The story of the crisis:or (not) knowing what to do

Ewald Engelen# and Karel Williams#AMIDSt, University of Amsterdam

CRESC and MBS, University of Manchester

First premise: finance is a democratic issue

• Historical context: 1979-2007 UK and US settlements insulated markets from democratic control + majoritarian influence (instead of corporatism + industrial policy, we had privatization, outsourcing, deregulation of everything, including finance)

• Looks different after 2007 when we now have good reasons for reasserting democratic control of finance:

• (a) finance is a pro cyclical industry which socialises its losses at the expense of the tax paying masses eg IMF estimates UK cost of bail out = £289-1183 billn

• (b) finance has directed funds into asset price inflation by lending on property and to other financial instns; not creating sustainable claims on more resources eg in UK productive busines invest was flat at !0% of GDP from 1996-2008

The paradox of 2009-10: big crisis and small reforms

• Window of opportunity for reform after 2008 Lehman collapse? politicisation via scapegoating bad bankers + banks (eg Dick Fuld, Fred Godwin and Goldman Sachs as the giant squid)

• Summer 2009: “ business as usual” banks profiting from state intervention + media criticising timid reform proposals eg June 2009 UK White Paper; now wrong kind of reform crits of recent populism eg UK tax on bonuses or Obama levy (eg Johnson FT 19 Jan 10)

• Why are we wasting a crisis ? Because what’s gone wrong + what’s to be done are not inside our knowledges: most of this presentation explains how that plays

Second premise:knowledges were blindsided

Crisis on the blind side of knowledges: for finance professors, central bankers and critical social scientists:

1. varieties of capitalism (Hall and Soskice on which capitalist instns matter + how fit togther)

2. SSF + constructionist radicals (Mackenzie on performativity)3. New or old IPE (liberal governmentality + Langley’s semi automatic

subjects)4. Heterodox economics ( Bryan + Rafferty on derivs as gold standard)

(1) entirely missed reinvention of banking; (2) + (3) + (4) celebrated bits not the chain from retail as mass marketing to investment banking as prop trading; previously unreflective on implications of new economy + tech stock crash implied; and now will “save the phenomena”

The narrative turn:capitalism runs on stories

• A master concept of how capitalism works is impossible; if there is no one law of value + we don’t all live in the same moment.

• But we can start from a perception: capitalism runs on stories that motivate expert regulators as well as mass political action and inaction; especially our mass financialized capitalism whose narratives about digitalisation or marketisation of risk are performative up to a point

• A story is a collective resource: often just tropes + memes; story tellers aim to use the story but are often used by its categories; complex distinction between good vs. bad stories depends on relation to evidence and getting the result politically;

Capitalism as the undisclosed and the mystified

• Understand capitalism via what’s not in the story/not as in the story: an undisclosed economy + mystified political actors; hence difficulty of directing or managing the process

• Capitalism as confusion of genres: Shakespearean comedy of misunderstandings + confusions about identity and motive; with a tragic ending because its not “ alls well that ends well”

• Hence the presentation in two parts(1) Financial innovation: the reassuring alibi vs the active undisclosed (no prescience before the crisis + difficulty of analysis afterwards)

• (2) Political mystification = the power of tropes + memes in the absence of a new story (interim result = not chaos but elites win by default)

Part IFinancial Innovation: from alibi to undisclosed story

Financial Innovation: a reassuring story

Reassuring pre 2007 story: authorised by financial economics + shared by policy makers, politicians, regulators, media (uncontested by critical academics)‘we should also always keep in view the enormous economic benefits that flow from a healthy and innovative financial sector. The increasing sophistication and depth of financial markets promote economic growth by allocating capital where it is most productive. And the dispersion of risk more broadly across the financial system has, thus far, increased the resilience of the system and the economy to shocks’ (Ben Bernanke, Chair US Federal Reserve, New York, 15 May 2007)

Visualisation of FI benefits: industry marketing exhibits depicted securitisation as decontextualized chains: flow diagrams + feedback loops projected an engineering rationality of foresight and control

JP Morgan: Securitizing sub-investment loansJP Morgan: Securitizing sub-investment loans

AAASecurities

£144mInvestment

MINCS

ASSETS

LIABS

£144mBBBNote

MorganGuarantee

TrustAAA

SeniorClass

TrancheAAA

AA

BBB

SEQUILS

ASSETS

LIABS

RBSLoan

Portfolio£852.5m

B-

CouponPrincipal

Swap Premium

Credit Event Payment

Swap PremiumCredit Event

Payment

Note issuance

Cash

True saleof assets

Cash

Note issuance

Cash

JP Morgan: Securitizing sub-investment loans2006 Synthetic CDOSEQUILS = SPV1 , MINCS = SPV 2

Reassurance works through promises

Promises about securitising assets, and tailoring derivative products (linked to those assets) to match wholesale investor risk + yield preferences + meet retail needs + deliver macro stability

1. generate liquidity at low cost & thus increase investment by raising funds from investors with different risk appetites.

2. distribute risk away from the core hubs of the financial system, ex shifting risky bets to those most able and willing to bear risk t.

3. create higher yield alternative assets for pension funds, + sovereign wealth funds needing yield under conditions of demographic changes.

4. enhance disintermediation + promote democratization of finance including lower retail access thresholds, increased competition and lower costs of capital.

But nothing was as it seemed: the undisclosed was then the opposite of the promises and is now a different story

Undisclosed and opposite(1) socially dysfunctional finance Not economically functional but socially dysfunctional

finance: • Steering capital into fancy financial products +

inflating asset prices; eg UK bank lending was about financing unsustainable debt (no material transformation); grimmest consequences in small economies like Iceland or Ireland

• Not supporting traditional productive business or new infrastructure + green technologies, not offering stable and secure pensions, good and simple financial products, no interest in developing economies except for BRICs opportunities.

Trends in UK lendingUK bank and building society loans to UK residents and businesses

0

200,000

400,000

600,000

800,000

1,000,000

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

£mill

Manufacturing Other productive and service activitiesFinance Real estateIndividuals and trusts

Undisclosed and opposite:(2) concentration of risk

Not competition and risk dispersion but concentration of everything including risk

• limited competition (= high concentration and standard fees) in most financial markets: asset management, m&a, securitisation, underwriting, prime brokerage, etc.

• risks concentrated on trading books of large commerical and investment banks: new agents like HFs and PE not independent but linked to banks through prime brokerage, funding etc.

M&A market share in Q4 2009 (in%)

1) Goldman Sachs 9.7

2) JPMorgan 8.5

3) Morgan Stanley 7.4

4) BoA/Merrill Lynch 6.1

5) CITI 6.0

6) UBS 5.8

7) Credit Suisse 5.3

8) Lazard 4.6

9) Deutsche Bank 4.2

10) Barclays Capital 3.9

Total of top ten 61.5

Undisclosed and opposite (3) fragility, opacity

Not transparency + robustness but opacity and fragility caused by unnecessary complexityOpacity caused by information losses through long chains of transactions which lead nobody knows where ( eg FSA inquiry into UK PE debt; Gorton 2009 on CDOs) Fragility; not simply within finance as counter party obligations but also real economic effects of asset value declines through hidden feedback loops (retail as feedstock for wholesale as (toxic) manure for retail funds) that link real and financial economiesContagion instead of decoupling and all markets are correlated because too many players make the same conventional bets

Who

lesa

le

bank

ing

Reta

il ba

nkin

gW

holesale banking

Retail banking

Household (Ultimate Borrower)

Originator Commercial Bank

InvestmentBank

Special Purpose Vehicle (SPV)

Ultimate Investor

Stages and the direction of the capital

Role in the chainTranching

Smoothing repayments and default risk to

create fixed return bonds

Role in the chainDistribution

Bundling and unbundling of the credit chain

IdentityBanksHedge fundsInsurance funds Pension funds

Sale of tradable bonds

Mainly fixed term & returnOff-exchange

Role in the chainPooling

Role in the chainOriginating loan

Stages and the direction of claims on income and assets

Fragmented regulation

Business model of mortgage loan origination and securitization

Fees Fees

FeesFeesManagement Fees

Credit rating agency

FeesRating

Bond insurer

FeesIndemnity

(Fixed rate but may vary repayments)

Undisclosed story: transaction generating machine

Why the complexity? Because banking for itself is a transaction generating machine where > turnover > fees and profits:– Derivatives allowed wholesale bankers to create transactions

and fees; joint venture of shareholders with wholesale seniors claiming 45% of net turnover + could create turnover

– Retail meant a high street workforce incentivised to “sell to” retail customers which was profitable; 30% of FTSE 100 profits in mid 2000s were coming from FIRE and banks had ROEs of 15-25%;

“Bricolage”of long chains or circuits where one retail transaction could generate seven fee earning opportunities (RMBS: $5-9 mln per deal; CDO’s over 1 % fees = $ 10 mln per $ 1 bn deal)

Smart at the links and dumb through the chains; fragile responses to conjunctural opportunities

Comparison of split in net revenue

Combined employee costs vs net income in Goldman Sachs, Merrill Lynch and Lehman

-40,000

-30,000

-20,000

-10,000

0

10,000

20,000

30,000

40,000

50,000

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

$ bi

ll.

Net Income for shareholders Staff costs

Average global investment bank pay, 2009 ($’000)

Base Bonus Total Change on 2008

Analyst 80 to 90 40 to 60 12 to 150 + 25 %

Associate 110 to 120 120 to 140 230 to 260 + 25 %

VP 150 to 200 350 to 500 500 to 700 + 35 %

Director 200 to 250 500 to 700 700 to 950 + 30 %

MD 300 to 400 $1.2m to $ 1.6m

$ 1.5m to $ 2.0m

+ 35 %

Part 2Mystified politics + interim

outcomes

Politics of Finance

• Politics is different from finance, though there is a politics of finance about the new crisis. This PoF has two old characteristics with each nation as an unhappy family:

• (1) The importance of national govs which managed extreme intervention in 2008; afterwards, nations were differently placed (internal deficit + external credibility probs and national calculations of advantage eg building Paris v City of London)

• (2) All politics is episodic, time bound + sequential on several different scales; politics is about events so “ a week is a long time in politics” + politics is framed in years by elections on fixed or variable terms

• What follows is mainly about one episode in the UK in 2008-9 ie the half successful attempt at closure in the 9 months after Lehman went under and the difficulty of coming up with an alternative problem definition.

UK politics in context:(a) more bad, old stories

Democratic politics runs on stories which motivate political action and inaction. Story telling more important after end of corporatism, as lobbying business is the new Scherezade

But (as the Left knows) its hard to invent a new electoral story so (a) elections are usually about political “ change” throwing out the scoundrels (b) economic changes often empower old stories as familiar, reusable, accessible ways of understanding the new world

Eg UK case 2008-9, the distributive coalition around finance reused bad old stories in lobbying to block reform while media + technocrats struggled to find a good new story,

UK politics in context:(b) mystified politics

Narrative confusion produces mystified politics + reduces the probability of democratic mobilisation ( at least when party membership is low + organisation is weak); especially at times of crisis:

(1) multiple reusable and irrelevant old stories provide ammunition for conflict within + between elite groups

(2) the absence of convincing new stories increases the prospect of contradictory, disengaged and unresolved political action.

Eg UK case 2008-9 elites quarrel amongst themselves about how it is and what to do; and by default financial elites rule OK because reform does not crimp their business models; the crisis begins with knowledges blind sided and continues with democracy sidelined

Scherezade’s game:going for closure in the UK

UK finance pre 2008 was already organised as a

distributive coalition for story telling (not corporatist

negotiation)

Had no need to pause for thought (a) objective was

deflecting reform and (b) reused bad old stories about

social value of finance and tropes about shareholder

value

The game = regulatory closure ie a socio-cultural

process of framing problems and painting out

radical policy options (not capture): target =

politicians + institutions

Reusing an old storyabout the social value of finance

City of London PR story about social value of finance by adding taxes paid, pays contribution, jobs created etc; pre 2007 used to justify light touch regulation + then reuse in Wigley (2008) and Bischof ( 20090 Reports to deflect re-regulation of valuable sector:.

Immediate political result via political buy in and copy out:

• Buy-in of politicians e.g. Chancellor’s forward to Bischoff on how “financial services are critical to the UK’s future”

• Copy out e.g. chap 1 (July 2009) White Paper does not review causes of crisis but copies out Bischoff’s claims and evidence on “the importance of financial services and markets to the UK economy and the pre-eminence of the UK as a global financial centre”

Precarious closure ex “a good bad story”

Good as politically intelligible + bad as evidence is mangled by econ. naive method of adding benefitsTax revenues from finance sector is offset by costs of bail out: 5

years of taxes paid and collected £203 billion vs. up front UK costs of bail-out of £289 billion (rising to £1,183 billion)

Job creation: finance sector directly employs just 1 million (mainly in retail); adding indirects in consultancy, law and accounting gives total of 1.5 million or 6.5% of UK workforce; against 2.4 million in UK manufacturing

Precarious closure because critics challenge the story of finance ( eg Alternative Report on UK Banking Reform); hence the importance of holding key institutions

Key success:Sh’older Value and UKFI

UKFI = state holding company set up to manage 70% holding in RBS and 43% in Lloyds:

Staffed by ex bankers + headed by City friendly civil servs, and NEDS (eg Kingman and Moreno) who reused old tropes to hold the instn:

• UKFI = creature of the Treasury which claimed to be “arms length” from government

• Main objective = SV via speedy divestment: March 09 Framework document set the “overarching objective of protecting and creating value for the taxpayer as shareholder”

Holding UKFI a key success as ownership stake would not be used to lever change

Outcome of the bankers game = win some + lose some, broader success ex weakness of the opposition

Honest struggle (a)journalists searching for a new story

• Honest struggle with a complex crisis: multiple causes from macro imbalance to financial innovation; no one best way solution of bank design or financial regulation

• Broadsheet response = make a virtue of complexity: analysis in instalments and expert commentary ex Gillian Tett in FT or Robert Peston on the BBC = soap opera for fans

• Tabloids and TV got a big picture for the masses by scapegoating bonuses and bankers; high spot of UK media coverage = Treasury Select Committee grilling of Fred Goodwin and Andy Hornby (like Dick Fuld in US)

• Scapegoating was a bad, bad story: delivered red top catharsis but (a) economically reductionist with crisis caused by greed and incompetence (b) politically diversionary with solution of bonus reform

Honest struggle (b)technocrats and academics embarrassedKnowledge failure overwhelmed technocrats and academics from

mainstream economics; pre-2007 endorsed the banker’s story about financial innovation as a good thing, post-2008 remorse about how they hadn’t seen it coming…..

Knowledge recovery for technocrats = like utility companies renewing mains i.e. lots of disruption at many different points without any clear immediate benefit

• Confusing causal disagreements (e.g. macro imbalances vs. etbics); differences about paradigm shift e.g. Akerlof/Shiller for behavioural vs. Haldane for ecological/epidemiological understanding

• Panaceas meet scepticism e.g. narrow banking and boundary problem; macro prudential regulation is the big new idea not a working control practice

Politicians can’t wait:with mixed interim results

• After December 2009 we get populism not democracy; bank profits and bonuses revive bad banker story; politicisans can’t wait for reforming elites to agree on ne good story + a reform package

• Politics defaults onto populism + produces UK bonus tax and US bank levy; inconsistent with Darling’s policy earlier position as his Tory opponent flirts with levy; entering a new phase of ricochet politics

• Bankers are still ahead; closure was partial but reform failed to find a point of intervention; business models + bricolage are unchecked

• But that’s only an interim result because economic prospects are uncertain: questions about economic trajectory and mass reaction to public expenditure cuts?