a liquidity crunch at the bank, but also made bankruptcy procedures very difficult to instigate. Instructively in this instance, in May 2007 Bernanke warned: substantial market risk may be associated with holdings of illiquid instruments tranches of bespoke collateralised debt obligations illustrate this well. A pattern of crowded trades may lead to market illiquidity, sometimes in surprising locations, when risk aversion heightens (in Madigan 2008). And while it is the banking sector that has suffered the bulk of losses and remains the focus of attention in the wake of the credit crunch, some observers doubt whether commercial banks have increased their leverage too much. According to Willem Buiter, most of the increased leverage in the financial sector took place outside the commercial banks in investment banks, hedge funds, private equity firms and a whole range of new financial institutions relying on the new securitisation-based financial instruments (Buiter 2008). Other analysts and regulators confirm that it is the spread of the hedge fund industry and, in particular, its involvement in the securitisation industry that aggravated the problem of risk concentration and market illiquidity. This process has been twofold. First, the expansion of the hedge fund sector led to more investors chasing the same opportunities. When this happens, profits start to decline. Declining profits in turn encourage investors to increase leverage, so that a Minsky-type Ponzi pyramid emerges. Second, hedge
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funds appear to have been using increasingly similar trading strategies, thus eroding the diversity of the market. According to the ECB, since 2001 hedge fund returns have become less widely dispersed, indicating that their positioning was becoming increasingly similar. In 2005, the ECB stated that under stressed conditions, hedge funds, because they simply cannot afford to wait when leveraged positions begin to lose money, would probably be among the first to rush for the exit (in Madigan 2008). It is also telling that not only did regulators note the potential dangers of risk concentration and crowding, but risk managers themselves admitted that problems in the credit sector were not really unexpected. In 2007, Madelyn Antoncic, New York-based chief risk officer at Lehman Brothers, admitted that there was too much complacency in the markets at the height of the boom: People didnt realise that one of the main factors that contributed to this periods recent stress was the crowded trade and the lack of liquidity for a particular trade once everyone gets out of the same strategy, especially when the trading models are the same (ibid.). The liquidity of the new financial system, therefore, was a somewhat artificial construction, created by the rarely questioned theorems of self-regulating, efficient and optimising market strategies and the collective behaviour of investors, or simply, herding: the sustainability of market turnover depended crucially on the collective actions and expectations of financial players.
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In the end, both pillars of the so-called liquidity boom proved illusory. The idea of risk-optimising financial engineering has turned out to be flawed at its core: it proved impossible to eliminate risk from the financial system since, in Buiters (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 20027: 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 20027: 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-makers presence in the market. At the heart of the function of a liquidity-maker lies the dilemma
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of transferring very specific, idiosyncratic knowledge about a given product into standardised and more transparent, common knowledge that would render underlying products knowable, valuable and tradable. In a national economic system, for instance, the state typically performs this function when issuing its own currency. In the private sphere of the securities markets there are other institutional arrangements designed to serve this role. According to Carruthers and Stinchombe, in postwar America, by pooling together large numbers of home mortgages and guaranteeing the income stream from them, Fannie Mae made them into more liquid securities, first, by making the task of discerning their market price easier and, second, by reducing the amount of information needed to understand their value. As Carruthers and Stinchcombe explain, instead of compiling information about each individual home and borrower on a case-by-case basis, a lender need only use aggregate information about means and variances in the pool of mortgages. By pooling mortgages the function of Fannie Mae was to increase market liquidity by transforming a future flow of payments to the issuing bank into a financial instrument to sell on the secondary mortgage market by using a short-run guaranteed price for mortgages that banks originate (ibid.: 359). More recently, in the new economy of the late 1990s it was financial analysts, accounting and audit firms that, by endorsing the financial reports of dot. com companies real and fictitious created market
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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. WorldComs 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. Enrons 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 Enrons potential return on investment and
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diminishing the firms 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: 5801; 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
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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 20027, 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 todays 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. Todays 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
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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: 301). 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,
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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
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aggravated the securitisation bubble by creating the illusion of liquidity in the markets and wider political-economic systems. Functionally, as noted above, they have been trapped by the basic conflict of interest between being private, profit-seeking companies and their function of providing an independent assessment of risks to the market. This trap has affected their performance in three ways. First, each rating agency had an incentive to overrate the products in order to attract more deals. Second, CRAs run a parallel line of business, giving advice on how to structure financial products. Just as in the case of financial analysts and crooked accounting firms in the 1990s dot.com boom, the CRAs advice was skewed by the hope that the products on which they advised would also come to them for rating, giving them a double stream of revenue and a double incentive to overrate. The third conflict, the most egregious of all according to Wade, also parallels the privately defined regulatory context of the dot.com boom. Under US securities law, ratings agencies were not obliged to undertake their own due diligence about the risk characteristics of the products they were rating. Legally, they were entitled to take the information provided by the seller more or less at face value. This, Wade (2008: 33) argues, gave the seller an even stronger incentive to deceive. Another crucial aspect of the CRAs role in precipitating the meltdown concerns the methods they relied on when rating the newly minted securities. Here, again in intriguing parallel to the new economy boom,
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a complex process of financial innovation has been at work: first, formal separation of ownership, driven by regulatory avoidance, manipulation of legal ownership of assets and creative accounting; and second, the technique of layering securitisation structures. Credit rating agencies have been pivotal to both. From the very beginning of the securitisation boom, a central objective in ensuring the marketability of securitised debt has been to enable the rating agencies to grade the credit risk of the assets in isolation from the credit risk of the entity that originated the assets. Rating agencies demanded legal opinion that the securitised assets represented a so-called true sale and were outside the estate of the originator in the event the originator went bankrupt (Baron 2000: 87). Such separation was essential for the approval stamp that the risk was redistributed and removed from the originators 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 Moodys analyst had, on average, a day to process the credit data from the bank. The analyst was not evaluating the mortgages but rather the bonds issued by the SPV. The SPV would purchase
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the mortgages. Thereafter, monthly payments from the homeowners would go to the SPV. The SPV would finance itself by selling bonds. The question for Moodys was whether the inflow of mortgage payments would cover the outgoing payments to bondholders. For the bank, the key to the deal was obtaining an AAA rating, without which the deal would not be profitable. The secret to turning a sub-prime loan into a triple-A asset lay in the innovative technique of layering various types of assets according to their seniority. The highest-rated bonds would have priority on the cash received from mortgage holders until they were paid in full, followed by the next tier of bonds, then the next, and so on. The bonds at the bottom of the pile the equity tranche got the highest interest rate, but would absorb the first losses in the event of defaults (IMF 2007b; Lowenstein 2008). Thus in another worrying parallel to the financial fraud of the dot.com era, the private agencies of the self-regulating market were now heavily implicated in facilitating dubious financial practices and outright fraud. The similarities between the true sale idea of using SPVs in the securitisation process and the legal manipulation through the use of special purpose entities (SPEs) in the dot.com era are hard to ignore. In the case of Enron, for instance, SPEs most infamous among them was something called Raptor provided hedging insurance to Enron for any losses the latter might suffer from its volatile investments. To achieve this, Raptor needed to be a legal entity independent and separate
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from Enron (Tinker and Carter 2003: 579). Being in full compliance with Generally Accepted Accounting Principles (GAAP) requirements as to its independence, Raptor was in a position to offer Enron a hedge contract on any of the latters investments, whereby Raptor guaranteed Enron that it would absorb any loss in value should the value of Enrons 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 Enrons own stock declined in value amidst rumours about the firms 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 Enrons accounts, registering an immediate loss in excess of $500m (ibid.: 580). Eventually, the firm sank. So we can see that the securitisation boom of 20027 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
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operating in such a system. Institutionally, the global financial architecture reflected the idea of liquidityenhancing financial innovation; as a result, a whole set of regulatory norms produced the specific pillars of the illusion of liquidity during 20027: 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 20027 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 20027 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
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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 20079 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
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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 governmentsupported 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 the turmoil. National Recapitalisation Schemes (9 October 20082009) 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:
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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 governments 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.
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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 latters 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
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20027, 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 world 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 administration 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
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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
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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
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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
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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, Obamas vision for a new financial system stands in stark contrast to a much more muted and light approach of the blueprint drafted by Paulsons team in spring 2008. In its call for a system-wide overhaul of financial supervision, nationally and internationally, 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 comprehensiveness 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
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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 administrations 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 EUs 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 policyrelated, 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 and liberalisation.
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The European roadmap for a new regulatory structure is built on four conceptual areas: improving qualitative information and transparency for investors; 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 20089, the EUs 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
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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 Britain 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
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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
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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).
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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. Intellectually, 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
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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 traditionalist 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
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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 traditionalists 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--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
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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, representatives 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 unaccountability. 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
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pooling their assets with those of other clients into a securitisation vehicle large enough to be rated by a credit rating agency. 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, doesnt 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-securitisation. 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
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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
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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 20027 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
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global financial system, for instance, is disappointingly reminiscent of its rather impotent predecessor: the brief attempt to erect a New International Financial Architecture (NIFA) in the wake of the late 1990s crises. Indeed, as stressed in the G20 communiqu: 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
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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 20027, 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,
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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
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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 19979 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-prudential 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,
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but no one knows precisely how best to define, measure or control it. One positive thing about calls for a closer macroprudential focus is that they are based on the apparently serious realisation that the micro-prudential institutionby-institution supervision undertaken by the FSA has not been sufficient. It certainly has not. But macro-prudential 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 nave: 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
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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 Obamas 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
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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,
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conclusion: a Ve ry munda n e c r i s i s
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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, todays 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
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political dynamics of the modern financial system. Predicated on the confusion between market confidence and systemic liquidity, and the notion of wealth-enhancing 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--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 unpopular 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,
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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. Minskys 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
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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 todays 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
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. 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 crystallisation of rollover risk (2008: 39).
chapter 1
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. 2. According to Inside Mortgage Finance. 3. In 2004, Forbes ranked HSBC as the seventh largest company in the world; in 2007 HSBC was the worlds seventh largest bank in terms of shareholders equity (data from Euromoney). 4. ResMae Mortgage filed for bankruptcy and Nova Star Financial reported a loss that analysts had not foreseen. 5. It filed for Chapter 11 bankruptcy on 6 August 2007. 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.
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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). 8. A year earlier, Bear Sterns had been worth 18bn. 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 Chinas holdings of US debt is in the hands of the government, Chinas 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
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13. 14.
15.
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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). COBRA (Cabinet Office Briefing Rooms) is the UK governments crisis response committee which deals with national crises such as pandemics and floods. 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. In March 2009, the IMF predicted that the total expected losses by banks and other financial institutions 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 6 trillion, or more than 50 per cent from the peak reached in summer 2007 (Papademos 2009). At the end of 2008, world manufactured output and world trade in manufactures shrank dramatically. Germanys 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
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). 2. Granite had no employees whatsoever. We are grateful to Victoria Chick for highlighting this key detail. 3. The figures include the Netherlands, which may be controversial; the rest, including Singapore, Switzerland, Ireland and Luxembourg, clearly attract these SPVs due
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to their very low tax regimes and because they offer a high degree of opacity and secrecy. 4. Renamed the Financial Stability Board in the wake of the global credit crunch. 5. Based on interviews and analysis by Jon Moulton, How the Banks Bet Your Money, Dispatches, Channel 4, 18 February 2008.
chapter 3
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: 1034). 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. 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).
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chapter 4
1. As a result of the bailout, 68 per cent of the bank is currently owned by the state. 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 Citys northern suburbs. 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). 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. 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). 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.
182
chapter 5
1. In this regard, Kregel (2008) notes, the ongoing financial crisis differs from the context Minsky identified. 2. Data from The Economist, 17 May 2007. 3. The accountancy firm Arthur Andersen, which was paid $4.4 million a year to certify that WorldComs books were honest, claims that WorldComs finance chief Scott Sullivan never handed over the material Andersen asked for (Kadlec 2002). 4. By issuing ratings downgrades.
chapter 6
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. 2. Accepting toxic debt as central bank collateral did not give the central banks a clear way out. 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). 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. 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
18 3
Fannie Mae and Freddie Mac central to the mortgage securities bubble will be regulated under the new rules. 6. The paper includes tighter capital and leverage requirements, and new norms of consumer protection in the country. 7. I thank Victoria Chick for highlighting this important point to me.
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index
Accounting, see also fraud, new economy, offshore, Ponzi, 448, 132 creative accounting 47, 139 and fraud 945, 105, 106, 133, 134 Accounting standards: 1358, 141 Agency debt (USA), 178n.9 Agencies, see ratings agencies Arbitrage, regulatory arbitrage 46, 87, 165, 194 Asia 38, 48, 73, 74 Naughty Asian exporters, 745, 77, 78, 79, 119, 180n.2 ADB 38 Asian capitalism 160 Asset(s) Asset-backed securities (ABS) xxx, 29, 43, 128 asset inflation 2, 3, 63, 96, 133 toxic, 144, 146, 147 and capital 31, 35, 48, 49, 95, 141, 163 and liquidity (also liquid assets) 6, 8, 11, 16,
212, 42, 778, 107, 110, 115, 117, 1201, 124, 125, 131, 164, 167 and risk 67, 81, 139 and securitisation 9, 1415, 78, 110, 11516, 118, 136, 13940, 162 Banking and liquidity, 117, 146 system 2, 9, 19, 21, 27, 49, 83, 88, 116, 161, 171, 179n.14 commercial (traditional) 13, 85, 158, 160 investment, see also Ponzi capitalism 66 ORD model 15, 116, 117, 118 shadow 15, 85, 119 Banking crisis 2, 24, 30, 34, 35, 36, 38, 91, 95, 129, 153 Bank of England and credit crunch 21, 36, 57, 58, 85, 86, 88, 94, 119, 177n.2 and Northern Rock, 31, 88, 94 Tripartite Agreement 31, 56, 88
197
198 financial alchemy in c risis
Bankruptcy 24, 26, 27, 28, 30, 34, 35, 92, 129, 139, 148, 177n.4 Basle Accord 95, 11617, 120, 137, 163 committees and groups 168, 171 Bernanke, Ben 29, 745, 81, 129, 157 BIS 19, 28, 49, 50, 69, 96, 124, 177n.2, 180n.1, 180n.2 on liquidity 19, 42, 76 Bretton Woods system 9 Bretton Woods-2 76, 148, 167 Bubble 3, 18, 637, 79, 91, 100, 103, 105, 122, 127, 135, 136 dot.com 48, 95, 133, 134 securitisation 20, 89, 138, 160, 169, 173, 183n.5 super-bubble 73 Business cycle theory of, 80 Capital see also recapitalisation: 1, 18, 41, 43, 114, 1334, 135, 165 Capital adequacy (also norms) 88, 1545, 1613, 172n.4, 172n.5, 183n.6 Capital markets 41, 43, 72, 74, 136, 175
Capitalism 1, 67, 76, 100, 114, 160, 164, 167 crisis of 24, 63, 70, 714, 79, 912, 96, 1712, 1745 financialised 3, 12, 912, 114, 168, 172 varieties of 150, 1601 Anglo-Saxon 63, 66, 714, 89, 157, 161, 175 Ponzi, see also Ponzi 10012 Central bank(s) 29, 30, 32, 36, 44, 88, 144, 145, 177n2, 178n7, 179n1, 182n2 ECB 16, 29, 44, 130, 155, 162, 177n2 Federal Reserve (the Fed) 29, 34, 35, 44, 68, 88, 146, 157, 178n7, 178n12 City of London 150, 156, 170, 181n3 Credit boom 3, 22, 25, 31, 42, 47, 53, 64, 65, 803, 91, 96, 99, 101, 108, 111, 120, 123, 124, 1278, 143, 164 Credit derivatives 87, 126, 178n12 Credit expansion 19, 69 Credit rating 142
index 199
Credit rating agencies (CRAs) 22, 81, 105, 135 role in the crisis 1359, 162 regulation of, 154, 163 Crisis of the 1930s, 345, 171, 172 of the 1990s, 74, 165, 167, 170 theories of, 6289 structural theories 719 cyclical theories 809 policy responses to, 32, 1449 Debt 2, 3, 6, 16, 20, 33, 40, 50, 523, 55, 95, 99, 1012, 116, 117, 121, 1734, 176, 178n.9, 178n.11, 180n.2 toxic 7, 35, 42, 59, 60, 86, 128, 131, 135, 139, 141, 145, 164, 182n.2 mortgage-backed, 25, 29 public 901 US debt 33, 42, 95, 178n.9 Debt culture 910, 634, 69, 725, 789, 956, 98, 102 Derivatives 10, 43, 44, 82, 87, 95, 105, 109, 119, 1268, 163, 1789n.12, 181n.3
Deregulation 11, 43, 64, 78, 124, 128, 172 Depression, see also crisis of the 1930s, 32, 956 Global 34, 171 Great Depression 35, 171, 175 Dot.com crisis, dot.com bubble 48, 95, 100, 132, 134, 138, 140 Europe 36, 37, 40, 45, 73, 77, 104, 119, 146 Eastern Europe, 77, 179n.14 response to crisis 1536, 161, 164 EU 32, 36, 150, 1534, 156, 161, 163, 170, 179n.15 Euromarket, also Eurocurrency, eurodollar market 9, 45, 116 Enron 48, 50, 51, 69, 1335, 1401 European Central Bank (ECB), see central bank Fannie Mae 33, 132, 145, 150, 178n.9, 183n.5 Freddie Mac 33, 145, 150, 178n.9, 183n.5 Federal Reserve (Fed), see central banks Financial expansion 98
200 financialalchemy i ncrisis
Financial fragility 20, 102, 118, 175 and liquidity 20 and ORD model, 118 Financial innovation 8, 1317, 203, 423, 51, 56, 59, 60, 83, 1003, 109, 181n.3 and liquidity 12942 crisis lessons, 150, 153, 157, 162, 1646, 168, 173, 1756 controversy over, 437 role in crisis, 10920 Financial liberalisation 150 Financial architecture, see also NIFA, 37, 142, 149, 156, 162, 165, 167 Financialisation 12, 15, 45, 66 Fraud 402, 47, 68, 89, 100, 128, 1334, 140, 160, 173, 181n.6 and offshore, 479 and Ponzi, 1009, 111 Galbraith, JK 1, 175 Geeks, finance 66, 84, 123, 158 Geopolitics 149, 156 Global recession, see also depression and crisis, 2, 33, 38, 148 Global savings glut see also savings and liquidity glut 78
Gold (standard) 9, 96 Governance, financial 16, 55, 82, 89, 120, 143, 148, 152, 1567, 166, 16870, 175 Granite, see also Northern Rock and Offshore 40, 42, 501, 525, 59, 141, 179n.2 Great Depression, see crises Greed 41, 82, 83, 84, 90, 15961, 176 Greenspan, Alan 14, 22, 34, 66, 68, 70, 73, 76, 166 Hedging 16, 140 Hedge fund(s) 15, 29, 43, 945, 1056, 109, 118, 12930, 1556, 181n.3 Herding, investor 95, 1267, 130, 159 Heterodox (economics, political economy) 3, 22, 95, 174 House prices 25, 28, 65, 103 Housing market(s) 2, 25, 28, 32, 81, 98, 103 Human factor, in crisis 829 Iceland 36, 41 Illiquid asset 14, 107, 116, 146, 163 institutions 182n.1
index 201
loans, also debt 6, 12, 174 system 20, 141 Illiquidity 117, 129 Systemic 141 IMF 26, 28, 32, 36, 90, 91, 140, 164, 170, 177n.2, 179n.15 Inflation, see also asset price inflation 45, 73, 81, 86, 989 Innovation, see financial innovation Interest rate 267, 30, 367, 45, 47, 64, 1045, 107, 140, 144, 178n.7 and subprime 1036 Japan 39, 75, 77, 104, 179n.16, 180n.2 Junk (securities) 145, see also toxic debt Keynes, John Maynard 34, 8, 10, 161, 175, 177n.1 Keynesian welfare state 71 Kindleberger, Charles 85 Lender of last resort 88, 145, 182n.1 (ch. 6) Leverage 1, 18, 73, 125, 12930, 146, 173, 182n.5, 183n.6 Liquidity artificial 42
concept, 56, 78, 1012, 1617, 60, 114, 121, 126, 136, 167, 173, 177n.2 crisis, also crunch, also meltdown 5, 24, 29, 30, 34, 126, 12831, 179n.12 illusion of 4, 60, 113, 143, 164, 173, 176 defined, 1723 pillars of, 11342 paradox of, 125 risk 19, 20, 57, 127 types of, 6, 145 and assets 8, 121, 135 and markets 7, 1011, 12, 1617, 34, 88, 115, 119, 1214, 1267, 132, 136, 141, 143, 144, 159, 167 and system 14, 17, 112, 11517, 1412, 143, 1734 and financial innovation 910, 11, 76, 112, 11516, 1379, 142, 159, 166, 1736 and regulation 57, 154, 163, 177n.2 liquidity glut, also liquidity boom, see also savings glut 7, 76, 78, 79, 97, 1245, 174, 176 Liquidity support in crisis 301, 146, 150, 178n.7
202 financi alalchemy in c risis
Loans, securitised 7, 57, 78, 103, 105, 114, 128, 139, 146, 179n.1, 180n.2 Loans, liars 103 LTCM 67, 69 Mania, tulip 100 Minsky, Hyman 3, 17, 1819, 20, 96, 102, 127, 129, 167, 1745, 181n.4, 182n.1 taxonomy of finance, 102 and Ponzi finance, see also Ponzi 96, 1023, 181n.4 on financial innovation 11517 Monetarism 169 Monetary policy 2, 30, 44, 56, 69, 81, 86, 105, 1445, 152, 163, 178n.7 Mortgages, sub-prime 2, 13, 14, 25, 26, 28, 38, 41, 55, 65, 79, 101, 103, 113 Residential 135 Neoliberal, capitalism 72 New economy 67, 112, 132, 134, 138, 172 New International Financial Architecture (NIFA) 165, 167, 168
Northern Rock, see also Granite and offshore 302, 39, 924, 128, 141, 147 and Granite 402, 5161 Offshore finance, see also Granite and Northern Rock 15, 42, 48, 51, 535, 59, 100, 107, 109, 128, 176 Offshore, entities 48, 60, 128, 139 Over-the-counter (OTC) 123, 163 Panic 29, 32, 34, 145 Ponzi, see also Minsky, Hyman Ponzi capitalism 1002, 1045, 134, 174 Ponzi, Carlo 100, 181n.4 Ponzi era 96 Ponzi finance, also Ponzi scheme 19, 22, 59, 95, 1004, 105, 106, 121, 127, 129, 134, 174, 176 and securitisation 10610, 174 Ponzi principle 5960, 1023, 104, 127 Privatisation of financial risk 11, 59, 166
index 203
Rating, see credit ratings agencies Real economy 12, 24, 37, 38, 65, 146, 148, 161 Real estate 14 Recapitalisation: 36, 37, 145, 146, 147 Recession 2, 24, 32, 33, 65, 67, 86, 109, 111, 171, 172 global 2, 33, 38, 148 Regulation; see also NIFA, governance 9, 11, 43, 49, 56, 64, 78, 81, 867, 923, 113, 124, 128, 133, 143, 172, 177n.2 macroprudential 16871 light-touch 89, 165 paradigm of, 78, 82, 89, 114 in wake of the crisis, 1507, 161, 1656 and Basle 11617, 137 and innovation, 437, 85, 1656 Risk and liquidity 10, 1922, 64, 107, 113, 116, 1215, 127, 12830, 1412, 177n.2 in the political-economic system, 59, 65, 82, 87, 94, 989, 102, 112, 117, 152, 153, 154, 155, 168, 170, 172
management of, 6, 9, 1112, 1415, 16, 256, 40, 412, 48, 50, 65, 76, 812, 83, 85, 923, 95, 120, 130, 135, 138, 142, 155, 166, 172, 178n.12 optimisation of, 6, 8, 1315, 19, 423, 110, 112, 121, 131, 136, 164 pricing of, also valuation, 13, 18, 28, 65, 67, 75, 7980, 82, 96, 102, 137, 1389, 173 systemic 59, 94, 155, 163, 169, 179n.14 underestimation (also misunderstanding) of, 18, 19, 25, 52, 57, 64, 65, 689, 81, 84, 86, 934, 105, 11112, 118, 119, 133, 180n.3 Savings, global glut, see also liquidity glut 75, 78 Speculation 73, 124, 127, 135, 159 Structured finance 13, 15, 21, 59 SPV 42, 4851, 55, 5960, 13940, 179n.3 SIV 15, 48, 118
204 financial a lchemy i n c risis
Toxic debt, see debt True sale 13940 United Kingdom 21, 30, 31, 33, 357, 401, 49, 51, 535, 58, 59, 712, 85, 868, 924, 97100, 104, 1468, 150, 154, 156, 161, 179n.13 United States 2, 7, 18, 25, 75, 77, 95, 124, 150
Wall Street 1, 28, 32, 34, 88, 150, 160 Washington Mutual 35 Wealth, illusion of 1, 2, 12, 17, 22, 34, 38, 91, 99, 112, 114, 119, 143, 164, 1736 Welfare 1314, 43, 71, 73, 112, 142 WorldCom 48, 105, 1334, 182, ch.5n.3

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Financial Alchemy in Crisis

Financial Alchemy in Crisis

library of Congress Cataloging in Publication Data applied for

For Alexandre Gennady Palan

fI nanc IaL a Lchemy In cr Is Is

IntroductIon the end of a Great IllusIon

f inancial alchemy in crisis

inT roducT i on: T h e end of a Gr e aT i l l u s i o n

f inanci al alchemy in crisis

liquidity and the crisis of invented money

in T roducT i on: T h e end of a Gr e aT i l l u s i o n

f inancial alchemy in crisis

inT roducT i on: T h e end of a G r e aT i l l u s i o n

f inancial alchemy in crisis

in T roduc Ti on: T he end of a G re aT i l l u s i o n

f inancial alchemy in crisis

in TroducT i on: T h e end of a Gr e aT i l l u s i o n

f ina nci al alchemy in crisis

in T roduc Ti on: Th e end of a G re aT i l l u s i o n

financi al alchemy in crisis

inT roducT i on: T h e end of a Gr e aT i l l u s i o n

fina nci al alchemy in crisis

in T roducT i on: Th e end of a G re aT i l l u s i o n

liquidity illusion and the Global credit crunch

f inancial alchemy in crisis

in T roducT i on: T h e end of a G re aT i l l u s i o n

f ina nci al alchemy in crisis

in T roducT i on: T h e end of a Gr e aT i l l u s i o n

f inanci al alchemy in crisis

inT roducT i on: T h e end of a G r e aT i l l u s i o n

1 the staGes of the Meltdown

The Prelude: The american sub-Prime crisis

financi al alchemy in crisis

f inanci al alchemy in crisis

from sub-Prime crisis to the Global credit crunch

financi al alchemy in crisis

financi al alchemy in crisis

Th e sTaGe s of Th e me lTd oWn

from Global credit crunch to Global recession

f inancial alchemy in crisis

f ina ncial alchemy in crisis

financi al alchemy in crisis

2 the tale of northern rock: Between fInancIal InnovatIon and fraud

f inancial alchemy in crisis

The controversy over financial innovation

fin anci al alchemy in crisis

financial alchemy in crisis

fina ncial alchemy in crisis

offshore: The uses and abuses of sPVs

f inancial alchemy in crisis

Source: BIS, International Financial Statistics, 2008.

northern rock and Granite

f ina nci al alchemy in crisis

financi al alchemy in crisis

fina nci al alchemy in crisis

financial alchemy in crisis

fina nci al alchemy in crisis

3 how the crIsIs has Been understood

Ex-Ante and Ex-Post Visions of the credit crunch

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

financial alchemy in crisis

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

financi al alchemy in crisis