ited at the time to the sagacity

1.4

of Greenspan and the “vitality” of US financial markets. While 1.2 low interest rates came from 1

0.8

global conditions, a deregula

0.6

tory political economy ensured

0.4

0.2

deregulation came to be seen 0

as natural and state involve-

ment construed as an anath-

architecture which had been put in place in the 1930s was consequently seen as irrelevant and a drag on the innovative capacity of the sector.

The upshot was a series of changes to the regulatory structure in the late 1990s and early 2000s. The Gramm-Leach-Bliley Act of 1999 replaced the Glass-Steagall Act and changed banking structures. The Commodity Futures Modernisation Act of 2000 was introduced in the lame duck session of Congress in 2000, was never debated, and silently replaced the Shad-Johnson Act of 1982. Among its many features, it exempted credit default insurance from regulation by terming them “swaps”, a feature which, as we shall explain, p ermitted and encouraged the financial markets to place vast sums of money on gambling in the explosion of credit default swaps. In 2002, off-balance sheet a ctivities their capital adequacy requirements (Labaton 2008). The normal debt to netcapital ratio which was fixed at a 12:1 ratio was relaxed to allow leveraging of

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credit, and significant increases in inequality. The authoritarian capitalists of the export-led South, in particular China, created complementary distortions, repressing domestic finance and subsidising exports with a pegged exchange rate. They traded forced savings (which were lent to the North but returned through foreign direct investment) for capacity-building gains from trade (see Fung et al 2002). This lopsided dynamic generated and continues to exacerbate the system’s inherent “upward instability” (to use Hyman Minsky’s phrase). What has been wound down however, since it has distended to the point of malignancy, is the most egregious outgrowth of the dynamic, the so-called “shadow-banking system”.

2 Structured Finance and the Financial Crisis

2.1 Regular Banking and Shadow Banking

Regular banking is made stable by two key features: regulation and emergency liquidity arrangements, both provided by the central bank. The latter feature implies the former. The centrality of the lender of last resort function, the result of institutional evolution over centuries of financial crises, indicates a simple truth about banks: they are inherently fragile because they are in the business of liquidity t ransformation and are therefore perpetually exposed to runs on liquidity. The emergency provision of the same entails r egulation by its provider to avoid moral hazard. But because banks are

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c ompetitive, profit-driven entities, they strain at the leash of regulation and seek the i lliquid edge of the risk distribution. Thus light regulation and plentiful liquidity undermine the very pillars of stability even while benefiting its constituent banks. In our present crisis, this systemic trade-off took the form of the shadow banking system.

Yet there is an even more fundamental predication of system stability. The central bank is able to provide emergency liquidity because it alone can ease the refinance constraints of the banking system as a whole. In a world where bank liabilities assume the form of money, the central bank has the best “money” because it is backed by the entity with the best credit, the state. The state, in turn, has the best credit because it, uniquely, has tax claims on every economic entity in its

jurisdiction going out into the

0

foreseeable future. Using this

differential power, the state’s –100 bank can move around the price

–200

of money in its key wholesale market, the interbank market,

–400

in an effort to keep this price in some s table relationship to economic activity. Together, this –600 monetary policy and sound regulation should obviate the need

–800

for emergency refinance, but history and uncertainty c ombine to make such a f acility crucial.

Stabilising control of the benchmark price of money in the interbank market, readiness to lend in the event of a liquidity shortfall, and prudential regulation are the therefore keystones of a sound banking

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Housing Enterprise Oversight.

the extent it enables regulatory arbitrage, innovation allows banks to expand their balance sheets beyond that which is considered prudent by regulators without the latter being able to trace and therefore counteract such expansion. The more financial innovation proceeds unchecked, the more brittle it renders the public good of systemic risk controls, entailing new methods of controlling systemic risk.

This tension between bank profitability and financial innovation, on the one hand, and systemic risk on the other lies at the heart of the present crisis. Because the entire system was being driven by the above-mentioned “search for yield”, the already compromised regulatory architecture was stretched to enable banks to assume even more risk. In a self-reinforcing dynamic of risk and liquidity, the availability of borrowing on relatively easy terms meant that most assets witnessed decreasing returns as their prices were bid up, and therefore even more risk had to be assumed to achieve above-average returns. Yet these elevated risks were deemed to be manageable given the easy availability of credit. Banks and nonbanks alike were compelled to find more yield thanks to easy money, and easy money allowed them to take on greater risks in ever-greater volume.

Yet regulated banks could only expand their balance sheets in mortgages so far

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regular banking system robust were missing from the shadow banking system. Indeed, they were missing by construction, as the very logic of shadow banking followed from the systemic tradeoffs outlined above. And as those tradeoffs suggest, once the balance between regulation, innovation, and profit had been pushed to its risk-bearing limit, the inherent fragility of banking resulted in a run on the shadow banks. This began with rising subprime defaults in late 2007 and ended with systemically unsupportable risks being borne by the only balance sheet capable of doing so, that of the state.

2.2 Mortgage Securitisation

The hidden abode of shadow banks is replete with an alphabet soup of special purpose vehicles that all essentially perform the same function as banks but through securitisation and therefore in a wholesale manner, in the total absence of regulatory oversight. Securitisation enabled the broad distribution of risks held by the banks, thus allowing banks to off-load loan assets and free up re gulatory capital to create the space to g enerate a fresh set of loan assets. As the pressure for increased yield grew, increasingly risky assets were distributed. L iquidity came to be stretched further and further as very illiquid, opaque, and long-term assets came to be funded by ever-shorter durations of liquid liabilities.

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2,000

1,000

Figure 2.4: Monthly Real House Price Index for US

250

200

150

100

and no further without incurring additional capital charges or raising more capital. They therefore used innovations in structured finance and took advantage of easy credit conditions and regulatory loopholes to float off-balance sheet entities that conducted the same business of borrowing short and lending long while incurring no capital charges and having no recourse to a lender of last resort. Thus financial innovation and r egulatory loopholes combined with easy credit conditions and seemingly endless rises in housing prices to create an entire parallel banking structure that was free of regulations. This was the shadow banking system.

The very features that made the

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So while they are idiosyncratic when taken individually, mortgage loans have standardisable actuarial properties when pooled, properties that can then be borne by individual securities issued against such a pool. With securitisation, illiquid assets turns to a liquid security, and bank capital is freed to pursue the social good of providing housing finance while the actual risks of the loan are spread over a broad range of investors. Banks become mere originators in this distribution model, generating raw material for a capital market machine. Relationship banking done at a local level that creates illiquid, held-to-maturity loans is replaced by arms length national and international investing enabled by the standardisation and massing of loan pools.

As we noted, Fannie Mae and Freddie Mac could only buy “conforming” mortgages, i e, those that met certain strict criteria. Those mortgage loans that did not meet such criteria, i e, “non-conforming” loans were dubbed “subprime”. Other buyers would have to be found for these risky pools. But at least two conditions would have to be fulfilled before this would be possible: the further structuring of investments and a radical increase in the risk appetite of investors. Both were enabled by the easy credit conditions of the early 2000s.

2.3 Architecture of the Shadow Banking System

If the securitisation of mortgages appeared as a shining example of how the market can be engineered to produce societal goods, it laid the basis for an explosive growth in structured credit products by loosening the link between the bank and its capital, on the one hand, and its loan customers on the other. If assets could be pooled, tranched, securitised and shipped off the balance sheet, all for handsome fees, banks could then go out and obtain more risky loans edge as long as they could find buyers for their product. Easy credit meant that banks both had to take on more risk to get yield and that they found other investors willing to do the same.

Abstracting from the wild profusion of structured forms, we can isolate two distinct forms of off-balance sheet entities that formed successive layers in the space securitisation created between the bank, its liabilities, and its loan assets. These are the collateralised debt obligations (CDO), the structured investment vehicle (SIV), with the money-market fund (MMF) bringing the shadow banks to the high street. Providing critical liquidity to the CDO m arket was the market for credit default swaps (CDS).

CDOs are products that give the holder a right to the cash flows generated from an underlying pool of asset-backed securities (ABS), typically mortgage-backed securities (MBS). The arranger of the CDO, usually an investment bank, assembles a pool of loans from one or more loan originators (banks) in a special purpose vehicle (SPV) and issues securities against these loan pools. These securities are then placed in tranches based on the risk properties of their cash flows, with “senior” tranches having very secure cash flows, “junior” tranches having less secure flows and so on down the line to the “equity” tranches. This tranched entity is then rated by one of the ratings agencies in order to provide some transparency and security to investors, who purchase obligations to pay a certain cash flows generated by securitised assets. The CDO is therefore the produce of two rounds of securitisation and is thus two degrees removed from an individual loan asset: this asset has first been pooled and securitised and then these securities have in turn been pooled and tranched. It is against these tranches that CDOs are issued. The complicated s tructure has opaque risk characteristics that could only be priced with the aid of both complex mathematical models and credit ratings.

The CDO structure was a bank. Instead of depositors it had investors to whom it promised a stream of cash flows. For loans it had not mortgages but mortgage-backed securities and/or other ABS. It was thus funding long-term illiquid assets with shorter-term liquid liabilities, exposing itself to liquidity risk just as a bank would.

In order to further strengthen the credit-worthiness and transparency of these structures, the underwriter might purchase credit insurance against the various CDO tranches in the form of CDS. As the name suggests, a CDS is an instrument that allows the transfer from credit risk between parties and can be thought of an insurance contract against credit events such as default. The seller of the CDS agrees to make the buyer whole on the occurrence of an agreed credit event, and obligation for which the seller receives periodic payments (insurance premium). By purchasing CDS on their CDO tranches, underwriters added a layer of security and transparency to their structures that pleased both the ratings agencies and investors. At this level, the CDS market enhanced the perceived value of the underlying assets.

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one could, for example, price an individual BBB-rated CDO tranche by referring to the price of insurance on the BBB index and add the price of the risk-free asset.2

Figure 3: Regular versus Shadow Banking

Shadow Banking

Source: Adapted from discussion with Perry Mehrling. Key: ABCP: Asset-backed Commercial Paper, ABS: Asset Backed Security, CDO: Collateralised Debt Obligation, CDS: Credit Default Swap, IRS: Interest Rate Swap, MMF: Money Market Fund, SIV: Structured Investment Vehicle, SPV: Special Purpose Vehicle.

This was the key structural role that the CDS market came to occupy. Notwithstanding this quasi-exchange standardisation by means of the indices, this market did not have any robust market maker of last resort. The main sellers of insurance against the highest-rated AAA CDO tran ches, the implicit benchmark, were reportedly American International Group (AIG) and the monoline insurers (companies which once guaranteed municipal debt but which now saw an opportunity for easy profits). Once Lehman Brothers, invested to the hilt in subprime failed, these previously highly rated companies were shown to be an utterly inadequate liquidity backstop and their ability to fulfil their CDS commitments was deemed severely compromised by a panicked market. They had, in effect, been writing insurance against something that they and indeed no entity but the State can credibly insure systemic risk. When the s ystemic event occurred, the market did not deem these insurers capable of fulfilling the contracts that served as the market’s benchmark, namely those which insured AAA default risk. Without a benchmark and a credible market maker of last resort, the CDS market stopped producing prices a dequate to its valuation function. The p ricing mechanism is the structured credit markets was broken.

The entire CDS market was in danger of collapsing given that its biggest players, the providers of its benchmark, were deemed to be insolvent or nearly so. And as we have seen, the CDS index market, being more l iquid than the market for the underlying CDOs, itself formed the b enchmark for the

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latter market. If the collapse of AIG and the monolines destroyed the pricing mechanism in the CDS market, the freezing of the CDS market would in turn debilitate pricing in the CDO market. Given that all entities had to mark their assets to market prices, the absence of a credible market maker of last resort in these key markets led to the debasement of those balance sheets holding CDS and CDOs.

While the above structures touched every day investors only through rather complex intermediation, the off-balance sheet entity that most directly affected every day investors was the SIV. Doing essentially the same thing as a CDO, the SIV exposed itself to even more liquidity risk by funding its assets at even shorter maturities in the commercial paper market. The explosion in the asset-backed-commercial paper market was the result, and the main buyer searching for yield in this market were MMF. The latter is not a new entity, of course, but it forms a vital final link in the shadow banking chain. MMFs are committed to holding their Net Asset Values at $1, making their liabilities look like regular savings account that bear interest. Being advertised as extremely safe and regulated by the SEC, MMFs attract significant volumes of retail investors, pension funds and other fiduciary institutions. Their track record is such that as an asset class, they have only once “broken the buck” in their entire history. That is, until 16 September of this year. Subprime-induced SIV implosions led to a freeze in the ABCP market as lenders refused to roll over SIV paper. Convulsions in the commercial paper market left several MMFs with severely impaired assets, forcing them to default on their “deposit” liabilities. In a securitised, capital market-based system, this constitutes a run on the “banks”.

If the failure of subprime mortgages was the match, then the absence of prudential controls and credible market makers of last resort in the structured credit markets was the desiccated forest. The run on the shadow banks had become a solvency problem for regular banks once the latter were forced to repatriate these “arms-length” entities (they after all had been the agents creating these entities) after various credit lines, the only real liquidity backstop around, were triggered by subprime losses. It was as if huge risk exposures had been smuggled into the regulated banking system, and it was swamped. The baroque nature of the asset structures fuelled panicked selling as holders of erstwhile shadow-bank assets rushed for the door. Unable to price their own assets, banks refused to lend to one another and the regular source of bank liquidity froze, leading to exploding interbank rates. Lender of last resort facilities, designed for individual conflagrations and therefore as a mechanism to prevent systemic crises rather than deal with one, were inadequate. Something radical was required, and Henry Paulson thought a $700 billion bailout was that something. As we will see in our concluding section, we believe he was asking the right question but came up with an inadequate answer.

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to implement. In trying to price impaired assets and remove them from bank balance sheets, the Troubled Assets Relief Program (TARP), as it came to be known, was following the well-regarded precedents of the Reconstruction Finance Corporation following the crash of 1929, the Resolution Trust Corporation post-Savings and Loans, and the Fed-organised private sector bailout of Long Term Capital Management, all of which were centralisations of crisis-impaired assets that ultimately led to profits for the public purse, (with the exception of the last: profitable but private). The problem with the current crisis was the scale and comple xity of the asset holdings. How could reverse auctions be conducted for each and every CDO or SIV tranche in anything like the time required? How could such a process be made to insure adequate prices that would feed enough capital into the system while not exposing the fisc to undue risk and causing aggravated moral hazard?

Notwithstanding these limitations, the focus on the asset side of banks balance sheets was, in hindsight, useful, given that this is where solvency problems manifest themselves. That massive liquidity injections did nothing to reverse the freezing up of the most liquid markets in the world indicated a problem deeper than the mere temporary absence of liquid funds. Liquidity was impossible to come by because the failure of the pricing mechanism in the structured credit markets meant that no one could tell good assets from bad, and therefore no one was willing to assume any counterparty risk by borrowing or lending.

As we saw above, any robust pricing mechanism is based on a credible benchmark. The benchmark in the CDS markets turned out to be rather less than credible, and there was no market maker of last resort capable of ensuring this credibility. With the ultimate source of liquidity absent from this vital value-setting market, even supposedly safe AAA CDO assets were being marked at prices that rendered the holders insolvent. Thus the problem was not liquidity per se but the robustness of the marketbased valuation process, which was itself based on the credibility of the benchmarks in the key CDS markets. These benchmarks were compromised thanks to the absence of prudential oversight that would have kept the price of risk they reflected in meaningful relationship with underlying economic realities. This permitted an extreme lack of coherence in the system, i e, a bubble. With no stabilising pricing of risk, no credible backstop, and no macro-prudential regulation, the shadow banking system was a ticking time bomb.

It took a while before the problem was acknowledged to be rather more fundamental than panic-induced illiquidity, although whether the exact structural inadequacies have been diagnosed is doubtful, including in our analysis here. Yet things changed in the period between the collapse of Lehman Brothers on 15 September and the peaking of the LIBOR-OIS spread on 10 October, at the end of the worst week on Wall Street in 75 years. In that time, several banks around the world had been bailed out and/or nationalised, the investment banking industry disappeared, the world’s central banks made massive coordinated rate cuts, TARP passed, the entire commercial paper market was taken on to the Fed’s balance sheet, massive swap lines were opened to allow foreign central banks access to dollar liquidity (making the Fed the de facto global central bank), and the Dow Jones Industrial Average melted. Yet asset firesales continued as banks scrambled to secure their balance sheets, further impairing the system’s collective balance sheet.

Thus although the failure of TARP has only been recently acknowledged officially, by 10 October it was clear that something else would be required. Following the British example, focus shifted to the liability side of the balance sheet. Interbank lending overnight and for longer maturities was guaranteed and, most importantly, a significant capital injection was provided to banks to ensure their solvency against unknown – and in the shortrun apparently unknowable – devaluations in shadow-bank assets. This “hit and hope” strategy seemed to work because of its sheer size and the explicit assumption of significant credit risk by the sovereigns concerned.

But the fundamental problem of valuation appears to remain. How could the authorities know how much capital to give the banks if they could not value the assets on their balance sheets? They might just be giving them another layer of capital to chew through as asset prices continue to fall.

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it would be doing the job that AIG or any other private balance sheet could not. Further, by going to the heart of the matter and establishing a liquidity and pricing backstop where there was none, this plan is both quick to implement and more p ermanent than other measures. By setting a floor in this market, the CDO market would recover and ipso facto bank assets would have stable marks. If paid for with bank preferred stock, this insurance would simultaneously recapitalise the banking system. Such a plan is thus addressing both liquidity and valuation issues. By pricing the systemic risk implicit in AAA products, state-backed credit insurance establishes a potential countercyclical tool adequate to the new nature of the system.

If macro-prudential pricing of refinance, sound regulation, and lender of last resort facilities are the pillars of the regular banking system, they have to be brought to the new capital market based system as well. Votaries of exchangetraded markets have been quick to point out that it was the OTC nature of the credit markets that was their undoing, but this reflects a partial understanding of the situation. The collapse of Long Term Capital Management in 1998 threatened the collapse of the US Treasury futures clearing house; centralised structures are by no means immune to the deluge. It is rather a question of hierarchy. The US Treasury futures clearing house did not collapse because behind it stood a bigger balance sheet, the Treasury.

In a system based on credit-money, economic entities are always in need of refinance when they face a short squeeze. Individuals have banks, banks have each other and, in a pinch, the central bank. Central banks have the sovereign, and sovereigns have other sovereigns, individual or collective. The OTC structured credit markets were not unstable because of their own structure but because they had not developed the backstops at higher l evels of the credit hierarchy like that which had evolved in the banking system. Being the creatures of a credit boom, these markets could not have developed such backstops, which are by their very nature creatures of crisis. These backstops would have to be appropriate to the

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capital market-nature of the system and would not, therefore, take the form of emergency refinance whose price can be altered in a counter-cyclical fashion. Given the arrangement of the current s ystem, a CDS backstop operated by the sovereign might be the appropriate instrument. Its existence would not have preempted the crisis itself, cycles being a consequence of cash commitments made on inherently uncertain investments, but it might have made it smaller. The fact of uncertainty means that this would not have been an insignificant accomplishment.

The deeper problem facing the economies of the world remain however unaddressed. The global imbalances we referred to earlier, the path dependency of 30 years of a particular pattern and structure of growth, and the highly complex negotiations which will have to occur outside the traditional realm of the nation state will all need to be addressed. Equally, the geopolitics of the time make this a particular fraught period. During the last period of rebuilding – post the second world war – there was a near hegemonic power in place which had both an interest and an ability to restructure the global economy in ways that were mutually beneficial to global macroeconomic growth and stability. The world economy has no rising leader in that way at the current moment. Nevertheless, there is a certain sense that political forces are moving to rethinking our views about finance, the state and the nature of the economy and its need for regulation. One can hope that a combination of restructuring the US economy with the new Obama administration and a coordinated set of institutional changes through the new Bretton Woods (with much more broad global representation) will be the beginnings of a long and ultimately successful transition and global rebalancing. The details of such programmes are, of course, a much larger d iscussion, and must be postponed for another time.

To review the argument, massive deregulation has allowed more non-banks to function like banks, exposing the institutional fragility particular to banking. This unprecedented scale of deregulation and the concomitant absence of systemic risk controls are facilitated by a radically l opsided political economy in the North. This political economy is in turn held up by an extremely lopsided global division of labour and financial repression in the South. Export-surplus-fuelled liquidity and excessive deregulation combine to exacerbate the cyclical nature of banking systems that follow from the creditary nature of money, leading to massive credit booms and searing busts. Layer upon unstable layer, these interacting dynamics have imperilled our world system and brought us to the brink. Each dynamic will now have to be rebalanced, which is a difficult political task.