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

Financial Alchemy in Crisis Nesvetailova 00 pre 29/03/2010 09:12 Nesvetailova 00 pre 29/03/2010 09:12 Financial Alchemy in Crisis The Great Liquidity Illusion Anastasia Nesvetailova Nesvetailova 00 pre 29/03/2010 09:12 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 Martin’s Press LLC, 175 Fifth Avenue, New York, NY 10010 Copyright © Introduction, Chapters 2, 3–6, Conclusion Anastasia Nesvetailova 2010 Copyright © Chapter 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 978 7453 2878 ISBN 978 7453 2877 Hardback Paperback Library of Congress Cataloging in Publication Data applied for This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources Logging, pulping and manufacturing processes are expected to conform to the environmental standards of the country of origin 10â•… 9â•… 8â•… 7â•… 6â•… 5â•… 4â•… 3â•… 2â•… Designed and produced for Pluto Press by Chase Publishing Services Ltd, 33 Livonia Road, Sidmouth, EX10 9JB, England Typeset from disk by Stanford DTP Services, Northampton, England Printed and bound in the European Union by CPI Antony Rowe, Chippenham and Eastbourne Nesvetailova 00 pre 29/03/2010 09:12 For Alexandre Gennady Palan Nesvetailova 00 pre 29/03/2010 09:12 Nesvetailova 00 pre 29/03/2010 09:12 Contents Abbreviations Acknowledgements ix x Introduction: The End of a Great Illusion ‘Liquidity’ and the crisis of invented money Liquidity illusion and the global credit crunch 17 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 24 24 28 33 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 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 40 43 48 51 62 62 71 80 Some Uncomfortable Puzzles of the Credit Crunch 90 Dismissed: the warning signs and the â•… whistleblowers 91 Ponzi capitalism: a crisis of fraud? 100 Nesvetailova 00 pre 29/03/2010 09:12 viiiâ•… fi nanc ial a lchemy in cr is is 2002–7: The Three Pillars of the Liquidity Illusion Liquidity and the paradigm of self-regulating â•… credit Playing with debt – together Liquidity as a â•… ‘state of mind’ The alchemists: turning bad debts into ‘money’ After the Meltdown: Rewriting the Rules of Global Finance? The three stages of the policy response The crisis and geopolitics: a new special â•… relationship? Conceptual dilemmas and traps 113 113 121 131 143 144 149 156 Conclusion: A Very Mundane Crisis 172 Notes Bibliography Index 177 184 197 Nesvetailova 00 pre 29/03/2010 09:12 Abbreviations ABSs Asset-backed securities BIS Bank for International Settlements CDOs Collateralised debt obligations CEO Chief Executive Officer CRA Credit rating agencies ECB European Central Bank FSA Financial Services Authority (UK) Financial Stability Forum FSF Financial Stability Board FSB GDP Gross domestic product IMF International Monetary Fund MBAs Mortgage-backed assets MBSs Mortgage-backed securities NIFA New international financial architecture OFC Offshore financial centre ORD Originate and distribute (model of banking) OTC Over-the-counter (trade) SIV Special investment vehicle SNB Swiss National Bank SPE Special purpose entity SPV Special purpose vehicle VAR Value at risk (model) ix Nesvetailova 00 pre 29/03/2010 09:12 190 â•… f inancial alchemy in crisis Hope, C 2009, ‘Revealed: Sir Fred Goodwin Was Still Advising the Treasury until Five Weeks Ago’, Daily Telegraph, March Hu, Y., Imkeller, P and Muller, M 2005, ‘Partial Equilibrium and Market Completion’, International Journal of Theoretical and Applied Finance, 8:4, June Hutton, W 2009 ‘You Give Bankers £1.3 Trillion and Do They Thank You? 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British Financial Stability from 1866 to 2007’, Working Paper, April, London: Cass Business School Wray, R 2008, ‘Lessons from the Subprime Meltdown’, Challenge, 51:2, March–April Nesvetailova 01 text 196 30/03/2010 11:40 index Accounting, see also fraud, new economy, offshore, Ponzi, 44–8, 132 creative accounting 47, 139 and fraud 94–5, 105, 106, 133, 134 Accounting standards: 135–8, 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’, 74–5, 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, 21–2, 42, 77–8, 107, 110, 115, 117, 120–1, 124, 125, 131, 164, 167 and risk 67, 81, 139 and securitisation 9, 14–15, 78, 110, 115–16, 118, 136, 139–40, 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 Nesvetailova 02 index 197 30/03/2010 11:40 198   financial alchemy in c risis Bankruptcy 24, 26, 27, 28, 30, 34, 35, 92, 129, 139, 148, 177n.4 Basle Accord 95, 116–17, 120, 137, 163 committees and groups 168, 171 Bernanke, Ben 29, 74–5, 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 ‘Bretton Woods-2’ 76, 148, 167 Bubble 3, 18, 63–7, 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, 133–4, 135, 165 Capital adequacy (also norms) 88, 154–5, 161–3, 172n.4, 172n.5, 183n.6 Capital markets 41, 43, 72, 74, 136, 175 Nesvetailova 02 index 198 Capitalism 1, 67, 76, 100, 114, 160, 164, 167 crisis of 24, 63, 70, 71–4, 79, 91–2, 96, 171–2, 174–5 financialised 3, 12, 91–2, 114, 168, 172 varieties of 150, 160–1 Anglo-Saxon 63, 66, 71–4, 89, 157, 161, 175 Ponzi, see also Ponzi 100–12 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, 80–3, 91, 96, 99, 101, 108, 111, 120, 123, 124, 127–8, 143, 164 Credit derivatives 87, 126, 178n12 Credit expansion 19, 69 Credit rating 142 30/03/2010 11:40 index  199 Credit rating agencies (CRAs) 22, 81, 105, 135 role in the crisis 135–9, 162 regulation of, 154, 163 Crisis of the 1930s, 34–5, 171, 172 of the 1990s, 74, 165, 167, 170 theories of, 62–89 structural theories 71–9 cyclical theories 80–9 policy responses to, 32, 144–9 Debt 2, 3, 6, 16, 20, 33, 40, 50, 52–3, 55, 95, 99, 101–2, 116, 117, 121, 173–4, 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 90–1 US debt 33, 42, 95, 178n.9 Debt culture 9–10, 63–4, 69, 72–5, 78–9, 95–6, 98, 102 Derivatives 10, 43, 44, 82, 87, 95, 105, 109, 119, 126–8, 163, 178–9n.12, 181n.3 Nesvetailova 02 index 199 Deregulation 11, 43, 64, 78, 124, 128, 172 Depression, see also crisis of the 1930s, 32, 95–6 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 153–6, 161, 164 EU 32, 36, 150, 153–4, 156, 161, 163, 170, 179n.15 Euromarket, also Eurocurrency, eurodollar market 9, 45, 116 Enron 48, 50, 51, 69, 133–5, 140–1 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 30/03/2010 11:40 200   financial alchemy i n crisis Financial fragility 20, 102, 118, 175 and liquidity 20 and ORD model, 118 Financial innovation 8, 13–17, 20–3, 42–3, 51, 56, 59, 60, 83, 100–3, 109, 181n.3 and liquidity 129–42 crisis lessons, 150, 153, 157, 162, 164–6, 168, 173, 175–6 controversy over, 43–7 role in crisis, 109–20 Financial liberalisation 150 Financial architecture, see also NIFA, 37, 142, 149, 156, 162, 165, 167 Financialisation 12, 15, 45, 66 Fraud 40–2, 47, 68, 89, 100, 128, 133–4, 140, 160, 173, 181n.6 and offshore, 47–9 and Ponzi, 100–9, 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 Nesvetailova 02 index 200 Gold (standard) 9, 96 Governance, financial 16, 55, 82, 89, 120, 143, 148, 152, 156–7, 166, 168–70, 175 Granite, see also Northern Rock and Offshore 40, 42, 501, 52–5, 59, 141, 179n.2 Great Depression, see crises Greed 41, 82, 83, 84, 90, 159–61, 176 Greenspan, Alan 14, 22, 34, 66, 68, 70, 73, 76, 166 Hedging 16, 140 Hedge fund(s) 15, 29, 43, 94–5, 105–6, 109, 118, 129–30, 155–6, 181n.3 Herding, investor 95, 126–7, 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 82–9 Iceland 36, 41 Illiquid asset 14, 107, 116, 146, 163 institutions 182n.1 30/03/2010 11:40 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, 98–9 Innovation, see financial innovation Interest rate 26–7, 30, 36–7, 45, 47, 64, 104–5, 107, 140, 144, 178n.7 and subprime 103–6 Japan 39, 75, 77, 104, 179n.16, 180n.2 Junk (securities) 145, see also toxic debt Keynes, John Maynard 3–4, 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, 129–30, 146, 173, 182n.5, 183n.6 Liquidity artificial 42 Nesvetailova 02 index 201 concept, 5–6, 7–8, 10–12, 16–17, 60, 114, 121, 126, 136, 167, 173, 177n.2 crisis, also crunch, also meltdown 5, 24, 29, 30, 34, 126, 128–31, 179n.12 illusion of 4, 60, 113, 143, 164, 173, 176 defined, 17–23 pillars of, 113–42 paradox of, 125 risk 19, 20, 57, 127 types of, 6, 145 and assets 8, 121, 135 and markets 7, 10–11, 12, 16–17, 34, 88, 115, 119, 121–4, 126–7, 132, 136, 141, 143, 144, 159, 167 and system 14, 17, 112, 115–17, 141–2, 143, 173–4 and financial innovation 9–10, 11, 76, 112, 115–16, 137–9, 142, 159, 166, 173–6 and regulation 57, 154, 163, 177n.2 liquidity glut, also liquidity boom, see also savings glut 7, 76, 78, 79, 97, 124–5, 174, 176 Liquidity support in crisis 30–1, 146, 150, 178n.7 30/03/2010 11:40 202   financial alchemy in c risis Loans, securitised 7, 57, 78, 103, 105, 114, 128, 139, 146, 179n.1, 180n.2 Loans, liars’ 103 LTCM 67, 69 Northern Rock, see also Granite and offshore 30–2, 39, 92–4, 128, 141, 147 and Granite 40–2, 51–61 Mania, tulip 100 Minsky, Hyman 3, 17, 18–19, 20, 96, 102, 127, 129, 167, 174–5, 181n.4, 182n.1 taxonomy of finance, 102 and Ponzi finance, see also Ponzi 96, 102–3, 181n.4 on financial innovation 115–17 Monetarism 169 Monetary policy 2, 30, 44, 56, 69, 81, 86, 105, 144–5, 152, 163, 178n.7 Mortgages, sub-prime 2, 13, 14, 25, 26, 28, 38, 41, 55, 65, 79, 101, 103, 113 Residential 135 Offshore finance, see also Granite and Northern Rock 15, 42, 48, 51, 53–5, 59, 100, 107, 109, 128, 176 Offshore, entities 48, 60, 128, 139 Over-the-counter (OTC) 123, 163 Neoliberal, capitalism 72 New economy 67, 112, 132, 134, 138, 172 New International Financial Architecture (NIFA) 165, 167, 168 Nesvetailova 02 index 202 Panic 29, 32, 34, 145 Ponzi, see also Minsky, Hyman Ponzi capitalism 100–2, 104–5, 134, 174 Ponzi, Carlo 100, 181n.4 Ponzi era 96 Ponzi finance, also Ponzi scheme 19, 22, 59, 95, 100–4, 105, 106, 121, 127, 129, 134, 174, 176 and securitisation 106–10, 174 Ponzi principle 59–60, 102–3, 104, 127 Privatisation of financial risk 11, 59, 166 30/03/2010 11:40 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, 86–7, 92–3, 113, 124, 128, 133, 143, 172, 177n.2 macroprudential 168–71 light-touch 89, 165 paradigm of, 78, 82, 89, 114 in wake of the crisis, 150–7, 161, 165–6 and Basle 116–17, 137 and innovation, 43–7, 85, 165–6 Risk and liquidity 10, 19–22, 64, 107, 113, 116, 121–5, 127, 128–30, 141–2, 177n.2 in the political-economic system, 59, 65, 82, 87, 94, 98–9, 102, 112, 117, 152, 153, 154, 155, 168, 170, 172 Nesvetailova 02 index 203 management of, 6, 9, 11–12, 14–15, 16, 25–6, 40, 41–2, 48, 50, 65, 76, 81–2, 83, 85, 92–3, 95, 120, 130, 135, 138, 142, 155, 166, 172, 178n.12 optimisation of, 6, 8, 13–15, 19, 42–3, 110, 112, 121, 131, 136, 164 pricing of, also valuation, 13, 18, 28, 65, 67, 75, 79–80, 82, 96, 102, 137, 138–9, 173 systemic 59, 94, 155, 163, 169, 179n.14 underestimation (also misunderstanding) of, 18, 19, 25, 52, 57, 64, 65, 68–9, 81, 84, 86, 93–4, 105, 111–12, 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, 48–51, 55, 59–60, 139–40, 179n.3 SIV 15, 48, 118 30/03/2010 11:40 204   financial a lchemy i n c risis Toxic debt, see debt True sale 139–40 United Kingdom 21, 30, 31, 33, 35–7, 40–1, 49, 51, 53–5, 58, 59, 71–2, 85, 86–8, 92–4, 97–100, 104, 146–8, 150, 154, 156, 161, 179n.13 United States 2, 7, 18, 25, 75, 77, 95, 124, 150 Nesvetailova 02 index 204 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, 173–6 Welfare 13–14, 43, 71, 73, 112, 142 WorldCom 48, 105, 133–4, 182, ch.5n.3 30/03/2010 11:40 .. .Financial Alchemy in Crisis Nesvetailova 00 pre 29/03/2010 09:12 Nesvetailova 00 pre 29/03/2010 09:12 Financial Alchemy in Crisis The Great Liquidity Illusion Anastasia Nesvetailova Nesvetailova... 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. .. 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