Charting the background to the financial crisis - How on earth did we get in this mess?

Back in 1987, I published my first book entitled '...Too Good To Be True - How to survive in the Casino Economy...'

I had left the Metropolitan and City Police Company Fraud Department (The Fraud Squad) where I had been investigating a large number of investment-related frauds in both the securities and the derivatives markets, and I had become increasingly concerned about the level of ignorance that existed among the investing public, both as to the way in which the financial market worked, and the way in which they wanted to invest their capital. Having investigated a large number of losses caused by greed, ignorance and fear, which I would later come to call the 'Fraudsters Credo', I hoped to write a cautionary tale which might help first-time investors to avoid losing their shirts.

I was particularly concerned by the way in which the London Financial market was going to be revolutionised following the 'Big Bang' and the philosophical process of 'deregulation' which was about to be rolled out. This policy was being driven by political ambition and aspiration, it encompassed the concept of 'wider share ownership' which Margaret Thatcher and her political philosopher guru, Keith Joseph, believed would turn the British people into a nation of petty-bourgeois property owners, thus driving a nail into the cadaver of Socialism.

I recently returned to my book, and re-read it again 25 years later, and I found that a significant number of my predictions had come to pass!

A friend of mine who shares my interests in all things financial, and who writes his own excellent blog, recently asked me where I thought things had begun to go wrong for the British financial services industry and why we were suffering so badly.

I now have no hesitation in placing the cause for our woes firmly on the shoulders of the de-regulatory changes ushered in by the new financial revolution, and particularly in the way we adopted American market methods without invoking American financial regulatory controls at the same time.

I had previously studied financial regulation in America, spending time with the Securities Exchange Commission and the Commodity Futures Trading Commission, as well as having studied and observed Exchange regulatory methods in Philadelphia, Chicago and New York. I had witnessed at first hand the way in which the Americans imposed draconian levels of regulatory control on their markets; I learned about their genesis in the era of Roosevelt's 'New Deal' following the Wall Street Crash, ( something I think we are going to have to introduce in Europe before the end of this recession if we want to move forward in the future), and I was under no illusion that if free markets were to be allowed to operate in an unfettered manner, then they had to agree to strong regulatory controls on those activities which had the potential to cause most damage to the market itself.

So, at that time, there was a complete separation of retail banks from wholesale banks, enforced by the Glass-Steagall Act; there was strong regulation of Thrifts (the equivalent of Building Societies to you and me); there was strong regulation of market manipulative practices such as insider dealing, and taken more generally, the Americans imposed a heavy standard of market regulation, but allowed a significant degree of freedom of activity as long as it stayed within the boundaries of the regulatory sphere. That is not to say they didn't have problems, of course they did, but they did not appear to be of the kind from which we suffered and were suffering more and more.

So when we in the UK moved to a greater degree of de-regulation of the London market, and we allowed foreign financial institutions to enter our markets and compete on equal terms with British financial houses, becoming members of the Stock Exchange, freeing the movement of international capital, abolishing exchange and currency restraints, we may have opened London up to take her place in a 24/7 international free market, but we also opened the floodgates to every scumbag, loblolly man, snake-oil salesman, and funny-money merchant under the sun. What was worse, we opened ourselves up to all the worst activities prevalent in an American-style market, but without the concomitant regulatory constraints.

When I was researching my first book, I was privileged to interview a number of leading commentators from both sides of the intellectual divide. Among them was Sir Peter Tapsell, (now the 'Father of the House of Commons') who was also a leading City stockbroker who specialised in Gilts. He shared a number of insights with me, which have since proved to be remarkably percipient. Among his concerns was the degree to which the City of the future would be driven by dangerous conflicts of interest, a temptation which had been tempered by the earlier structure of the dealing market where the two sides of the contracting process, the brokers and the jobbers were separate and  distinct functions with different ways of remuneration, thus mitigating the temptation to indulge in conflicts of interests.

The American required a segregation of client functions within regulated firms and where client interests were breached, the firms concerned faced huge fines and significant regulatory penalties. In the UK, attempts to impose what became known as 'Chinese Walls' between different departments of the same firm were routinely ignored. This failure to regulate this market aspect has led to massive insider dealing activities. Sir Peter said to me; 'I do not know why Chinese Walls are so called but I have visited the Great Wall of China. It has this characteristic. It has never kept anyone in or out,'

Following the changes brought about by the impact of Big Bang and de-regulation, the City of London was weakened immeasurably by the lack of regulatory constraints imposed. Instead of opting for an American-styled Regulatory Commission, the British model was to try and encourage a series of self-regulatory organisations (SROs) whose role would be to have responsibility for admitting their members, providing a set of rules by which they should operate, and then policing and enforcing them to ensure a satisfactory level of compliance. I have used the word 'policing' although that word was never ever used by anyone within the new regime and if you asked anyone about it, there would be a unanimous agreement that the compliance function was not there to 'police' its members activities. It was a concept which was considered to be anathema to financial practitioners and they would have none of it.

Even when I was in charge of the Investigatory Department of one of the SROs which regulated the activities of so-called financial intermediaries, my work and methods were criticised bitterly by our members because they felt I was adopting 'policing tactics' to uncover wrong-doing and criminality. It was while I was at FIMBRA as it was called, that I first became aware how little regulation was going to be properly applied. Even when I undertook a major investigation into the activities of one of the country's leading firms of intermediaries for egregious breaches of the client money rules, (the firm was depositing client's money on overnight deposit, and not paying for the securities and investments the clients thought they had bought, for a minimum of 6 months, before finally settling with the issuing houses). The money being generated by the interest there from belonged of course to the clients, but the intermediary firm kept it for themselves. When I investigated and proved how much was being unlawfully acquired from the clients, other members of the FIMBRA hierarchy burgled my office and leaked a copy of my report to the member, who began a press campaign saying how unfair it was that they were being singled out for investigation in this way.

The person who stole my report took the copy I had deliberately doctored and left for him to find, because I was certain that he was dumb enough to do such a thing, so that when the terms of the report were being discussed, later, it was the doctored report to which they referred. Even when I was able to prove what he had done, the FIMBRA Board did nothing about it.

The firm concerned is still in business by the way, and its former owner and my suspect is now a multi-millionaire.

So, we had a new market which was wide open for exploitation; we had a regulatory regime that had no intention of imposing any kind of meaningful controls over the actions of its members; and to compound the problem, we were faced by the actions of a group of men who became known as the 'arbitrageurs' or 'greenmailers', whose actions were causing mayhem in the traded securities markets.

These men, led by people like Ivan Boesky, Denis Levene, Michael Milken, Sir James Goldsmith, and a host of others were making aggressive bids to take-over large companies, with the aim of 'releasing shareholder value'. They were buying up the shares of companies whole balance sheet value outweighed their share value. These were long-established and good companies that played an important role in the community life of the towns in which they were situated. The 'arbs' bought them up with the aim of stripping out all the assets, selling them off at a profit, keeping the cash and jettisoning the shell of the company. In this way, thousands of working men and women were thrown on the industrial scrap heap, while the 'arbs' moved on to new targets. Sometimes, the mere threat of these men's activities would be enough for the company concerned to pay them off, hence the word 'greenmail', blackmail with greenbacks!

The direct impact of this activity which was funded by the aggressive use of a new derivative-inspired financial product which became widely known as a 'junk bond', led to companies everywhere divesting themselves of spare capital in order to reduce their attractiveness to the predators. The immediate effect was to lead to a policy of short-term thinking and focus on immediate returns, ensuring that revenues were maintained while divesting every last penny of profit in the form of dividends to shareholders. What became known as 'optimising shareholder value' became instead a gadarene rush to quick profits, fast returns, and short-term gains, which had to be fuelled by offers of enhanced bonuses in order to stimulate the growth demands.

Thus the bonus culture was born, and banks and financial institutions began to focus more intently on the generation of quick profits, enhanced revenues, and self-generated returns in the form of financial gambling. The fact that it was called 'proprietary trading' did not alter the fact that banks found it easier, and more profitable to gamble with their money in the exponentially-growing market for derivatives, swaps, options, and other financial alchemy, than they could by traditional banking practices.

And when after the revocation of the Glass-Steagall Act, they found that they could amalgamate their actions, so that both wholesale and retail arms fell under the same roof, opening up the access to client's deposits, and subject to the same feeble regulatory restraints, then the market was wide open for every kind of skulduggery you can name.

The Reagan-inspired de-regulation of the Savings and Loan industry, coupled with the emergence of securitised and thus tradable baskets of mortgage instruments, where mortgages could be created, sold on, stripped, and re-packaged in an ever-upward spiralling tsunami of debt, meant that no-one had any ultimate responsibility for their outcome. Pay brokers huge bonuses for selling more and more mortgages; encourage people who didn't have enough money to feed their children properly to buy houses they couldn't afford, and underpin the whole damn thing by taxpayer's money, and you have a recipe for a major disaster.

When you have banks which by now have become part and parcel of each other's debts, and who hold each other's obligations on a global basis, and you can begin to perceive the likelihood of a global financial meltdown.

We are now paying for that madness, and as I have said before, we shall go on paying for long time to come.

It seems to me the answer is very simple.

People who deal in money are motivated by nothing more than greed. The more they have, the more they want. The more they want, the more they will be tempted to cut corners to get it. To keep on earning the profits they require to satisfy their short-term ambitions and shareholder demands, they must engage in practices which will impact others unfairly and to their financial detriment. For every winner there has to be a loser. We cannot expect them to regulate themselves in such a way that they turn aside from these dishonest and unfair practices, they have to be forced into line, and the only way we will achieve that is through good and effective regulations, properly applied, with penalties which mean something and hurt if they have to be applied.

Sir Peter Tapsell reviewed for me the future for financial regulation as he saw it coming, he said this. Remember, this was in 1986, so applaud him for his percipience. He said;

'...Whether in the long run the general community will be well served by having these huge financial conglomerates, where you get banks and merchant banks and foreign banks all mixed in together, with a British stock-broking firm, I very much doubt. I think it's going to be extremely difficult to regulate. I think that the authority of the Bank of England will be greatly undermined and I think a great many of the people who will be operating in the future ...will have different traditions from those in which my generation has grown up and I think you will get a lot of scandals as a result of moving into internationalisation. I fear we shall lurch from scandal to scandal, and when these scandals break, the Government will be held responsible for them...'

Anybody want to say he was wrong?