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The mad world of shadow bankers

Gordon Brown has still to deal with the toughest problem of all - how to clean out a contaminated sy

In 1988, when two City financial whizzkids, Stephen Partridge-Hicks and Nicholas Sossidis, invented "structured investment vehicles", 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. They had created a Gordian knot all right - a system of financial mechanisms so complex that no one could unravel what was going on.

This past week Gordon Brown, a latter-day Alexander, tried to cut the Gordian knot, but he may have simply set the public finances adrift on a sea of debt. The state has exposed itself to the billions of pounds in liabilities held off the balance sheets of Britain's delinquent banks. This is the world of shadow banking.

The stock market crash early this month was largely a result of panic selling in this shadow banking system of structured finance. Hedge funds and, to some extent, private equity companies are having to liquidate billions in assets as their business models collapse under the weight of falling 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 half 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 that 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 other financial institutions did exactly the same, setting up "orphan companies", often under charitable trusts, that did not appear on their published balance sheets. This is one reason why such apparently well-capitalised and solvent institutions as Royal Bank of Scotland collapsed so suddenly. Their true liabilities had been hidden for years in the shadow system while they made huge profits from 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, as it generated so much profit and tax revenue. This was the regime of "light-touch regulation" of the City that turned the British economy into a cross between a Liechtenstein tax haven and a giant hedge fund.

The claim about SIVs, as with hedge funds and private equity companies, was that bankers had found ways to "abolish" risk through complex financial engineering. Typically, they packaged up long-term debts, usually residential mortgages, sealed them with credit default swaps (theoretically insuring the risk of loan default) and sold them as securities. It was a unique combination of self-delusion and financial manipulation, 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, hedge-fund managers claimed to possess a mysterious secret formula, called "alpha", which allowed them to make profits in any market, bull or bear, through speculative activities such as short selling. In fact, their innovative "alpha" was largely based on boring old debt, cheap money. Private equity companies used easy credit to launch 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 capital - 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, until it ended.

The Brown package is imaginative, comprehensive and deservedly praised – not least by the Nobel Prize-winning economist Paul Krugman – but it is also a hell of a risk

The exploding market in credit default swaps was an integral part of this world of fantasy finance. CDSs are like insurance policies taken out on the possibility of a company defaulting on its debts. It is rather like taking out insurance on your neighbour's house burning down - only this is multiplied by thousands of other speculators also betting on your neighbour's house burning down. The trouble was that no one actually knew who was liable if and when the house did burn down - until one investment bank did burn down. The collapse of Lehman Brothers triggered $400bn worth of credit default swaps. 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 $62trn in seven years. Swaps were traded as if they were bonds, meaning that they turned into another source of credit and leverage. The global market in financial derivatives as a whole, of which CDSs are a part, has grown to more than £500trn - a huge black cloud hanging over the world financial system.

The truth is, no one knows what's out there. The British government is in the process of spending £500bn to find out through nationalising the likes of Royal Bank of Scotland 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 enormous losses of the shadow banking system could now find their way on to the public balance sheet.

There is a huge deleveraging under way, which will bring trillions in losses across the world banking system. The hedge-fund industry is disappearing before our eyes as worried investors pull their money from these vehicles that pro mised never to lose. It is expected that the industry will halve in value to roughly $1trn, but its leveraged liabilities will be much larger than that.

If, as expected, British property slumps by 35 per cent, that will mean another £1trn or so of value removed from the financial system, further undermining the value of all those mortgage-backed bonds in the SIVs. Even after the post-bailout rally, the UK stock market has lost a trillion or so this year. Who pays? Well, pension funds will absorb many 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 be in negative equity if the 35 per cent fall in house prices takes place will also be paying debts for many years. Sovereign wealth funds that 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 Institute for Fiscal Studies, the liabilities from RBS alone could add £1.8trn on to the public debt, taking it to £2.5trn. Britain's GDP is only £1.4trn. 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 actually very similar, only on a much larger scale.

Sorting out the shadow banking system, assessing liability and clearing out the debt will be a huge task for the British government and people. It will take great ingenuity and international co-operation of a kind never seen. Gordon Brown showed political courage in cutting the Gordian knot. Now he faces the larger task of cleaning out the Augean stables.

This article first appeared in the 20 October 2008 issue of the New Statesman, My year with Obama

Biteback and James Wharton
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“It was the most traumatic chapter of my life”: ex-soldier James Wharton on his chemsex addiction

One of the British Army’s first openly gay soldiers reveals how he became trapped in a weekend world of drug and sex parties.

“Five days disappeared.” James Wharton, a 30-year-old former soldier, recalls returning to his flat in south London at 11pm on a Sunday night in early March. He hadn’t eaten or slept since Wednesday. In the five intervening days, he had visited numerous different apartments, checked in and out of a hotel room, partied with dozens of people, had sex, and smoked crystal meth “religiously”.

One man he met during this five-day blur had been doing the same for double the time. “He won’t have been exaggerating,” Wharton tells me now. “He looked like he’d been up for ten days.”

On Monday, Wharton went straight to his GP. He had suffered a “massive relapse” while recovering from his addiction to chemsex: group sex parties enhanced by drugs.

“Crystal meth lets you really dig in, to use an Army term”

I meet Wharton on a very different Monday morning six months after that lost long weekend. Sipping a flat white in a sleek café workspace in Holborn, he’s a stroll away from his office in the city, where he works as a PR. He left the Army in 2013 after ten years, having left school and home at 16.


Wharton left school at 16 to join the Army. Photo: Biteback

With his stubble, white t-shirt and tortoise shell glasses, he now looks like any other young media professional. But he’s surfacing from two years in the chemsex world, where he disappeared to every weekend – sometimes for 72 hours straight.

Back then, this time on a Monday would have been “like a double-decker bus smashing through” his life – and that’s if he made it into work at all. Sometimes he’d still be partying into the early hours of a Tuesday morning. The drugs allow your body to go without sleep. “Crystal meth lets you really dig in, to use an Army expression,” Wharton says, wryly.


Wharton now works as a PR in London. Photo: James Wharton

Mainly experienced by gay and bisexual men, chemsex commonly involves snorting the stimulant mephodrone, taking “shots” (the euphoric drug GBL mixed with a soft drink), and smoking the amphetamine crystal meth.

These drugs make you “HnH” (high and horny) – a shorthand on dating apps that facilitate the scene. Ironically, they also inhibit erections, so Viagra is added to the mix. No one, sighs Wharton, orgasms. He describes it as a soulless and mechanical process. “Can you imagine having sex with somebody and then catching them texting at the same time?”

“This is the real consequence of Section 28”

Approximately 3,000 men who go to Soho’s 56 Dean Street sexual health clinic each month are using “chems”, though it’s hard to quantify how many people regularly have chemsex in the UK. Chemsex environments can be fun and controlled; they can also be unsafe and highly addictive.

Participants congregate in each other’s flats, chat, chill out, have sex and top up their drugs. GBL can only be taken in tiny doses without being fatal, so revellers set timers on their phones to space out the shots.

GBL is known as “the date rape drug”; it looks like water, and a small amount can wipe your memory. Like some of his peers, Wharton was raped while passed out from the drug. He had been asleep for six or so hours, and woke up to someone having sex with him. “That was the worst point, without a doubt – rock bottom,” he tells me. “[But] it didn’t stop me from returning to those activities again.”

There is a chemsex-related death every 12 days in London from usually accidental GBL overdoses; a problem that Wharton compares to the AIDS epidemic in a book he’s written about his experiences, Something for the Weekend.


Wharton has written a book about his experiences. Photo: Biteback

Wharton’s first encounter with the drug, at a gathering he was taken to by a date a couple of years ago, had him hooked.

“I loved it and I wanted more immediately,” he recalls. From then on, he would take it every weekend, and found doctors, teachers, lawyers, parliamentary researchers, journalists and city workers all doing the same thing. He describes regular participants as the “London gay elite”.

“Chemsex was the most traumatic chapter of my life” 

Topics of conversation “bounce from things like Lady Gaga’s current single to Donald Trump”, Wharton boggles. “You’d see people talking about the general election, to why is Britney Spears the worst diva of them all?”

Eventually, he found himself addicted to the whole chemsex culture. “It’s not one single person, it’s not one single drug, it’s just all of it,” he says.



Wharton was in the Household Cavalry alongside Prince Harry. Photos: Biteback and James Wharton

Wharton feels the stigma attached to chemsex is stopping people practising it safely, or being able to stop. He’s found a support network through gay community-led advice services, drop-ins and workshops. Not everyone has that access, or feels confident coming forward.

“This is the real consequence of Section 28,” says Wharton, who left school in 2003, the year this legislation against “promoting” homosexuality was repealed. “Who teaches gay men how to have sex? Because the birds and the bees chat your mum gives you is wholly irrelevant.”


Wharton was the first openly gay soldier to appear in the military in-house magazine. Photo courtesy of Biteback

Wharton only learned that condoms are needed in gay sex when he first went to a gay bar at 18. He was brought up in Wrexham, north Wales, by working-class parents, and described himself as a “somewhat geeky gay” prior to his chemsex days.

After four years together, he and his long-term partner had a civil partnership in 2010; they lived in a little cottage in Windsor with two dogs. Their break-up in 2014 launched him into London life as a single man.

As an openly gay soldier, Wharton was also an Army poster boy; he appeared in his uniform on the cover of gay magazine Attitude. He served in the Household Cavalry with Prince Harry, who once defended him from homophobic abuse, and spent seven months in Iraq.


In 2012, Wharton appeared with his then civil partner in Attitude magazine. Photo courtesy of Biteback

A large Union Jack shield tattoo covering his left bicep pokes out from his t-shirt – a physical reminder of his time at war on his now much leaner frame. He had it done the day he returned from Iraq.

Yet even including war, Wharton calls chemsex “the most traumatic chapter” of his life. “Iraq was absolutely Ronseal, it did exactly what it said on the tin,” he says. “It was going to be a bit shit, and then I was coming home. But with chemsex, you don’t know what’s going to happen next.

“When I did my divorce, I had support around me. When I did the Army, I had a lot of support. Chemsex was like a million miles an hour for 47 hours, then on the 48th hour it was me on my own, in the back of an Uber, thinking where did it all go wrong? And that’s traumatic.”

Something for the Weekend: Life in the Chemsex Underworld by James Wharton is published by Biteback.

Anoosh Chakelian is senior writer at the New Statesman.

This article first appeared in the 20 October 2008 issue of the New Statesman, My year with Obama