Minsky in the Shadows: Securitization, Ponzi Finance, and the Crisis of Northern Rock

Review of Radical Political Economics http://rrp.sagepub.com/ Minsky in the Shadows: Securitization, Ponzi Finance, and the Crisis of Northern Rock Anastasia Nesvetailova and Ronen Palan Review of Radical Political Economics published online 28 January 2013 DOI: 10.1177/0486613412470090 The online version of this article can be found at: http://rrp.sagepub.com/content/early/2013/01/28/0486613412470090 Published by: http://www.sagepublications.com On behalf of: Union for Radical Political Economics Additional services and information for Review of Radical Political Economics can be found at: Email Alerts: http://rrp.sagepub.com/cgi/alerts Subscriptions: http://rrp.sagepub.com/subscriptions Reprints: http://www.sagepub.com/journalsReprints.nav Permissions: http://www.sagepub.com/journalsPermissions.nav >> OnlineFirst Version of Record - Jan 28, 2013 What is This? Downloaded from rrp.sagepub.com at CITY UNIVERSITY LIBRARY on February 15, 2013 470090 RRPXXX10.1177/0486613412470090Review of Radical Political EconomicsNesvetailova and Palan Minsky in the Shadows: Securitization, Ponzi Finance, and the Crisis of Northern Rock Review of Radical Political Economics XX(X) 1–20 © 2013 Union for Radical Political Economics Reprints and permission: http://www. sagepub.com/journalsPermissions.nav DOI: 10.1177/0486613412470090 http://rrpe.sagepub.com Anastasia Nesvetailova1 and Ronen Palan2 Abstract One of the many lingering questions posed by the continuing meltdown of global finance concerns the role of securitization and the so-called shadow banking system in amplifying the scope of the crisis. As the crisis has revealed, a crucial function of many shadow financial units such as special purpose vehicles (SPVs) has been to make complex debt structures marketable and liquid. To what extent can the financial malaise of 2007 be attributed to the widespread use of such schemes? And how can this problem be conceptualized in contemporary political economy? In this paper we address these questions, examining the case of Northern Rock and its offshore SPV structure, Granite Master Trust. Drawing on the financial instability framework of Hyman Minsky, we find that the collapse of Northern Rock was caused by a confluence of two institutional trends in modern finance. First, it is the tendency of financial firms to exploit the regulatory gap by relying on financial innovation; second, it is the spread of the Ponzi culture as the defining mode of financing for today’s economic units. In this, the crisis of Northern Rock is symptomatic of a wider problem of today’s financial system where the process of securitization and liquefying debt structures is facilitated through the shadow financial system and often involves illicit practices, as well as outright fraud.1 JEL codes: P16; B310; H260; G010; G210; G280. Keywords credit crunch, securitization, offshore, SPVs, financial innovation, Minsky, shadow banking, Northern Rock, Granite. 1 This paper has gone through several rounds of revision. We are grateful for thorough and helpful critique, comments, and suggestions of the editors of the RRPE and referees, including David Kotz and Don Goldstein, made on earlier versions of this article. We are especially indebted to Mehrene Larudee for her constructive feedback and editorial help. 1 Reader in International Political Economy, Department of International Politics, City University, London, UK Professor of International Political Economy, Department of International Politics, City University London 2 Date received: June 13, 2009 Date accepted: March 12, 2012 Corresponding Author: Anastasia Nesvetailova, Reader in International Political Economy, Department of International Politics, City University, London Email: a.nesvetailova@city.ac.uk Downloaded from rrp.sagepub.com at CITY UNIVERSITY LIBRARY on February 15, 2013 2 Review of Radical Political Economics XX(X) 1. Introduction In January 2006, London’s Credit Magazine congratulated Northern Rock, a British bank, on winning the award for the best securitization deal of 2005. The caption in the magazine explained that the operation was the first European securitization program to transfer first-loss risk through a credit default swap (CDS) contract.2 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. The beauty of the transaction, as David Johnson, operational director for securitization at Northern Rock explained, was “its simplicity, parcelling the reserve funds and writing a credit default swap thereby transferring the majority of Northern Rock’s first-loss risk to the international capital markets” (Credit Magazine, January 2006). Translated into plain English, the essence of the deal was indeed simple enough. Broadly defined, securitization is a way of making debts marketable and liquid. By using a CDS, Northern Rock found an ingenious way to get rid of the risk associated with a large amount of very lowquality debt, described in the jargon as “first-loss,” and pass this risk on to third parties (trade it on the international markets). As it was assumed that a CDS contract protects the portfolio of the bank from the risk of bankruptcy, the deal allowed Northern Rock to transfer a very high risk portfolio off its balance sheet. Fortunes turn quickly in the financial markets, as the fate of Northern Rock soon confirmed. In winter 2007, Northern Rock was one of the largest mortgage providers in the UK, valued at £5bn. By February 2008, its share price had dropped to 90p per share (about $1.41), pulling the value of the company down to $380 million. On 18 February 2008, the UK government announced a controversial decision to nationalize the bank. Northern Rock, along with other high-profile financial collapses of the global crisis, such as Bear Sterns and Lehman Brothers in the United States, Bradford & Bingley in the UK, Fortis in Belgium, and most of the Icelandic banks, collapsed under a convoluted chain of securitization techniques, centered on the sub-prime mortgage industry in the United States and connected together by instruments such as collateralized debt obligations (CDOs),3 CDSs, and their derivatives. As the securitization boom came to a halt in the summer of 2007, many critics pointed out that, contrary to the key assumptions of the efficient market theory of finance, which views financial innovation as a benign and progressive force, securitization techniques had never discovered new ways to optimize risks. In fact, as the crisis intensified, it became apparent that the techniques and products of financial securitization had not only hidden the risks in the dark corners of the banking system, but amplified the systemic risk and fragility of the financial system as a whole. Since the first onslaught of the current crisis in August 2007, much has been written about the failure of the securitization market and the processes of financial innovation. Focusing on the failure of Northern Rock in the UK, we address some of the lessons about the role of securitization structures in precipitating the global credit crunch. In particular, drawing on Hyman Minsky’s theory of financial fragility, we inquire into the function of specific instruments and techniques of financial innovation that facilitated the conversion of very low-quality debt into liquid and marketable assets. 2 A credit default swap (CDS) is a form of an insurance contract between two parties where a buyer pays a regular fee to the seller in exchange for a guarantee that s/he will be compensated in the case of any default on a stipulated piece of debt. Importantly, CDS contracts are freely traded and can be struck even if the buyer does not own the debt he wishes to “insure” (Tett 2009: 284). 3 Collateralized debt obligations (CDOs): a form of asset-backed security. They are typically created by bundling together a portfolio of fixed-income debt (such as bonds) and using those assets to back the issuance of notes. Such notes usually carry varying degrees of risk. Cash CDOs are created from tangible bonds, bonds, or other types of debt; synthetic CDOs are created from credit derivatives (Tett 2009: 284). Downloaded from rrp.sagepub.com at CITY UNIVERSITY LIBRARY on February 15, 2013 Nesvetailova and Palan 3 Our analysis centers on the problematic relationship between Northern Rock and its offshore Jersey-based special-purpose vehicle (SPV),4 Granite Master Trust. We believe that the case of Northern Rock may serve to illustrate the role of two broad institutional trends that lay at the heart of the banking collapses and the broader crisis: first, the tendency of financial firms to exploit regulatory gaps offered by the offshore economy (Palan 2004) by relying on financial innovations; and second, the spread of the Ponzi culture as the defining mode of raising finance for today’s financial units. The latter, in turn, has been facilitated by existence of what is now known as the shadow financial system and often involves illicit behavior and practices, as well as outright fraud. 2. The Crisis of Financial Innovation In retrospect, the crisis of Northern Rock was only a prelude to the subsequent chain of transatlantic financial collapses that would nearly paralyze the world economy in autumn 2008. The scale and scope of the crisis that ensued has motivated numerous attempts to theorize the credit crunch as a historical event in the evolution of world affairs (Altman 2009; Bremmer 2009; Woods 2010); as a rupture of Anglo-Saxon capitalism; and, in more localized interpretations, as crisis of a particular segment of the financial system: namely, the crisis of securitization (Soros 2008; Wade 2008; Wigan 2010). Emergent theorizations of the global crisis of 2007-,5 while quite diverse ideologically, are rarely mutually exclusive. Most scholars concur that while the crisis centered on the emergence and spread of new techniques of risk trading in the financial system, it has been an outcome of a broader historical process of financialization, facilitated both by the policy environment of Anglo-Saxon monetary authorities, and by the developments in the financial industry over the past few decades (e.g. Amato and Fantacci 2012; Foster 2010; Lysandrou 2011; Mackenzie 2011; Merhling 2010). At the same time, the disagreements among different schools of thought on the crisis center on how the processes and functions of financial innovation are understood in the wider political-economic context. In analyses of modern political economy, the phenomenon of financial innovation proves to be a highly divisive issue. According to mainstream economics and business studies, capitalism thrives on innovation; the invention of new products, advances in technology, and new practices of management and marketing promote competition, efficiency, growth, and therefore ultimately enhance prosperity and welfare. For much of the past few decades, mainstream finance theory has evolved around a paradigm of growth-enhancing financial innovation, and the regulatory framework of the financial system has reflected this. In the words of Robert Merton, “innovations involving derivatives can improve efficiency by expanding opportunities for risk sharing, by lowering transaction costs and by reducing asymmetric information and agency costs” (1995: 463). It has also been widely assumed that financial innovation advances economic growth, democratizes access to credit, and enhances societal welfare by mobilizing economic resources through financial markets and, more specifically, by relying on scientific approaches to managing economic and financial risk, and hence “completing the markets” for various assets. Financial 4 Special purpose vehicle (SPV): a shell company that is created to hold a portfolio of assets, such as bonds or derivatives contracts, and then issue securities backed by those assets. It may be created by a bank, but crucially, it exists as a separate legal entity (Tett 2009: 286). 5 As this article is finalized for publication in early 2012, the financial crisis that began in summer 2007 has advanced to its third phase, the crisis of European sovereign debt and the eurozone. Reflecting this, we refer to what we see as a continuing meltdown as the “crisis of 2007-.” Downloaded from rrp.sagepub.com at CITY UNIVERSITY LIBRARY on February 15, 2013 4 Review of Radical Political Economics XX(X) innovations were responsible for the ascent of the “new economy,” argued Alan Greenspan, providing “net benefits for the majority of the American people” and significantly contributing to America’s accelerated economic growth.6 As to the risks posed by financial derivatives for financial stability, Merton’s colleague Myron Scholes has concluded that “[t]here is no empirical evidence that supports the conjectures that derivative contracts can lead to massive failures and create systemic risk” (1996: 285). It was only in the wake of the major financial crises of the late 1990s and the global credit crunch of 2007-, that critical views on the role of financial innovation in economic stability would gain currency and some weight in the public debate (e.g. Bello et al. 2000; Bezemer 2001; Kregel 2001; Nesvetailova 2006, 2007; Soederberg 2005; Wolfson 2000). In the heyday of finance-led “new economy” and against the power of the sophisticated mathematical foundations of modern finance, the reputation of Noble Prize winners in economics, and the advance of financial liberalization across the emerging markets, one needed to be very skeptical indeed about the worth of capitalism itself to doubt the ultimate benefits of financial innovation. 3. Minsky, Financial Innovation, and Financial Stability Such a skeptic did exist. Hyman Minsky (1919-1996), having devoted his life to the study of financial instability in capitalism, did not live to witness the meltdown of 2007-. Yet the global credit crunch, initially dubbed a “Minsky moment” in the world economy, or a crisis of Ponzi finance, has lifted his name from the relative obscurity of heterodox political economy to the very center of public debate about the crisis and its long-term repercussions. Minsky produced his major works in the 1970s and 1980s. At a time when mainstream economics was increasingly gravitating towards mathematical and technical methods of analysis, Minsky was primarily concerned with the systematic nature and behavior of a financially advanced capitalism, and more concretely, with the ever-present “natural instability” of finance and the associated danger of a recurrence of a major financial crisis. Minsky’s main analytical framework, the financial instability hypothesis (FIH), offers “a theory of how a capitalist economy endogenously generates a financial structure which is susceptible to financial crises, and how the normal functioning of financial markets in the resulting boom economy will trigger a financial crisis” (1986: 67-68). This argument, and his belief in the fragility inherent in the very structure of a financially advanced capitalism, isolated Minsky’s academic work from the neoclassical orthodoxy. It would take three decades of financial instability, culminating in the crisis of 2007-, to rehabilitate Minsky’s scholarship. “Stability – or tranquility – in a world with a cyclical past and capitalist financial institutions is destabilizing,” Minsky famously observed in his FIH (1982: 101). Amidst the ostensible rehabilitation of his name, it is this message about destabilizing effects of a tranquil environment that resonates in many commentaries on the global credit crunch. According to Minsky, “good” economic times breed complacency, exuberance, and optimism about one’s position in the market, which in turn leads to heavier reliance on leverage and underestimation of risks. Minsky unpacked this process through a taxonomy of financing modes. The FIH is founded on the premise that financial instability is inherent in advanced capitalism, which in turn can 6 Greenspan anticipated that the pace of innovation in the financial sector would increase, with virtually no limit to the possible types of new products and services that would be offered by financial institutions (Greenspan 2000, cited in Leathers and Raines 2004). Merton agreed: “The rapid five-year growth in overthe-counter derivatives reflects a growing confidence in the issuing institutions’ modeling and evaluation skills” (Merton 1995: 463). Downloaded from rrp.sagepub.com at CITY UNIVERSITY LIBRARY on February 15, 2013 Nesvetailova and Palan 5 assume a variety of institutional forms. The main source of instability relates to the mode by which economic units raise their finance, and specifically rely on debt as a source of cash flows. Minsky distinguished between hedge, speculative, and Ponzi modes of financing. Each stage represents a more aggressive mode of using borrowed funds to finance one’s outstanding obligations, and relates to systemic liquidity. In this instance, it is interesting that most emergent accounts of the global credit crunch do concur that the crisis came as a result of a boom (or superbubble) which led economic agents to severely underestimate the risks they were taking on: 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) At the same time, once we follow Minsky’s insight into the origins of financial fragility and his focus on the contentious function of innovation in the stability of a financialized economy, it appears that only a selective version of Minsky’s theory of finance informs current readings of the global meltdown. In his 1986 book Stabilizing an Unstable Economy, Minsky discussed the role of financial innovation in economic stability at length, arguing, somewhat controversially, that financial fragility fundamentally stems from the process of financial innovation: [I]n a capitalist economy that is hospitable to financial innovation, full employment with stable prices cannot be sustained, for within any full-employment situation there are endogenous disequilibrating forces at work that assure the disruption of tranquility. (Minsky 2008 (1986): 199) Today, while noting the risk-numbing effects of the general macroeconomic environment and investor expectations, most observers tend to overlook the core of Minsky’s framework. Specifically, it concerns his message that the very ability of financial intermediaries to stretch the frontier of private liquidity ultimately accentuates fragility in the system, magnifying the scope for a structural financial collapse and hence an economic crisis.7 Minsky explained that over the course of an economic cycle, the expanding web of debtdriven financial innovations produces a two-fold effect on the system’s liquidity. On the one hand, the spread of financial innovations increases the velocity of credit. Yet on the other, 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” (Minsky 1984 (1982): 173, emphasis added). Most controversially, therefore, Minsky showed that the mechanism that spreads fragility and crisis throughout the system involves a complex chain of liquidity-stretching financial innovations that appear to enhance liquidity but in fact, by replacing high-quality and more reliable assets, such as state-backed money, with privately created and riskier financial instruments, make the financial system progressively more illiquid (Nesvetailova 2007). The global credit crunch has revealed a disturbing implication of this problem. The liquiditycreating function of new financial structures in fact has become the underbelly of the official banking system. Today, it involves a complex web of shadow financial units, such as SPVs and 7 For insightful studies of the causes and implications of the creation of such private liquidity channels in the UK and United States see Ryan-Collins et al. (2011) and Merhlring (2010), respectively. Downloaded from rrp.sagepub.com at CITY UNIVERSITY LIBRARY on February 15, 2013 6 Review of Radical Political Economics XX(X) other structured vehicles,8 over-the-counter (OTC) deals,9 off-balance sheet operations that have been central to facilitating the process of shifting the risk away from the visible (regulated) financial system into the unregulated financial space, broadly conceived. In the contemporary financial system, according to Jan Kregel, the ultimate effect of structured securitization has been to produce the so-called riskless arbitrage, or the ability “to convert less-liquid, higher-risk securities into securities that appear to be more liquid and lower risk” (2010: 11). In other words, financial innovations lead to apparently changing risk profiles on both the asset and the liability sides of the balance sheets of traditional banks and other financial intermediaries, often creating “secondary,” “parallel,” or “shadow banking” systems.10 The frequent underpricing of the new products and services, in turn, encourages excessive risk taking (Mullineux 2010: 243; see also Banque de France 2008). In the latest credit boom, this process of temporary liquidity creation was one in which longerterm, higher-risk, lower-liquidity assets were funded through the issue of shorter-term, lowerrisk, higher-liquidity assets via special purpose entities or the use of over-the-counter derivative loan structures that did not require complying with formal margin requirements. In other words, it was done through what has come to be known as the “shadow” banking system. According to the few in-depth studies that exist, at the heart of this complex phenomenon lies the process of reverse maturity transformation, or the transformation of long-term savings into short-term savings, driven by the growth demand of institutional asset fund managers for safe, liquid, and shortterm collateral (Pozsar and Singh 2011: 7-8). Currently estimated to accommodate a staggering $67 trillion (FSB 2012), the shadow banking system is typically seen as an outgrowth of the official banking system and a symptom of the new era in finance. Yet scholars have argued that the emergence of a parallel banking system is in fact common in major financial crises and is usually associated with a preceding period of deregulation or liberalization (or forbearance). Mullineux notes, for instance, that the UK secondary banking crisis in the early 1970s, which involved commercial property lending, has strong parallels with the current crisis (Mullineux 2010: 247). The result of the latest bout of financial innovation through structured securitization has been an ostensibly increased system liquidity, without the same regulatory prudential measures imposed on banks to ensure the liquidity (Kregel 2010: 11). The crisis that ensued was centered on the systemic fragility of the highly complex network of financial intermediation, and in many readings was a crisis of illusory, or artificial, liquidity 8 The general term used for these entities is special purpose entity (SPE), in finance synonymous with special purpose vehicle (SPV): a “bankruptcy-remote entity” whose operations are limited to the acquisition and financing of specific assets. The SPV is usually a subsidiary company with an asset/liability structure and legal status that makes its obligations secure even if the parent company goes bankrupt. Investorpedia also suggests that SPV can be a subsidiary corporation designed to serve as a counterparty for swaps and other credit sensitive derivative instruments. Most SPEs are established in economies other than the economy of the parent company, and often have little or no physical presence (IMF 2004: 2). 9 Over-the -counter (OTC) financial instruments are securities that are traded in some context other than on a formal exchange platform. The term “OTC” also refers to debt securities and other financial instruments such as derivatives, which are traded through a dealer network. 10 The term “shadow banking,” while increasingly popular, has no precise definition. Existing studies use it to loosely refer to a complex network of financial activities undertaken by banks off their balance sheets, and largely beyond existing regulations. Conventionally, the inhabitants of the shadow banking system include non-depository money market funds, the use of securitization and credit derivatives by financial institutions, and private repo (repurchase) operations (Ryan-Collins 2011: 95). Downloaded from rrp.sagepub.com at CITY UNIVERSITY LIBRARY on February 15, 2013 Nesvetailova and Palan 7 (Borio 2000, 2004; Langley 2010; Nesvetailova 2010). It did not center on a classical “bank run” but on a collapse of security values, insolvency in the securitized structures, and a withdrawal of short-term funding. What aggravated the financial rupture, according to Mullineux (2010), was the fact that the existing safety net designed to contain bank runs appeared to be totally inadequate to respond to a capital market liquidity crisis. In the wake of the credit crunch, the controversial link between financial innovation and systemic risk, underlying its liquidity aspect, has been addressed by several authors (Acharya and Richardson 2009; Goldin and Vogel 2010). At the same time, the lingering effects of the crisis, including its new phase as a crisis of sovereign debt in Europe, as well as the unresolved conceptual issues of the nature of systemic risk in finance today, warrant further inquiry. For the purposes of this article, the mechanics of the systemic rupture are best understood in a two-fold way. First, technically, the credit crunch is a crisis of the industry of securitization and more specifically, the practice of re-securitization. It was propelled by advances in so-called “scientific” finance, the ascent of credit derivatives, and crucially by the belief that sophisticated techniques of parceling debts, creating new products, arranging structured deals, and opening up new markets create additional and plentiful liquidity. In reality, just as Minsky warned, the proliferation of obscure techniques of valuing risk and even more obscure financial securities has driven the financial system into a structurally illiquid and hence crisis-prone state. At the level of the financial system, securitization has produced an incredibly complex and opaque hierarchy of credit instruments, whose liquidity was assumed but in fact never guaranteed. Once the process of valuing these products malfunctioned, the continuity of the chain of securitization and re-securitization was jeopardized and crisis ensued (Nesvetailova 2010). The second impact of financial innovation on the stability and liquidity of the system relates to the political economy of its origins. Rarely do innovations in the financial markets emerge out of the blue. Although comparatively less costly and more fungible than inventions in other areas of business (such as car manufacturing), modern financial products require substantial analytical and technical effort, as well as institutional support and a receptive market environment. Most importantly, however, innovations are introduced for a reason: they help financial institutions gain profits by circumventing existing barriers to profit-making. These barriers, in many cases, are related to official regulations and rules. Van Horne (1985: 622) has pointed out that economic and structural changes that tend to prompt financial innovations include: (1) volatile inflation rates and interest rates; (2) regulatory changes and circumvention of regulations; (3) tax changes; (4) technological advances; (5) the level of economic activity; and (6) academic work on market efficiency and inefficiencies. In this sense, the credit crunch is a culmination of a series of consequences of the introduction of the Basle rules on banking regulation, the essence of which was to establish the concept of risk-weighted capital requirements for banks. The introduction of the concept of risk-weighted capital, in turn, provided financial companies with both the motive and the means to search for ways to redistribute the official amount of risk held on their books. The creation and sale of high-leverage instruments such as synthetic CDOs deepened the crisis, effectively magnifying losses by providing more securities to bet against. At the end of 2009, about $8 billion of these securities remained on the balance sheet of AIG, an insurance giant rescued by the U.S. government in September 2008. From 2005 through 2007, at least $108 billion in these securities were issued. And the actual volume was much higher, because products such as synthetic CDOs and other tailor-made trades are unregulated, unvalued, and hence unreported (International Herald Tribune, 26-27 December 2009). In late 2010, for instance, the volume of “toxic” assets on the balance sheets of Citigroup, RBS, Commerzbank, and HSBC together was near $1 trillion (down from $1.6 trillion in early 2009).11 In September 2010, the 11 The Economist, “Taking Out the Trash,” 26 March 2011, p. 88. Downloaded from rrp.sagepub.com at CITY UNIVERSITY LIBRARY on February 15, 2013 8 Review of Radical Political Economics XX(X) top ten U.S. banks had $360.7 billion in so-called “level 3” securities, illiquid investments that cannot be easily valued using market prices. The Wall Street Journal reported that if losses on such assets were assessed against banks’ earnings, it would have reduced the banks’ pretax income for the first nine months of 2010 by 21 percent (Rapoport 2011). At the same time, and with disturbing regularity, financial innovation also helps disguise illicit practices such as tax avoidance and evasion, as well as outright fraud (Nwogugu 2008, 2009; Gottshalk 2010; Haynes 1997). Two high-profile cases pertaining to the legal aspects of securitization deals have hit the headlines in the wake of the credit crunch. In 2010, Goldman Sachs was accused by the Securities and Exchange Commission (SEC) for duping their clients into buying structured mortgage-backed securities that effectively were bets on the client’s chance of going bankrupt. In March 2011, Germany’s Deutsche Bank stood trial and was censured for $768,942 in damages for failing to advise a client on the true risk of a complex swap transaction (The Economist, March 26, 2011: 88). As Sylvain Raynes, an expert on structured finance, put it: “when you buy protection against an event that you have a hand in causing, you are buying fire insurance on someone else’s house and then committing arson” (International Herald Tribune, 26-27 December 2009, p. 11). It is two of these elements that we focus our discussion on below: the circumvention of regulation and of rules of taxation. Both, as this paper shows, have been at the epicenter of the credit meltdown generally, and of the fiasco of Northern Rock in particular. Using the case of Northern Rock, we aim to show that the banking collapses that culminated in the global credit crunch were a result of two institutional trends: first, the tendency of financial firms to exploit the regulatory vacuum by relying on financial innovations; and second, the spread of the Ponzi culture as the defining mode of financing for today’s financial units. The latter, in turn, has been facilitated by existence of the shadow financial system and often involves illicit behavior and helps disguise fraud. 4. Offshore Finance: The Uses and Abuses of SPVs Some twenty years ago, the then scant literature on financial innovation pointed out that a key impetus to the process of financial innovation 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). In the deregulated market, the ability to bypass existing regulations tends to provide competitive advantage to firms: 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) Shah’s investigation of the workings of regulatory arbitrage in the convertible bond market confirms that companies are able to design sophisticated schemes of regulatory avoidance relying on the expertise of investment bankers and lawyers. In turn, the regulators, the media, and analysts were unable to expose these practices publicly and restrain such creativity. He concluded that: 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 Downloaded from rrp.sagepub.com at CITY UNIVERSITY LIBRARY on February 15, 2013 Nesvetailova and Palan 9 industry out there which is capable of undermining the spirit behind accounting regulations. (Shah 1997: 99) The financial structure of capitalism of the 1970s and the 1980s analyzed by Hyman Minsky pales in comparison with the degree of sophistication of the financial system of the early 21st century. In the time of Minsky, financial products, while complex, were less esoteric; the world economy was still divided into capitalist and Communist-ruled blocs; financial markets were much less integrated. In fact, it is interesting that recent revisions of Minsky’s FIH have argued that his framework is most adequately tuned to explaining the cumulative fragility of industrial business units, rather than modern financial firms as such (Bellofiore and Halevi 2010; Toporowski 2009). In contrast, the period of 1998-2007 has appeared as the “Golden Decade” in finance, marked by the explosive growth of sophisticated financial instruments and expanding resale markets for capital (Gai et al. 2007, cited in Goldin and Vogel 2010). Indeed, whereas the trading of derivatives had been marginal in the three previous decades, by the turn of the century the global overthe-counter derivatives market had reached $100 trillion worth of outstanding deals. By the end of the Golden Decade in 2007, the market had expanded to $600 trillion, sixteen times global equity market capitalization and 10 times global GDP (Goldin and Vogel 2010: 2).12 The advent of “financialization” and the derivatives revolution have been understood by various authors as the rise of casino capitalism (Strange 1997; MacKenzie 2011); the new era of fictitious capital (Gowan 1999; Magdoff 2006); or even Ponzi capitalism (Henwood 1997; Sen 2008; Canterbury 2000). What is interesting when reading through these characterizations is that, while unavoidably skeptical of the social utility of the new financial instruments, and acutely aware of the crisis potential inherent in the speculative financial markets, few commentators have dwelt on the issues of legality of the new financial practices. Indeed, although Minsky himself immortalized the name of an Italian-born crook Carlo Ponzi, he did not dwell on the role of regulatory avoidance, much less fraud, in his theoretical framework. And yet according to Dorn (2010), Minsky’s FIH does accommodate the spread of Ponzi culture within the financial system and beyond it. Indeed, Minsky argued that periods of stability lull market players (and regulators) into thinking that stability is an inherent and defining aspect of the financial system. In such a situation, more risky financial tactics are pursued, as investors believe that they can reap higher profits while effectively removing risk away from the system. As this way of thinking spreads from the professional investment world to the whole population, Ponzi styles of investment become generalized, becoming the norm at certain (turning) points in the cycle (Wray 2008: 15). Dorn has drawn on studies of the AIG case to argue that the insurance giant seemed to be doing fine right up until the market turned. While AIG managers may not have intended to defraud their customers, the taking on of obligations beyond the capacity to repay is a Ponzi-like characteristic, common to some licit and illicit market behavior (Dorn 2010: 28-29; Tymogne 2010). Lawyers and criminologists often are unhappy with a blurring of the distinction between outright fraud, including Ponzi schemes, and opaque financial practices such as leveraging. Yet the ambiguity that exists at the juncture between law and financial practices, particularly in common law countries, has created a grey zone accommodative to competitive financial innovation. In fact, thriving in this grey area, financial innovation produced what scholars have described as a 12 These proportions have been largely retained even in the midst of the credit crunch: in December 2010, the notional amount of OTC derivatives was $601,048 billion, while the world GDP was valued at $65 trillion. Downloaded from rrp.sagepub.com at CITY UNIVERSITY LIBRARY on February 15, 2013 10 Review of Radical Political Economics XX(X) rhizomatic pattern of the financial system itself (Delueze and Guatarri 1987; Vlcek 2010). The term “rhizome” comes from botany, where it is used to describe a horizontal, usually underground stem that often sends out roots and shoots from its nodes. Adopted by Delueze and Guattari (1987) in philosophy, rhizome was a concept, and more accurately a mode of thought, that, in contrast to conventional linear patterns of causation, allows for multiple, non-hierarchical entry and exit points in representation and interpretation of information. In the context of the financial system, the notion the rhizome captures the essence of a value transfer process “as financial transactions that ‘pass between things’ and exist parallel to or alongside the formal banking system” (Vlcek 2010: 429). Within this rhizomatic web, financial innovation has amplified the interconnectedness between visible and invisible nodes of financial relationships. Goldin and Vogel (2010) argue that this process contributed to “robustness of the network by spreading risk through securitisation, but also rendered the system fragile to targeted attacks on its hub nodes, with the potential for risk amplification and contagion” (2010: 7). Most problematically, the global crisis revealed that these crucial hub nodes tend to be located, in a juridical if not a territorial sense, in the invisible underbelly of the financial system, that is, in the offshore world. In economics, offshore financial havens have been mainly conceptualized as entities that help business units reduce transaction costs. As such, economists believe that offshore havens originate in tax competition between economic zones that, according to mainstream analyses, is a benign function of a competitive market (Hong and Smart 2007). More recent critical literature has focused on the social and political implications of the process of money laundering through offshore locations (Haynes 1997; Zhang and Li 2009). More specifically, Larudee (2009) has stressed that offshore financial havens impoverish society and impede the development process. At a general level, however, the credit crunch has revealed that the offshore financial system has become the backbone to the process of securitization and the credit boom generally. It is notable that the role of offshore finance in the development of securitization practices and structures remains a contentious issue. While the few official reports that exist on this question avoid identifying a direct link between the existence of the offshore financial world and opportunities for securitization through SPEs and SIVs, the Bank for International Settlements has observed that “decisions as to where to locate an SPE—in onshore or offshore jurisdictions— appear to be based on ensuring that the SPE vehicle itself is fairly tax neutral and thus does not impose marginal increases to a firm’s tax burden” (BIS 2009). Similarly, market actors acknowledge that the decision as to where to set up an SPE is case-specific and depends on the application of structured finance techniques. Tavakoli (2003), for instance, notes that while in the United States SPEs are often set up as trusts for tax reasons, in non-U.S. venues the use of a special purpose corporation is a more common practice. She concludes, however, by saying that “venues can be chosen wherever an SPE structure is allowable, but as a rule, only tax friendly venues for the specific structured finance application are chosen. Special purpose entities are currently set up in a variety of tax friendly venues including Delaware, New York, Luxembourg, the Netherlands, the Caymans, Ireland, Jersey, Guernsey, and Gibraltar” (Tavakoli 2003: 4). We believe therefore, that offshore financial centers, providing a variety of regulatory and tax niches for financial innovation, play a crucial role in facilitating the spread of complex securitization structures, and thus contribute to the phenomenon of shadow banking. In terms of evidence of the scale of the problem, suggestive data can be gleaned from the BIS locational statistics. Figures on external liabilities in all currencies indicate that between 26 percent to 28 percent of cross-border lending and borrowing is conducted through such jurisdictions.13 (See Table 1.) 13 The figures include the Netherlands, which may be controversial. The rest, including Singapore, Switzerland, Ireland, and Luxembourg, clearly attract these SPVs partly due to their very low tax provision and partly because they offer a good degree of opacity and secrecy. Downloaded from rrp.sagepub.com at CITY UNIVERSITY LIBRARY on February 15, 2013 11 Nesvetailova and Palan Table 1. Selected Offshore Financial Centers: External loans and deposits of banks in all currencies visà-vis all sectors in individual reporting countries (US $ billions) All countries Caymans Netherlands Singapore Switzerland Hong Kong Luxembourg Bahamas Ireland Jersey Guernsey Bahrain Isle of Man Total Percent of world total Loans Deposits 23,013.2 1,507.0 856.9 806.7 756.5 640.5 617.7 508.0 427.6 259.8 159. 4 154. 9 74.3 6,012 26.0% 24,188.0 1,594.4 873.0 775.3 838.6 632.3 584.3 506.1 27.2 174.6 143.3 151.6 55.5 6,857 28.3% Source: BIS 2011, Preliminary International Banking Statistics, Second Quarter. Table 3A, pp. A16-A17; authors’ calculations. Most recent financial crises, including those in East Asia, Russia, as well as corporate scandals associated with the dotcom bubble, Enron, WorldCom, Refco, Parmalat, and to some degree Northern Rock and the 2007-09 credit crunch, can be attributed at least partly to the opacity of current accounting practices and the use of tax haven affiliate entities for either fraudulent or opaque purposes. Securitization and derivitization, as well as mortgage broking, generated substantial fee income, thus feeding the growth of a parallel system of raising funds. Many shadow banking units serve to draw in short-term funds (from foreign banks and from money market mutual funds) in order to lend long, just as commercial banks traditionally have done (Mullineux 2010: 5). In its function, therefore, the shadow banking system has not only provided an alternative (market-based) way to raising funds; being tightly intertwined with the offshore financial world, the shadow banking system has helped conceal those financial innovations that are deemed illegal,14 for instance in the U.S. context (Palan, Murphy, and Chavagneux 2010). The crises also contain a more critical dimension: negligent executives and fraudsters do not only deceive investors; they leave many workers without pensions and jobs, and have effects on the entire economy. The economy ultimately bears the resulting costs without having enjoyed the risk premiums created during the boom. The offshore entities that seem to have caused most of the problems are the special purpose vehicles or entities (SPVs or SPEs, respectively). As mentioned above, 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). This ghost company is typically set up for the purpose of buying receivables and issuing bonds which may be backed by those receivables. In most instances it will be situated in an offshore jurisdiction. Alternately, a 14 Nwogogu (2009) argues that securitization constitutes several violations of U.S. law: it violates the free speech clause of the U.S. Constitution; it constitutes a violation of the right to contract clause of the U.S. Constitution and hence is illegal; it constitutes a violation of the equal protection clause; it constitutes a violation of the separation of powers doctrine. Downloaded from rrp.sagepub.com at CITY UNIVERSITY LIBRARY on February 15, 2013 12 Review of Radical Political Economics XX(X) double special purpose vehicle can be adopted in cases where over-collateralization is used to obtain a good credit rating15 (Haynes 1997: 10). SPEs raise severe prudential problems. First, while tax havens have made it exceedingly easy to set up offshore SPEs, these jurisdictions do not have the resources, especially in terms of staff, to perform appropriate due diligence on operations that in reality are highly complex financial vehicles. For example, the banking system of the Cayman Islands, a country whose budget needed to be rescued by emergency loans in 2009-10, holds assets of over 500 times its GDP. Jersey, another offshore haven, holds assets worth over 80 times its GDP. It is highly questionable whether these and other small jurisdictions can allocate sufficient resources to monitor and regulate such colossal sums of money. A report by the UK National Audit office has clearly suggested that they do not (NAO 2007). The second prudential issue related to SPEs is the potential to accommodate fraud that securitization structures offer. Haynes (1997) documents many instances of offshore bond issues or similar arrangements being used to fleece investors of money which then disappears. Some of these cases involved banks being successfully asked to guarantee an SPV. They were then left with the financial liability when the funds raised by the vehicle disappeared along with those behind the scheme (Haynes 1997: 152). As the author explains, one advantage a secondary securitization vehicle provides to a fraudster: is a plausible reason for the bond issue being made from an offshore centre, [typically offering] a good combination of low taxes, efficient communication, a convenient time zone, a wide range of double taxation treaties, easy access to the core financial markets (such as USA) and a tradition of SPVs being based there. What they also offer the fraudster is a regulatory system that is not always as effectively enforced as it could be. Once the bond issue has been made, the funds could disappear and the fraudsters with them. (Haynes 1997: 153) SPEs hit the headlines following the collapse of Enron. The Powers committee which investigated Enron’s collapse reported that Enron had created complex financial arrangements, partnerships, and SPEs in order to shift debt around and pay illicit money 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 bonafide economic objectives or to transfer risk” (Powers et al. 2002: 4). Enron’s fraud was organized through 3,000 SPEs “with over 800 organized 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” (U.S. Senate 2002: 23). Nevertheless, despite headline reports, neither the Powers report nor the congressional hearings have demonstrated that offshore structures were palpably more poisonous that the onshore ones in the Enron case. It appears, rather, that Enron’s offshore SPEs were set up primarily for tax avoidance purposes. Against this background, the global crisis of 2007, and specifically the collapse of the British bank Northern Rock in autumn 2007, raised further questions about the nature of offshore SPVs and their role in the current financial crisis. 15 Haynes (1997) explains that under such an arrangement the originator will set up two vehicles. The transfer of the assets to the first (SPV 1) will be a true sale for the purposes of bankruptcy risk and those assets are then transferred to SPV 2 in a transfer that is a true sale for the purposes of the relevant accounting rules. SPV 2 then proceeds to issue the bonds. On termination of the arrangement, when the bonds are paid off, SPV 2 can re-transfer any outstanding receivables to SPV 1 which may itself then be hived up (absorbed) into the originator. Downloaded from rrp.sagepub.com at CITY UNIVERSITY LIBRARY on February 15, 2013 Nesvetailova and Palan 13 5. Northern Rock and Granite Northern Rock was a UK mutual building society that was converted into a public limited company in 1997. Building societies typically raised the money they lent in a rather conventional fashion, by attracting it from depositors. Banks, on the other hand, have the option of accessing larger sums from the money markets somewhat more easily. After demutualization Northern Rock became a bank, and in early 2007 became the fifth largest mortgage lender in the UK. It was quite distinct from conventional commercial banks in that it had a small deposit base and relied heavily (75 percent) on wholesale money markets to get the funds. This was an aggressive technique: the audit of Northern Rock’s accounts in 2006 showed that it raised just 22 percent of its funds from retail depositors, and at least 46 percent came from bonds. It was this aggressive strategy of financing that brought Northern Rock its prize for the best securitization deal of the year in January 2006. Importantly, the bonds were not issued by Northern Rock itself, but by what became known as its “shadow company.” This was Granite Master Issuer plc and its associates, which was an entity formally owned not by Northern Rock but by a charitable trust established by Northern Rock. The trust in question was the Down Syndrome charity in northeast England. After the failure of the company it became clear that this charitable trust had never paid anything to the charity, and that the charity meant to benefit from it was not even aware of its existence. The sole purpose of Granite was, in fact, to form a part of Northern Rock’s financial engineering that guaranteed that Northern Rock was legally independent of Granite. Granite was, therefore, solely responsible for the debt it issued. The arrangement was but a sophisticated masquerade, and one that was helped by the fact that the trustees of the Granite structure were, at least partly, based in St. Helier in Jersey. When journalists tried to locate these Granite employees they found there were none in Jersey. In fact, an investigation of Granite’s accounts showed it had no employees at all, despite having nearly £50 billion of debt. The entire structure was acknowledged to be managed by Northern Rock, and therefore (and unusually) was treated as being on the balance sheet of Northern Rock and hence included in its consolidated accounts. Experiencing the first shockwaves of the global financial crisis, Northern Rock faced a dilemma. Granite was used to securitize parcels of mortgages on the money market through bond issues. When in August 2007 the money market lost its appetite for that debt, Northern Rock’s business model malfunctioned; it could no longer refinance the debt. Consequently, Northern Rock had to support Granite in meeting the obligations Granite had entered into with its bondholders, even though the company was notionally independent. The same confusion arose as to whether Granite was onshore or offshore. In practice the arrangement included elements of both. When the crisis of the bank broke out, debates at the House of Commons ran well into the night on whether the nationalization of Northern Rock also meant the nationalization of Granite. Yvette Cooper, then 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, column 277). On 20th of February 2008 Alistair Darling, the then UK chancellor, reiterated this in a letter to Vince Cable, his then shadow counterpart: “Granite is an independent legal entity owned by its shareholders…. Northern Rock owns no shares in Granite” (Accounting Web 2008). During the very same parliamentary debate, however, Yvette Cooper confirmed that “Granite is part of the funding mechanism for Northern Rock and it is on the bank’s balance sheet” (Hansard 2008, column 277). How could Granite be part of the Northern Rock’s funding mechanism and yet be a separate legal entity? The details of the ownership structure of Granite companies and its financial relationship with Northern Rock remain murky to this day. Because Granite is a Jersey-incorporated vehicle, and due to the secrecy laws of Jersey there was no way of finding out who precisely was Downloaded from rrp.sagepub.com at CITY UNIVERSITY LIBRARY on February 15, 2013 14 Review of Radical Political Economics XX(X) the trustee or creditor of Granite. As a result, the issue was never resolved. After the bank was nationalized, no one seemed to know whether a company wholly managed by the state-owned enterprise but notionally owned by a charitable trust was under state control, or not. Despite that, the UK government had little choice but to extend its guarantee to the Granite bond holders. What is more or less clear is the fact that the Jersey-based offshore structure was used as a securitization vehicle for mortgages issued by Northern Rock. It is also implied that Granite served as an equivalent of a price transfer channel for Northern Rock, a means through which the bank could transfer profits earned in the UK to the near-zero tax regime of Jersey. In evidence before the Treasury Committee of the UK House of Commons, the former chief executive of Northern Rock, Adam Applegarth, explained this arrangement as follows: Granite is our securitisation vehicle and accounts for roughly 50% of our funding. The way securitisation works… is you borrow against a pool of mortgages. The bond holders, the people who are lending the money against it, they carry the risk and therefore there can be no risk from those loans to [Northern Rock’s] balance sheet, so even though it is shown in our balance sheet, it has to be a separate legal entity. The separate legal entity is a matter of trust. (Cited in Tomasic 2008) What Applegarth did not mention is that Northern Rock did not carry the risk either, because the risk was nominally removed to its SPE. The confusion created by the structure is indicative of the problem that the use of SPEs, often “orphaned” from their parent through the artificial use of charitable trusts to break nominal control, can create. Such schemes are commonplace throughout the financial system and have been widely used in the securitization of sub-prime mortgages. In legal terms, the relationship between banks and their SPEs is captured in the concept of “true sale.” The idea of true sale is to separate the credit risk of the actual assets owned by a bank (in our example mortgages originated by Northern Rock) from the default risk of the entity that originated these assets (Northern Rock itself) (Baron 2000: 87). In plain terms, structures like the Jersey-based Granite are used by the visible “onshore” financial institutions to take the risk away from the estate of the originator in the event it goes bankrupt. The rationale for banks and financial institutions to employ such schemes goes far beyond capitalizing on the benign tax regimes offered by offshore jurisdictions. The main reason why such schemes have been used across the financial system has to do with the liquidity of the newly created asset-backed securities. Indeed, from the very beginning of the securitization boom, a central concern in facilitating the marketability of securitized debt has been to enable the rating agencies to analyze and grade the credit risk of the assets in isolation from the credit risk of the entity that originated the assets. According to Lowenstein (2008), such legal arrangements of true sale were absolutely essential for the approval stamp of credit ratings agencies, which in return for their stamps of approval demanded that the risk was redistributed and taken away from the originators’ books. The primary purpose of such a transfer of ownership is to prevent the seller and its creditors (including an insolvency official of the seller) from obtaining control or asserting a claim over the assets following the seller’s insolvency. The purchaser of the assets is typically an SPV, such as Granite. Overall, “once the assets have been isolated from the insolvency risk of the originator, there is no additional credit risk analysis required on the purchaser” (Credit Magazine 2008). Curiously, Northern Rock was a relatively clean case compared to many. In order to obtain good ratings on its mortgage-based securities, the bank set up two SPVs. The name of the Down Syndrome charity, the nominal beneficiary of the scheme, was used as SPE1 for the purposes of bankruptcy risk. The assets were then transferred to the second SPV, Granite, a transfer that is a true sale for the purposes of the relevant accounting rules. SPV2, Granite, then proceeded to Downloaded from rrp.sagepub.com at CITY UNIVERSITY LIBRARY on February 15, 2013 Nesvetailova and Palan 15 issue the bonds. On termination of the arrangement, when the bonds are paid off, SPE2 (Granite) can re-transfer any outstanding receivables to SPE1 (Down Syndrome charity) which may itself then be folded back into the originator. The delinquency of Northern Rock revealed the great complexity of dealing with the resulting situation on the part of almost every regulator who approached the scene; and this ambiguity has remained even after the bank was nationalized by the UK government. While the UK government may have settled the issue of Northern Rock, despite the great ambiguities in its relationship to Granite, the existence of so many orphaned SPEs, holding billion upon billion of debts, yet legally separated from their onshore parents, has unnerved banks and investors and contributed to the freeze-up of the wholesale financial market. The secrecy and lack of transparency offered by offshore financial havens not only magnify credit and counterparty risks, but also facilitate outright scam or quasi-legal Ponzi schemes, or regulatory avoidance schemes, preventing public authorities from adjudicating in cases when private financial manipulation leads to systemic risks and public losses (Palan 2004). Like many subsequent casualties of the global credit crunch, the Northern Rock crisis has highlighted controversies about how, in the contemporary financial system, private financial gains and socialized economic losses are addressed by political leaders.16 (In 2006, Rock’s former CEO, Adam Applegarth, was paid $1.36 million. During 2007, he cashed in shares worth more than £2 million. Upon his resignation, he reportedly was paid a $1.5 million bonus. In the midst of the collapse, members of Northern Rock’s senior management were offered £100,000 in compensation pay.) These figures might pale in comparison to the large bonuses that companies like Goldman Sachs or Barclays paid out to their senior executives in 2010, a year after the credit crisis. Yet as the post-crisis recovery initiates calls for the “end to banker-bashing” (e.g. Treanor 2011), the episode of Northern Rock and the unresolved dilemmas of its securitization vehicles raise concerns about the spread and longevity of Granite-like schemes across the global financial system and its distressingly large shadow component. It also leads to the question of how many other companies might be continuing to benefit from similar schemes through the use of structured finance and complex investment pyramids. Lead underwriters on the Granite program included Lehman Brothers, Merrill Lynch, and UBS; underwriters were Barclays Capital, Citigroup, JP Morgan, and Morgan Stanley. The list linking the names of the world’s once largest investment banks to an obscure offshore financial scheme bordering on fraud suggests that toxic debts, sub-prime lending, and hence the global crisis of 2007 were not a result of one malfunctioning institution, market segment, or even financial model. Rather, the crisis is an outcome of a political and legal regime which has facilitated the privatization of gains from financial risks, at a cost of socializing their losses (Wade 2008; Turner 2008), in other words, a regime that has institutionalized Minsky’s Ponzi principle of financing as a legitimate and prominent vehicle of financial innovation. 6. Conclusion The arrangement that Northern Rock set up with its Jersey-based SPE illustrates one of the problems that financial markets are facing nowadays. The British government accepted the arrangement, having swept under the carpet the complex legal situation it found itself in. Private investors, however, are not so forgiving. As Hyman Minsky warned us, stability is destabilizing: an ambiguity of ownership structures, as well as the concealed risks associated 16 In November 2011, four years after the crisis began, the saga of Northern Rock came to an end. Richard Branson’s Virgin Money bought Northern Rock from the British state for £747 million, around half of what the UK government injected into the bankrupt structure. Downloaded from rrp.sagepub.com at CITY UNIVERSITY LIBRARY on February 15, 2013 16 Review of Radical Political Economics XX(X) with such schemes, may be overlooked during “good” economic times. During periods of distress or crisis, however, the use of securitization structures proves extremely damaging, amplifying the connections between the hidden nodes of the financial system and thus magnifying systemic risk. Curiously, the emergent theorizations of the 2007- financial crisis tend to overlook the offshore nexus of the global meltdown. While many accounts of the credit crunch point to the seizure of markets, and to the fear and unwillingness of banks to lend to one another and to the rest of the economy, there is very little analysis of the causes and institutional channels of such fear and mistrust. However, as we have shown in this article, the web of offshore entities, orphaned and legally separated from their visible parents, yet holding massive amounts of debts servicing the parents, plays a crucial role in creating mistrust. In contemporary finance, at least half of all international lending is conducted through offshore jurisdictions and through ambiguous securitization arrangements. According to recent data for the United States, at the peak of the credit boom in 2007, the size of the “shadow banking system” was $20 trillion, while the “official” banking system was estimated only at $13 trillion (Pozsar et al. 2010). More recent estimates by the Financial Stability Board (2011) suggest that the size of the shadow banking system is close to $60 trillion. 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Downloaded from rrp.sagepub.com at CITY UNIVERSITY LIBRARY on February 15, 2013 20 Review of Radical Political Economics XX(X) Bio Anastasia Nesvetailova is Reader in International Political Economy at City University London, UK. Prior to that she worked at the universities of Liverpool and Sussex. She is the author of Fragile Finance: Debt, Speculation and Crisis in the Age of Global Credit (2007, Palgrave) and Financial Alchemy in Crisis: The Great Liquidity Illusion (2010, Pluto), as well as numerous other publications on the issues of financial instability, liquidity, financial innovation, and governance. Ronen Palan is Professor of International Political Economy, City University London. Recent publications include Tax Havens: How Globalization Really Works (Ithaca, NY: Cornell University Press, 2010) (with Richard Murphy and Christian Chavagneux) and Global Political Economy: Contemporary Theories, 2d ed. (London: Routledge, 2013). 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