Nesvetailova financial alchemy in crisis; the great liquidity illusion (2010)

Abbreviations ixIntroduction: the end of a Great Illusion 1 ‘liquidity’ and the crisis of invented money 4 liquidity illusion and the global credit crunch 17 1.. the stages of the Me

Financial Alchemy in Crisis

The Great Liquidity Illusion

AnAstAsiA nesvetAilovA

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

Anastasia nesvetailova 2010

Copyright © Chapter 2 Anastasia nesvetailova and Ronen Palan 2010

the rights of Anastasia nesvetailova and Ronen Palen to be identified

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Abbreviations ix

Introduction: the end of a Great Illusion 1

‘liquidity’ and the crisis of invented money 4

liquidity illusion and the global credit crunch 17

1 the stages of the Meltdown 24

the prelude: the American sub-prime crisis 24

From sub-prime crisis to the global credit crunch 28

From global credit crunch to global recession 33

2 the tale of northern Rock:

Between Financial Innovation and Fraud 40

(Anastasia nesvetailova and Ronen Palan)

the controversy over financial innovation 43

offshore: the uses and abuses of sPvs 48

3 How the Crisis has been Understood 62

Ex-ante and ex-post visions of the credit crunch 62

structural theories of the credit crunch 71

Cyclical theories of the crisis 80

4 some Uncomfortable Puzzles of the Credit Crunch 90

Dismissed: the warning signs and the

Ponzi capitalism: a crisis of fraud? 100

5 2002–7: the three Pillars of the Liquidity Illusion 113

liquidity and the paradigm of self-regulating

Playing with debt – together liquidity as a

the alchemists: turning bad debts into ‘money’ 131

6 After the Meltdown: Rewriting the Rules of

the three stages of the policy response 144

the crisis and geopolitics: a new special

Conceptual dilemmas and traps 156

Conclusion: A Very Mundane Crisis 172

ABss Asset-backed securities

Bis Bank for international settlements

CDos Collateralised debt obligations

Ceo Chief executive officer

CRA Credit rating agencies

eCB european Central Bank

FsA Financial services Authority (UK)

FsF Financial stability Forum

FsB Financial stability Board

GDP Gross domestic product

iMF international Monetary Fund

MBAs Mortgage-backed assets

MBss Mortgage-backed securities

niFA new international financial architecture

oFC offshore financial centre

oRD originate and distribute (model of banking)

otC over-the-counter (trade)

siv special investment vehicle

snB swiss national Bank

sPe special purpose entity

sPv special purpose vehicle

vAR value at risk (model)

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

Fire of earth, and Water of the Wood these are to lie

together and then be parted Alchemical gold is made

of three pure souls, as purged as crystal Body, soul, and

spirit grow into a stone, wherein there is no corruption

this is to be cast on Mercury and it shall become most

worthy gold

Pierce the Black Monk, sometime in sixteenth-century europe

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

to be outdone by their sixteenth-century brethren,

invented a new formula take one part motor car debt,

add two parts credit card debt and three parts house

mortgage debt, and mix well together leave for six

days, and call the whole, Bond Call in the Wizard, a

man versed in mathematics, ask him to throw the Bond

in the air When it falls to the ground, ask for an AAA

rating, then sell to a bank

Alchemy makes gold from base materials; today’s

experts have become as adept as their sixteenth-century

forebears in the dark arts of wealth-creation

the end of a Great IllusIon

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

considered a buttress of the high plateau and a built-in defense

against collapse were really a profound source of weakness The

leverage, of which people only a fortnight earlier had spoken so

knowledgeably and even affectionately, was now fully in reverse

With remarkable celerity it removed all of the value from the

common stock of a trust

(Galbraith 1955)Sounds familiar? John Kenneth Galbraith wrote these

words in 1955 in his celebrated text on the 1929 Wall

Street Crash Few thought that his classic study on

economic history would be applicable to a crisis of

advanced twenty-first-century capitalism The general

opinion among financial experts had been rather

reassuring: ‘innovative techniques of corporate finance

have led to more careful evaluation of corporate wealth

and more effective allocation of capital’ (Bernstein

2005: 2) Yet, as George Santayana famously wrote,

‘those who cannot learn from history are doomed to

repeat it’ Indeed, as is argued in this book, it is the

ill-understood process of modern financial alchemy that

has become the real cause of the global credit crunch

The turmoil that engulfed an unsuspecting world

one Tuesday in early August 2007 has paralysed the

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,

that these people were not heeded? And why did the

global credit crunch come as a massive shock to the

world of finance?

The trouble is that the sceptics who had been asking

awkward questions and voicing concerns about debt

levels and asset bubbles during the credit boom were,

as a rule, not ‘mainstream’ economists Intellectually,

many of them come from the same school as John

Maynard Keynes, Hyman Minsky and other scholars

who form the tradition of heterodox, or critical,

political economy Suspicious of purely econometric

techniques and abstract models in their analyses,

these scholars prefer critical historical inquiry into

the dynamics of financialised capitalism Detecting

historical parallels with previous socio-economic and

financial crises and warning against history repeating

itself, they often sound like unenlightened sceptics

of finance-led economic progress As a result, a few

economist celebrities like Paul Krugman, Joseph Stiglitz

and Nouriel Roubini aside, they are rarely invited to air

their views in the pages of glossy business periodicals

or high-profile policy forums Still others ventured their

prognoses on the basis of intuition and gut feeling, and

their concerned voices were simply muffled amidst the

general sense of a credit bonanza in 2002–7 If the

party is so good, why listen to the killjoys who want

to spoil it?

This book offers an analysis of the credit crunch

from the same perspective that warned about the

dangers of the financial system in the first place There

is no doubt that complex sets of factors – historical,

geopolitical, economic, social, even cultural – have

shaped the preconditions for the global malaise Yet

as the following pages contend, the key cause of the

global credit crunch can be traced back to one pervasive

and dangerous myth Specifically, it is the idea that by

inventing novel credit instruments and opening up new

financial markets, today’s financiers create money and

wealth This belief had been shared by many participants

of the crisis, including its major casualties; strikingly, it

remains current in the wake of the credit crunch During

the boom years of 2002–7 this fallacy, apparent to many

in the aftermath of the crisis, was concealed by one great

myth of today’s finance: the illusion of liquidity As will

be argued below, the global credit crunch has shown this

idea to be a dangerous – and costly – fallacy

‘liquidity’ and the crisis of invented money

There is a certain oddity about the realm of finance

and economics Although apparently precise, technical,

strict, rational and calculative, a substantial part of

the discipline operates with concepts that are better

described as metaphors rather than as a coherent

conceptual grounding or a set of definitions We all

know, for instance, what ‘price’ is, but for centuries

scholars of political economy have been arguing among

themselves about how best to define the concept of

‘value’ They have yet to reach an agreement Keynes

famously described the financial market as a ‘beauty

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

things in this beauty contest often turn rather ugly In

this sense, after the financial wreckage of 2007–9, the

world economy may require not just a facelift, but a

major transplant

Most commonly the global financial meltdown has

been defined as a ‘credit crunch’ or crisis of liquidity:

liquidity simply melted away from the world markets

in the space of just a few days The problem is that

‘liquidity’ is precisely one such category in contemporary

finance that seems to be easier understood by means of

metaphors and allusions, rather than as a clear, agreed

definition or framework Just weeks before the crisis

erupted, leading policymakers were concerned with

what they believed was a structural ‘liquidity glut’

Yet within a matter of days, these worries turned into

the fear of a global liquidity meltdown That fear soon

materialised in a very real financial and economic crisis

Everyone knows that liquidity is the lifeblood of

any financial market and that it is essential for general

economic activity Most people, even those outside

finance, would intuitively prefer to be in a position

that is liquid rather than one that is illiquid The irony,

however, is that economists and finance professionals

would probably never agree on what liquidity actually

is As one official put it: ‘liquidity clearly ain’t what

it used to be But it is much less clear what such a

statement means, still less whether that is a “good” or

a “bad” thing’ (Smout 2001)

The problem is conceptual Liquidity is a very fluid, complex, multidimensional notion It describes a

quality – of an asset, portfolio, a market, an institution

or even an economic system as a whole Liquidity also

denotes a quantity – most often associated with the

pool of money or credit available in a system at any

given time Liquidity is also a probability – a calculated

chance of a transaction being completed in time without

inflicting a major disruption on the prevailing trends in

the market Liquidity is also about depth – of a market

for a particular class of assets – and speed – with which

a certain transaction can be completed

To make things more complicated still, liquidity can also comprise all these things and describe several layers

of economic activity at the same time – for instance,

the liquidity of an individual bank, a segment of the

market, national economy and finally, the global

financial system as a whole Liquidity is also an

inter-temporal category: liquidity in good economic times is

not the same as liquidity in bad times Or, as economists

like to stress, liquidity to sell is not always the same as

liquidity to buy The liquidity that was widely assumed

to be abundant during the pre-crisis period was not

the same liquidity that melted away during the crisis

Assets that are easy to sell when investors are confident

about their profitability and risk profiles often turn out

to be unwanted and expensive bundles of poor quality,

illiquid debt when confidence and optimism evaporate

Liquidity can literally vanish overnight

This is exactly what happened to trillions of

dollars of securitised loans and a plethora of highly

sophisticated and opaque financial instruments during

2007–9 At the height of the 2002–7 liquidity boom,

financial institutions employed armies of young

MBAs, gave them fancy job titles and paid them

handsomely Bankers could confidently sell highly

complex instruments in bulk to clients around the

world Not many buyers, it now transpires, took the

trouble to learn about the nature of these instruments

in depth All they seemed to care about was that the

market for these products appeared highly liquid

and that they – and, importantly, their competitors –

were making money When the boom came to a halt,

synthetic financial products were exposed for what

they actually were – parcels of toxic debt – and their

market liquidity evaporated, as did the markets for

these products: whereas in 2007 $2,500bn of loans

were securitised in the US, in 2008 almost none were

sold to private sector buyers (Tett and van Duyn 2009)

The new generation of finance professionals turned

out to be nothing but a highly motivated sales force,

bent on persuading even the most sceptical clients to

part with their cash for bundles of securitised loans

As will be argued below, these and many other

puzzles of the credit crunch centre on the problem of

liquidity and its metamorphoses in the modern financial

system Most chronicles of the crisis concur that the

global meltdown centred on, or at least started as,

liquidity drainage from the markets There is no clear

consensus, however, on what the concept of liquidity

actually implies today As the field of credit crunch

studies expands, the diversity of views becomes ever

more apparent

Not that long ago things were somewhat simpler In the brief age of Keynesian economic stability, ‘liquidity’

was generally assumed to describe a quality of an asset

and ultimately was related to the notion of money And

even though the concept of ‘money’ remains probably

the most controversial aspect of economics and finance,

most students of finance at the time would concur

that liquidity is a property of an asset As such, it is

conditioned by the market context, but crucially it is

intimately related to the notion of money: liquidity is

‘an asset’s capability over time of being realised in the

form of funds available for immediate consumption

or reinvestment – proximately in the form of money’

(Hirchleifer 1986: 43)

But then the real life of the financial markets complicated matters In 1971, the postwar system

of fixed exchange rates and financial controls was

dismantled As a result of the financial innovations that

led to this collapse, the state lost its monopoly over the

process of credit-creation The financial sector has been

transformed from being part of the service economy,

an intermediary between lenders and investors, into

an industry of trading and optimising risk In parallel,

the concept of liquidity has undergone its own series

of mutations

First, the transformation of liquidity has paralleled

the rise of private financial markets During the

centuries of metal-based money, and later in the era of

the Gold Standard and even the fixed exchange rates

of the Bretton Woods system, liquidity was closely

associated primarily with state-generated credit money

and, second, the banking system’s ability to extend

credit With the collapse of the Bretton Woods regime

and the rise of private financial markets, the notion of

liquidity, both functionally and conceptually, has been

gravitating towards the realm of the financial markets

themselves A key factor in this trend was the emergence

in the late 1960s of the unregulated financial space, the

Euromarket Created by commercial banks to avoid

national regulations, the Eurocurrency market became

the global engine of liquidity-creation and

debt-financ-ing, and became prone to overextension of credit Most

dramatically, this trend manifested itself in the global

debt crisis of the 1980s (Guttman 2003: 32)

The second mutation of liquidity has been the

so-called securitisation revolution Theoretically,

secu-ritisation is a technique used to create securities by

reshuffling the cash flows produced by a diversified pool

of assets with common characteristics By doing so, one

can design several securities (tranches) with different

risk-reward profiles which appeal to different investors

(Cifuentes 2008) The idea behind this principle

is economic flexibility: by securitising previously

non-traded products and putting them on the market,

financial institutions attach a price to these assets, widen

their ownership and hence, by expanding the web of

economic transactions, strengthen the robustness of the

economy as a whole In theory, therefore, securitisation

is supposed to enhance liquidity and economic stability

The business of securitisation has been assumed to bring many benefits to the economy Boosted by the

resolution of the debt crisis of the 1980s, the

securiti-sation of credit became a process through which often

poor quality, obscure loans have been transformed into

securities and traded in the financial markets Facilitated

by technological and scientific advances, as well as the

spread of the derivatives markets, the securitisation

of credit has greatly increased the variety and volume

of trade in the global financial markets, creating the

sense of much greater liquidity of these markets and

the depth of the credit pool (ibid.: 40–1) With banks

rapidly becoming major players in this global financial

market, and with their greater reliance on

securitisa-tion techniques in managing their portfolios, the nosecuritisa-tion

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 sations of liquidity, while emphasising its evasive and

conceptuali-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

change in the analytical approaches is to be found in the

financial developments of the post-1971 era Specifically,

the privatisation of financial and economic risks and

the denationalisation of money have shifted the process

of liquidity-creation away from the public sphere of

political economy and into the realm of private financial

markets (Holmstrong and Tirole 1998: 1)

The policies of financial deregulation and

liberali-sation reinforced this trend, thereby institutionalising

liquidity firmly as a category and instrument of the

market and its pricing mechanism As a result, over

the past few decades, analyses of finance in the

macro-economy have assumed that liquidity is no

longer primarily a property of assets, but rather an

indicator of the general condition and vitality of a

financial market As one web-based financial dictionary

suggests, liquidity describes ‘a high level of trading

activity, allowing buying and selling with minimum

price disturbance Also, a market characterised by the

ability to buy and sell with relative ease’ (Farlex Free

Dictionary)

The outcome of this chain of mutations – both

analytical and market-based – is that in most

contemporary readings the connection between ‘money’

and ‘liquidity’ has waned After all, the global financial

system is based on credit and a multitude of economic

transactions With money itself becoming increasingly

dematerialised, it may seem odd to link liquidity to

categories of cash, high-powered or state-backed

money Instead, liquidity has been presumed to relate

to the complex mechanism of financial transactions

taking place in the markets and confronting a variety

of risks This in turn has produced several interrelated

assumptions that have shaped finance theory and policy

in the run-up to the global credit crunch

The first trend concerns the expansion of the global credit system and can be described as a process of

demonetised financialisation It encapsulates two

intertwined tendencies in contemporary capitalism: first,

the deepening of the financial sector and the growing

role of finance-based relations in shaping the nature

of socio-political developments today, or what social

scientists understand as financialisation; and second, the

process of securitisation (depicted above), centred on

financial institutions’ ability to transform illiquid loans

into tradable securities, reaping profits in the process

In terms of understanding what liquidity is and how it

behaves, an important assumption correlated with this

trend As financialisation advanced, both spatially and

intertemporally, liquidity has progressively lost its public

good component Just as money itself is, therefore,

marked by the inherent contradiction between money

as a public good and as a private commodity, liquidity

has increasingly assumed the features of a private device

of the financial markets in the sense that it is created by

agents seeking to benefit individually from that privilege

(Guttman 2003: 23) The expansion of the credit system

and the accumulation of financial wealth, or

financial-isation, therefore have been progressively abstracted

from the dynamics of productivity, trade, real economic

growth and, crucially, developments in the sphere of

state-backed or high-powered money

Second, analytically, mainstream finance theory

and practice supported and guided these trends by

embedding the new credit system in a paradigm of

scientific finance In this view, the key function of the

financial system as a whole is no longer the

intermedia-tion between savers and borrowers as such; that role has

been assigned to just one sector of the financial system

– commercial banking Rather, the ultimate aim of the

financial system today is to manage and optimise risk

in three steps: (i) by identifying and pricing risks (for

instance, by pooling a bunch of sub-prime mortgages

from several mortgage lenders); (ii) by parcelling them

into specific financial vehicles (such as tranches of

mortgages or structured financial products); and (iii)

by redistributing the risk to those who are deemed most

able and willing to hold risk (i.e by selling it on to

third and fourth parties, often institutions specialising

in trading these particular products, or placing them

off the balance sheet, as happened with many highly

risky securitisation products) (e.g Toporowski 2009)

This complex chain of financial innovation is known

in mainstream finance theory as market completion In

the context of the sub-prime market, for instance,

risk-optimising and market-creating financial innovations

have been seen as key to enhancing social welfare more

generally:

The subprime market provides a market-opening and -completing opportunity … The subprime market allows funding to those who would otherwise not be homeowners By pricing the risks of different types of credit quality, prime lenders can target some applicants who otherwise might not be qualified … The prime mortgage market allows all borrowers meeting a particular threshold to be qualified … adding a subprime market provides a welfare gain, even to applicants able to qualify in a prime-only market Those applicants obtain a welfare gain by having more choices and flexibility (chinloy and macdonald 2005: 163–4)

Ultimately, as Alan Greenspan foresaw, ‘financial

innovation will slow as we approach the world in

which financial markets are complete in the sense

that all financial risks can be effectively transferred

to those most willing to bear them’ (2003, cited in

Wigan 2009) Financial innovation, therefore, by

relying on scientific approaches to risk management

and calculative practices, is believed to create new

facilities for risk optimisation and thus complete the

system of markets As the theory holds,

securitisa-tion, for instance, transforms previously unpriced

and typically illiquid assets, such as real estate, car or

student loans and sub-prime mortgages, into tradable

and liquid financial securities, thereby optimising risks

and enhancing the liquidity of the financial system as

a whole (Cifuentes 2008) According to Greenspan,

this process – extending far beyond the sub-prime

market – symbolised ‘a new paradigm of active credit

management’ (cited in Morris 2008: 61)

Third, the spiral of demonetised financialisation

has been underpinned by institutional and operational

advances in financial innovation In addition to the

structural shift towards the ‘originate and distribute’

(ORD) banking model, there has been a remarkable

rise in the number of hedge funds; the growing

sophis-tication and specialisation of offshore financial centres

and techniques (Palan 2003); the expansion of the

so-called shadow banking industry; and the spread

of new methods of risk management and trade, such

as value-at-risk (VAR) models, all leading to the

extraordinary growth of variety and complexity of

financial products themselves

What is striking about the wave of financial

innovation that defined the last two decades of the

global financial system is that many newly created

products of risk management became so specialised

and tailor-made that they were never traded in free

markets Indeed, as Gillian Tett writes, in 2006 and

early 2007, no less than $450bn worth of ‘collateralised

debt obligations of asset-backed securities’ (CDOs of

ABSs) were created Yet instead of being traded, as the

principle of active credit risk management would imply,

most were sold to banks’ off-balance-sheet entities, such

as structured investment vehicles (SIVs), or simply left

on the books Generally, she argues, a set of innovations

that were supposed to create freer markets and complete

the system of risk optimisation actually produced an

opaque world in which risk became highly concentrated

– worryingly, in ways almost nobody understood

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

could take a whole weekend for computers to carry out

the calculations needed to assess the risks of complex

CDOs (Tett 2009)

What does the combination of the three trends imply for the analysis of the crisis offered in this book? It

appears that most analytical and policy frameworks of

the global financial system have been based on a strong

and relatively straightforward assumption Namely, they

conceive liquidity fundamentally as a property of the

market or an institution, rather than as a quality of assets

as such At the level of financial institutions themselves,

the axiom that financial innovation and engineering

have the capacity to liquefy any type of asset – or, more

accurately, debt – has resulted in the now mainstream

notion of liquidity that is divorced from any attribute

of assets per se And although some recent analyses

have drawn a distinction between market and systemic

liquidity (Large 2005), or between search and funding

liquidity (ECB 2006), in the Anglo-Saxon economies

it is the concept of market liquidity – describing the

depth of markets for the sale or loan of assets or the

hedging of risks that underlie those assets – that has

come to inform most recent frameworks of financial

governance (Crockett 2008: 13–17) Here, liquidity

is most commonly understood as ‘confidence’ of the

markets, able and willing to trade at a given point in

time at a prevailing price level (Warsh 2007)

This conceptualisation of liquidity in turn has produced a sequence of analytical fallacies which have

contributed to the illusion that this is the real cause of the

global credit crunch The first fallacy is the assumption

that it is the market-making capacity of financial

inter-mediaries to identify, price and trade new financial

products that creates and distributes liquidity in the

markets Second is the view that general market trade

and turnover are synonymous with market liquidity

The third and corresponding fallacy is the notion that

market liquidity itself – when multiplied across many

markets – ultimately is synonymous with the liquidity

(and financial robustness) of the economic system as

a whole Altogether, this line of reasoning has been

underpinned by the notion that financial innovation in

its various forms ultimately enhances the liquidity of

the financial system as a whole

This misunderstanding, I believe, originates in a

hollow notion of liquidity itself and, consequently, in

the flawed vision – academic as well as political – of the

dynamics of the relationship between private financial

innovation and the liquidity and resilience of the

financial system generally Therefore, the hollow notion

of liquidity lies at the heart of the great illusion of wealth

and the belief in financial markets’ capacity to invent

money that are the real causes of the 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

this message that seems to attract most commentaries

on the credit crunch According to Minsky, ‘good’ times

breed complacency, exuberance and optimism about

one’s position in the market and lead to greater reliance

on leverage and underestimation of risks Indeed, as

stated famously by Citi’s Chuck Prince in July 2007:

‘When the music stops, in terms of liquidity, things will

be complicated But as long as the music is playing,

you’ve got to get up and dance’ (cited in Soros 2008:

84) Most observers concur that the major factor in the

global credit crisis was the progressive

underestima-tion, or misunderstanding, of risk by financial agents,

based in turn on the general sense of stability, economic

prosperity and optimistic forecasts that pervaded North

Atlantic economies and financial markets

Indeed, regardless of their intellectual and policy affiliations, most commentators on the credit crunch

recognise the tendency to underestimate the risks in a

bearish market or bubble Many American observers

continue to believe that the root cause of this problem

was the liquidity glut coming from the emerging

markets Economists analysing the crisis do recognise

the role of a liquidity crunch in the first stage of the

crisis (August 2007–September 2008), notably again

identifying the link between the supply of capital from

abroad and the housing bubble in North America:

The creation of new securities facilitated the large capital inflows from abroad The trend towards the ‘originate and distribute model’ … ultimately led to a decline in lending standards financial

innovation that had supposedly made the banking system more

stable by transferring risk to those most able to bear it led to an

unprecedented credit expansion that helped feed the boom in

housing prices (Brunnermeir 2009: 78)

The BIS arguably went furthest in analysing the

repercussions of this collective underestimation of

risks for liquidity and admitted that, essentially, this

phenomenon constitutes an illusion of liquidity, or a

situation in which markets under-price liquidity and

financial institutions underestimate liquidity risks (CGFS

2001: 2) In other words, the illusion of liquidity is

understood as a false sense of optimism a financial actor

(be that a company, fund manager or a government)

has about the safety and resilience of a portfolio and/or

market as a whole As the credit crunch revealed, this

illusion can have very real – and destructive – social,

economic and political consequences In this sense,

many emergent theories of the global credit crunch

appear to have strong Minskyan undertones, as now

commonplace references to a ‘Minsky moment’ in

finance or the crisis of Ponzi finance suggest

Yet once we consider the contentious place

of ‘liquidity’ in the crisis, it appears that only a

fragmented and highly selective version of Minsky’s

theory resonates in current readings of the global

meltdown While noting the risk effects of the general

macroeconomic environment and investor expectations,

most mainstream analysts of the crisis overlook the core

of Minsky’s framework Very few indeed cast a critical

eye on the very ability of private financial

intermediar-ies to extend the frontier of private liquidity, ultimately

accentuating financial fragility in the system and thus

accelerating the scope for a structural financial collapse

and economic crisis

According to Minsky, the web of debt-driven financial innovations has a dual effect on the system’s

liquidity On the one hand, as financial innovations gain

ground, the velocity of money increases Yet, on the

other, as Minsky warned, ‘every institutional innovation

which results in both new ways to finance business

and new substitutes for cash decreases the liquidity of

the economy’ (1984 [1982]: 173) The latest round

of securitisation, propelled by the belief that clever

techniques of parcelling debts, creating new products

and opening up new markets, create additional and

plentiful liquidity, in fact has driven the financial system

into a structurally illiquid, crisis-prone state

At the level of the financial system, securitisation has produced an incredibly complex and opaque hierarchy

of credit instruments, whose liquidity was assumed but

in fact was never guaranteed What is astonishing is that

some market players seemed to be aware of this danger

Just as the securitisation bubble was beginning to inflate,

one of the big investors warned about specific liquidity

risks faced by his company Although the firm’s

secu-ritisation strategy had been based on the assumption

that collateralised mortgage obligations (CMOs) would

be more liquid than their underlying collateral – the

properties – he warned that this assumption was far too

short-sighted and over-reliant on the market’s shared

sentiments: ‘as a guide to market discipline, we like

the expression, “sure they’re liquid, unless you actually

have to sell them!”’ (Kochen 2000: 112), or, as one

risk manager admitted in the wake of the crisis: ‘The

possibility that liquidity could suddenly dry up was

always a topic high on our list but we could only see

more liquidity coming into the market – not going out

of it ’ (The Economist, 9 August 2008).

A notable outcome of the credit crunch is that it

seems to have raised the importance of liquidity in the

hierarchy of concerns of some policymaking bodies.2

However, most discussions of liquidity in the crisis,

by focusing on the problem of valuations and risk

mis-pricing, diagnose the evaporation of liquidity as

a result of market failure rather than as a systemic

tendency None of the studies, indeed, makes the

connection between the excesses of private financial

innovation and its liquidity-decreasing effects Yet the

evidence is abundant For instance, in October 2008,

the Bank of England documented a depletion of sterling

liquid assets relative to total asset holdings in the UK

banking sector, stating that:

The ongoing turmoil has revealed that, during more benign periods,

some banks sought to reduce the opportunity cost of holding liquid

assets by substituting traditional liquid assets such as highly rated

government bonds with highly rated structured credit products This

has been part of a longer-term decline in banks’ holdings of liquid

assets in the united Kingdom, which has been replicated in other countries (2008: 39–40)

In this instance, an important question about the

credit crunch remains unanswered If the participants

of the credit boom themselves did admit that some of

the foundations of their innovative techniques were

shaky, and if a whole body of scholarship in heterodox

political economy can explain the dangers of financial

euphoria and innovations, why is it that the illusion of

liquidity and wealth was sustained over a prolonged

period, leading people like Greenspan to celebrate ‘the

new era in credit risk management’?

The answer, as is explained in the following chapters, can be found in three political-economic pillars of the

liquidity illusion: the paradigm of a self-regulating

financial system; Ponzi-type finance, which thrives in

a climate of deregulated credit and robust financial

innovation; and a structure of authority able to

legitimise the newly created financial products and thus

assure their marketability (the credit rating agencies

in the case of the current crisis) Together, these three

elements helped sustain the illusion of infinite liquidity

during 2002–7

In what follows, therefore, this book tells the story of the global credit crunch as a crisis brought about by a

pervasive and multifaceted illusion of wealth, or more

concretely, illusion of liquidity Such a narrow subject

matter may seem far too technical and specific, yet it

serves an important purpose in unpacking the political

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

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

than that In the United States, which has been the

epicentre of the global malaise, the prelude to the global

financial meltdown unfolded in late 2006/early 2007

It all started with a boom Between 2002 and 2007,

housing markets in the Anglo-Saxon economies were

booming at unprecedented levels The great housing

boom was supported by cheap and plentiful credit

and the widely held belief that house prices would

continue to rise In the US in particular a whole new

segment of housing finance – sub-prime mortgages –

provided a major motor for the credit boom and the

expanding financial system ‘Sub-prime’ designates

a category of borrowers who otherwise would be

considered ‘high-risk’ clients: they had poor or no

credit histories But in the booming housing market,

supported by opportunities to manage the high risks

that the new financial system offered, these clients were

now granted access to credit and could own a house

on what appeared – initially at least – to be favourable

and affordable rates.1 The expansion of the

mortgage-backed securities (MBSs) market drew investors into

some of the more risky tranches of MBS debt In 2006,

the US sub-prime market was worth $600bn, or 20

per cent of the $3 trillion mortgage market.2 In 2001,

sub-prime loans made up just 5.6 per cent of mortgage

dollars In global terms, American MBSs became the

largest component of the global fixed income market,

accounting for a fifth of its value

Yet it was as early as 2006 that the price increases in

the American housing market slowed down, and the first

wave of mortgage delinquencies started to spread The

trigger to the rising number of defaults was the increase

in the interest rate, which climbed to 5.35 per cent in

2006, from 1 per cent in 2004 Also, crucially, in 2006

the structure of US sub-prime mortgages shifted many

borrowers out of their initial (presumably favourable)

fixed-rate terms, thereby increasing the interest payment

on the loans Observers offered different readings of this

trend: some argued that despite the notable increase in

bankruptcies, the trend historically was insignificant

(IMF 2007: 5) Others began to anticipate a bigger wave

of defaults and bankruptcies: most 2006 borrowers

were still in the ‘teaser rate’ period of their mortgages

According to the structure of sub-prime loans, their

repayments were due to rise in a year or two Some

sceptics warned that against this background a default

of one or two financial companies could well spark a

worldwide financial crisis The words of reassurance,

for those who needed them, came from the architect of

mortgage-backed finance himself, Lewie Ranieri, who

said: ‘I think [the risk] is containable … I don’t think

this is going to be a cataclysm’ (in Kratz 2007)

The sceptics were proven right Homeowners, many of whom could barely afford their mortgage

payments when interest rates were low, began to default

on their mortgages and defaults on sub-prime loans

rose to record levels By the end of 2006, sub-prime

delinquencies more than 60 days late jumped to

almost 13 per cent, compared to 8 per cent in 2005

Commentators explained this by the fact that in 2006

some of the more neglected sub-prime loans had

reached their refinancing limits, and borrowers could

no longer afford to pay the mortgage on a new, and

higher, interest rate The number of bankruptcies and

foreclosures also rose: according to Moody’s, in 2006 it

reached almost 4 per cent, compared to 2.2 per cent for

a similar type of loan originated in 2004 The impact of

these defaults was felt throughout the financial system

as many of the mortgages had been bundled up and sold

on to banks and investors (BBC 2009) Eventually, the

housing boom stalled and, through the complex web of

mortgage-backed finance, started to affect the financial

and banking system more generally

The winter of 2006–7 brought the first signs of the real

magnitude of the coming meltdown On 22 February

2007 HSBC, the largest sub-prime lender in the US

and a leading investment bank globally,3 announced a

$10.5bn loss in its mortgage finance subsidiary, HSBC

Finance Market sceptics immediately read this as a sign

of a greater trouble ahead: HSBC’s total annual profits

were around $15bn Many smaller sub-prime lenders

were already facing bankruptcy.4

At the time, a giant like HSBC could write off the

$10bn loss and escape relatively unscathed from the

mounting market distress Smaller sub-prime lenders

operating on the American markets were in a less

healthy position In March 2007, news of heavy

losses from the ailing sub-prime market hit American

building companies This fuelled fears of bankruptcy in

several sub-prime lenders, most notably New Century