Market Money Madness
by Raphie de Santos
The major falls seen in all the world’s stock markets mark the end of a long period of capitalist expansion which started in early 1980s. Stock markets discount the future and they are discounting major falls in the earnings of corporations around the world. In other words they are forecasting recession - two quarters of successive negative gross domestic product (GDP) growth - and periods of stagnation across all the major economies.
The turbulence is far from over and stock markets hate uncertainty and there is so much of it around. In the weeks ahead we can expect more dramatic falls and partial recoveries. This is because nobody knows the full extent of the subprime crisis and its impact on the world financial system and economy.
While it widely held view that the US economy will go
into recession in 2008, opinion is divided as to what will happen in
the other major economies.
The most optimistic view is that the UK will enter a shallow recession
at the end of 2008/start of 2009 and the rest of Europe’s economies
will stagnate while there will be a slowing down of the emerging economies
of China, India, Russia and Brasil.
At the roots of the crisis is the US Federal Reserve (akin to the UK
Treasury) decision to cut interest rates aggressively in 2001 to avert
a deep recession and help financial markets recover from the bursting
of the dot boom bubble.
This led to an inflated housing market and cheap credit, leading to a
big increase in credit in particular to those on lower incomes. From
this policy flowed the sub-prime lending boom and repackaging of this
debt and the seeds of inflation.
Capitalism is caught between a rock and hard place. On the one hand it
needs to cut interest rates to increase the amount of money in circulation
and ease credit repayments but on the other hand inflation is on the
rise because of the demand that has been fuelled by years of cheap credit
and growing demand from China and India in particular.
Cutting interest rates has a very limited shelf life as if they run with
the policy for too long then the major developed economies will start
importing inflation because their currencies will be weaker against the
currencies of the countries they are importing from.
Already the bond markets are implying that interest rates will have to
go back up within six months to a year to curb inflation.
All this is combined with end of the benefits of the technological boom that started in the 1980s - productivity gains are being offset with lower profit levels as more and more of the production process is carried out by technology and not humans meaning a reduction in new value or profits being produced.
In this article we will take a look at:
• the US housing boom and the Fed
• sub-prime lending
• shift the debt off my books (engineered
financial products)
• the kings clothes
• impact of China, Russia, India and
Brasil on the world’s economy
• the Soc Gen and market turbulence
• what it all means for ordinary people
and how they are all interrelated and could lead to biggest financial and
economic crisis since the 1970s.
US Housing Boom and the FED
The boom in the US housing market has its roots in the
US Federal Reserve (the FED) decision to reduce aggressively short-term
interest rates during 2001/2002 to stem the crisis that arose through
the bursting of dot.com bubble and the US economy sliding into recession.
This created a boom in housing construction, a big increase in the paper
value of US residential property which spilled over into the rest of
the economy.
With short-term interest rates at around 2 per cent banks went out looking
for new potential clients.
Interest rates normally increase gradually the longer
the loan is for. The idea is that the longer the time of the loan the
more chance that someone will not be able to repay it.
The lender is paid a premium for the risk of not being fully repaid.
The Fed cutting rates so aggressively for shortdated loans that this
opened up many new transactions for banks and other financial institutions.
They could borrow from each other at low rates for short periods of time
and roll the loans over when they matured. At the same time they could
lend at higher rates for longer dated loans. There was a fat spread between
where they could borrow and where they could lend.
As long as interest rates kept low for borrowing for short periods of
time they could carry on making money.
All sorts of financial products - subprime loans, normal mortgages without
offsetting customer deposits (Northern Rock) and Collateralised Debt
Obligations (CDOs) - were designed around this strategy.
It provided capitalism with new pools of credit to fuel its booms and
soften its recessions. We were in a new ‘golden age’ of capitalism
where all the old problems of boom and slump had been eliminated. But
this market has, as we will see, blown up.
It has brought the great credit boom, which stated after the Second World
War to an end.
Capitalism will now find it difficult to find sources of credit to manage
the fluctuations which are inherent in the system making more frequent
and longer recessions likely.
Sub-prime Lending
In the US these fat spreads we have talked about meant
banks and loan companies could even loan money out to the poorest sections
of society - they could be compensated for even a significant minority
of lenders not being able to repay their loans in full.
A new sub-prime market was created of heavily indebted individuals, low
or middle-income households and even people on social security benefits.
This type of lending spread to other parts of the world - particularly
the UK but not to the same extent.
With interest rates as low as 2 per cent lenders could still charge 6-8
per cent to sub-prime lenders to be compensated for extra risk and still
make fat profits. The loans were typically mortgages or loans secured
on homes.
Shift the Debt off My Books
Traditionally banks and other financial institutions
have financed their loans and mortgages through the deposits they receive
from their customers.
This limited the amount of credit they would offer.
At the start of this century they moved to a new model where they sell
on mortgages and loans (personal, car and credit) onto the bond markets.
This meant a growth in credit. But at the same time the initial lenders
no longer have the incentive to check if the borrower is able to repay
the loans as they are offloading their risk onto someone else.
The business proved extremely profitable for the banks because of the
fat spreads we talked about earlier and they used loan and mortgage brokers,
who took a fee, to aggressively sell these products to the sub-prime
market.
In the US up to 20 per cent of mortgages and loans are of the sub-prime
type.
The Kings Clothes
The Investment Banks took these sub-prime loans and ‘engineered’ them
into complex financial products.
Their value was not decided like traditionally shares by an open liquid
market place with many buyers and sellers but by complex models.
They were valued by the investment banks themselves based on an assumption
about how many people would default on the loan and the relationship
between the borrowers.
The rate of defaults could be observed but were massively underestimated.
The relationship between borrowers (correlation) could not be observed
and was estimated quite liberally. As the number of defaults in sub-prime
market increased quite rapidly the value of these instruments fell dramatically.
Defaults increased as the Fed pushed up short-term rates to curb inflation
and the housing market.
They did not fully understand the link between property prices, interest
rates, the sub-prime market, these structured financial products and
the financial system.
The market for these products dried up in the summer of 2007 and rumours
swept the market that major banks were in trouble that is the losses
on these products could cause bankruptcies.
The inter-bank lending market - were Northern Rock borrowed its money
- dried up as banks stopped lending to each other as no one knew who
might go bankrupt.
So far the investment banks have reported $100 billion of loses and this
is a conservative number.
As we mentioned earlier these instruments are based on an estimate of
the relationship between borrowers. Some banks, only a minority, are
using an independent estimate which has seen the value of these instruments
fall by 80 per cent over a year.
If all banks were to move to this estimate the losses
are likely to be in the region of $500billion to $1000billion with many
likely bankruptcies causing a potential crisis in the world’s financial
system.
Many of the banks have off loaded these products onto pension funds and
insurance companies which mean the person on the street could be facing
heavy losses as well.
Most of these write downs have occurred in the last quarter of 2007 and
will be reported in the next couple of months.
The problem is that nobody knows who owns these products and where the
next time bomb will explode.
For instance, the town of Cleveland in the US is virtually owned by a
German bank. Of course all these properties are in the poor predominantly
black areas.
China, Russia, India and Brasil
Many economic commentators believe that the existence
of these markets and the restoration of capitalism in the former so called ‘socialist
states’ will lead to a softening of the recession and even the
possibility that most countries outside the US and UK will escape it.
There is a double-edged sword with this argument.
One, these countries demand for raw materials and food have pushed inflation
up globally which limits the scope for interest rate cuts in the US,
the UK and Europe.
Two, banks and financial institutions in these countries
are exposed to subprime products - nobody knows by how much of course ñ and
this will limit lending and credit and slow their economies.
Three, a lot of the wealth in these countries is based on the paper profits
of private individuals investing in the local stock markets. Much of
this has been wiped out by recent market falls and this will reduce consumer
confidence and dampen the economies. Four, recessions in the west will
reduce demand for their products and slow their economies down further.
Finally, the US, the UK and Europe will try and gain back some of the
ground lost in competition with these countries forcing an inter-capitalist
protectionist trade war.
All these factors could combine with what is happening in the west to
create a truly global slump of 1930s proportions.
Soc Gen and Market Turbulence
Some parts of the financial markets have tried to blame
the market falls on the rogue trader at Soc Gen. This is just wish full
thinking, trying to deflect attention away from the real fundamental
problems we have discussed.
The Fed has stated they had no knowledge of the near $7billion trading
loss at Soc Gen when they made the decision last week to cut rates by
0.75 per cent.
The losses meant that the trader had open positions (investments) worth
about $80billion.
It points to gross ineptitude by the bank’s internal
risk management. They must have had to post $1billion to $4billion a
day to the financial markets (margin payments).
They to would have been a large percentage of the positions on several
European markets (open interest).
How this was not picked up was not down to a trader hacking into internal
accounting systems but gross ineptitude as the margin payments and open
interest are derived from each local financial system and the trader
would not have had the skill and the knowledge to hack into these systems.
Unwinding the investments may have accounted for some of the losses in Europe where Soc Gen had the positions but cannot account for the big falls in US and Far Easter stock markets where they had no positions.
What it All Means for Ordinary People - Capitalism’s Reaction
Falling profit levels, recession and the credit crunch
will see an all out assault by capitalism on ordinary people in 2008.
We can expect to see attempted wage cuts, productivity increases, layoffs
and workplace closures. Credit will be harder to come by and banks will
be very tough in dealing with defaults.
We are likely to see a much higher rate of house repossessions and personal
bankruptcies in 2008. This together with inflation edging higher, which
is lagging the decline in demand, will mean real cut in living standards
and hardship for many working people in 2008.
We will also see cuts in public services and rises in council tax particularly
from fiscal year 2008/2009 as government revenues come in way below government
estimates with a declining GDP.
During 2003-2005 in the developing world the world’s
major financial institutions have passed up the opportunity to ease the
grip of their suffocating loans.
As these institutions seek to put their own houses in order they will
likely tighten the grip on the poor south, leading to more poverty and
death.
Unlike capitalism’s last major offensive against the poor in the
late 1970s, working people’s organisations are much weaker and
the demographics of capitalism have changed dramatically.
But it does not mean there will not be a fight back.
In 2008 Socialists will have plenty of opportunities to stand alongside working people and continue the fight for a rationale economy based on the democratic decided needs of the majority as they stand up against capitalism’s onslaught.