In 1988, when two City financial superbrats, Stephen Partridge-Hicks and Nicholas Sossodis, invented structured investment vehicles (SIVs) they inadvertently ignited the fuse that blew up the world’s financial system in the Crash of 2008. Their company, called “Gordian Knot” helped banks devise ingenious ways to hide their extravagant risk-taking by creating off-balance-sheet companies. Structured finance created a Gordian Knot all right - a system of interlocking financial mechanisms so complex that no one could unravel what was going on.
Gordon Brown, a latter day Alexander, tried to cut the Gordian Knot, but he may have simply cut the public finances adrift on a sea of debt. The state has now exposed itself to the billions of liabilities held off the balance sheets of Britain’s delinquent banks. October's stock market crash was largely a result of panic selling in this shadow banking system of structured finance. These vehicles of leverage, including hedge funds and private equity companies, are having to liquidate billions in assets as their business models collapse under the weight of collapsing share and house prices. Until these losses work their way through the system the British economy remains in intensive care.
The madness of the shadow banking system became apparent over a year ago when Northern Rock was nationalised, but regulators ignored the implications. The treasury minister, Yvette Cooper, discovered to her dismay that Northern Rock didn’t own most of its own mortgages. £50bn had been hived off to a Jersey based company, Granite, registered as a charity benefiting Down’s Syndrome Children in the North East of England. Needless to say the charity didn’t get any cash - this was a special purpose vehicle which allowed the Rock to trade in complex securities without having to meet the stringent capitalisation requirements of a normal bank.
But it wasn’t just the Rock. Most banks and financial institutions did exactly the same setting up “orphan companies”, often under charitable trust, that didn’t appear on their published balance sheets. This is one reason why apparently well-capitalised and solvent institutions like Royal Bank of Scotland collapsed so suddenly recently. Their true liabilities had been hidden for years in the shadow system while they make huge profits from irresponsible lending.
How did they get away with it? If you or I set up fictitious offshore identities to evade tax and conceal high-risk financial activities we would end up in jail. But the regulators turned a blind eye, partly because they didn’t fully understand structured finance, and partly because the government believed that it must be a good thing because it generated so much profit and tax revenue. This was the regime of “light touch regulation” of the City which turned the British economy into a cross between a Liechtenstein tax haven and a giant hedge fund.
The USP of SIVS, as with hedge funds and private equity companies, was that they had found ways of abolishing risk through complex financial engineering. Typically they packaged up long term debts, usually residential mortgages. sealed them with credit default swaps, and sold them as securities. It was a unique combination of self-delusion and sophisticated fraud ultimately premised on the notion that house prices could never fall. The financial engineers were often mathematicians who possessed brilliant minds but were devoid of common sense.
Like Medieval alchemists the hedge funds claimed to a mysterious gift called “alpha” which allowed them to make profits in any market, bull or bear, through speculative activities like short selling. In fact, their innovative alpha was based on boring old debt, cheap money. Buccaneering private equity companies used it to go on leveraged buyout raids on FTSE companies. Money was so cheap that you could buy billion pound firms by putting up less than a hundred million of real money - the rest was borrowed from banks eager to hand on the huge amounts of credit they were generating through their shadow banking system. It was a hell of a party, till it ended.
The exploding market in Credit Default Swaps CDS were an integral part of this world of fantasy finance. CDS’s are a bit like insurance policies taken out on the possibility of a company defaulting on its debts. They’re a bit like taking out insurance on your neighbour’s house burning down - only this is multiplied by hundreds thousands of other speculators also betting on your neighbour’s house burning down. The trouble was that no one actually knew what who was liable if and when the house really did burn down - until Lehman Brothers did exactly that last month leaving a charred hole of losses worth $300billion. Since then all the parties to these unregulated derivative contracts have been trying to avoid the losses from the conflagration of Lehman bonds.
The CDS market had grown from almost standstill to $62 trillion dollars in seven years. These CDS’s were themselves traded as if they were bonds, meaning that they turned into another source of credit and leverage. The global market in financial derivatives, of which CDSs are a part, has grown to over £500 trillion - a massive black cloud hanging over the world financial system. The truth is, no one really knows what’s out there.
The British government is in the process of spending £500bn to find out through nationalising banks like RBS and underwriting all new bank debt. The Brown package is imaginative, comprehensive and has won widespread praise - not least from the Nobel Prize-winning economist, Paul Krugman - but it is also a hell of a risk. The huge losses of the shadow banking system could now find their way on the public balance sheet.
There is a huge deleveraging underway which will mean trillions in losses across the world banking system. The hedge fund industry is literally disappearing before our eyes as worried investors pull their money from these vehicles that promised never to lose. The industry is expected to halve in value to around $1.000 bn, but its leveraged liabilities will be much larger than that figure.
If British property slumps by 35%, that means another trillion or so of value removed from the financial system, further undermining the value of all those mortgage-backed bonds in the SIVs. The UK stock market has lost another trillion or so this year, even after this week’s rally. Who pays? Well, pension funds will absorb much of the losses. They are estimated to have lost £150bn so far, but the true figure will be much higher. The 2.5 million homeowners who will in negative equity if, as expected, house prices fall by 35% , will also be paying debts for many years. Sovereign wealth funds who invested in British banks and equities will find themselves out of pocket.
But an awful lot of money is going to land on the public purse. The shadow banking system is an imponderable black hole of financial loss. According to the IFS, the liabilities from RBS alone could add £1.8 trillion on the public debt, taking it to £2,5 trillion. Britain’s GDP is only £1.4 trillion. These are terrifying numbers. Be in no doubt: if all the liabilities of the UK banks fell on the state, Britain could find itself in the same predicament as Iceland. Our economy is acutally very similar, only on a much larger scale.
Sorting out the shadow banking system, assessing liability and clearing out the debt, will be a massive task for the British government and people. It will take great ingenuity and international co-operation of a kind never seen before. Gordon Brown showed great political courage in cutting the Gordian Knot, but now he faces the much bigger task of cleansing the Augean Stables.