How do we get out of this mess?
24/10/08 14:17 Filed in: Economic Crisis
I find all the numbers about the economy that are being banded around now to be mind-boggling. There are two big numbers that stick in my mind and that is the size of the bank bailouts in the UK and the USA. In the UK, the cost of the bailout plan is estimated to be around $1 trillion and in the USA, $700 billion.
The USA is the largest economy in the world with an annual Gross Domestic Product of $13.8 trillion, that represents about 25% of the world’s total economic output. The UK is the fifth largest economy with a GDP of $2.8 trillion. Ranking at positions of 2, 3, and 4 are Japan, Germany and China. China’s economic importance is growing fast but the size of its economic output is a little over 25% of that of the USA.
These are a lot of numbers I know. I wanted to write them down so I got some perspective on what it is we are talking about.
The size of the UK bank-bail out if it was looked at on the scale of national economies would rank at 13th in the international GDP table. The amount of money that the UK is making available to its banks is greater than the GDP of some 166 other countries.
With the cost of the bailout, the size of the national debt of USA and UK has soared during 2008. Under the Bush administration, the size of the national debt as a proportion of GDP has risen from 60% to around 115%. In the UK, the national debt may reach 100% of GDP or more this year.
Another alarming statistic (Source: BBC Business news 24 October 24, 2008) is that the UK aggregate of national debt, corporate and personal borrowing is three times that of the country’s annual economic output.
So what’s happening now? We’ve had runs on banks and international markets. Now there’s a new game on the streets. We’re having runs on national economies. Banks, hedge funds and mutual funds are demanding repayment from economies that they perceive to be at risk, either because of their reliance on foreign borrowings or because they are net importers of goods and services or both.
The UK pound has fallen 20% against the dollar in the past three months. South Korea’s currency, the won, has fallen by 29%. There are some obvious candidates like Hungary, Ukraine and Iceland lining up in the financial emergency room too.
The South Korean problem is complex and again, whilst the issues are in the banking systems, they have nothing to do with mortgages, housing or sub-prime loans but wholesale capital withdrawals resulting from imprudent deals struck by banks in currency hedges (Currency hedges are intended to offset risk through the simultaneous sale and purchase of forward currency contracts).
South Korea is a strong exporter. Its trading performance and its balance of trade is healthier than UK’s and probably the USA’s too albeit on a smaller scale. It ranks thirteenth in the world in terms of economic output.
Other countries suffering substantial capital withdrawals are South Africa and Argentina.
It’s expected that the UK will announce economic contraction today or “negative economic growth” as the city boys like to call it. It will get worse, possibly much worse as the UK has moved out of manufacturing industries to an economy where its mainstay is the fast contracting financial services sector. The financial services sector in the UK while it only accounts for 4% of total employment represents 30% of the UK’s GDP.
As Mr. Bush Sr. said, “It looks like we’re in deep doo doo now.”
It’s not only about the sub-prime issue anymore. When markets start dealing in national economies, it affects us all. Historically, national instability on a wide scale has tended to result in conflict and wars. Let’s hope we’ve learned some lessons from the past.
I’ve heard lots of arguments about reducing taxation and the bailout bringing benefits from the “trickle down” effect. Trick or treat more like! The treat is that the wealthy benefit, and the trick is that the poor suffer. Trickle down has been argued since Hoover in the twenties. It didn’t work then, it doesn’t work now. There is nothing to support the argument that it has ever worked.
In principle, I am strongly opposed to the bail out now. I have changed my mind about it. I am opposed to it since it is fundamentally undemocratic. To use, Chomsky’s words, “private corporations are tyrannies who account to no one other than themselves.” They are run for their own profit, not the benefit of the world or the public. In short, they are in it for themselves and no one else. If banks want to play Russian roulette with national economies, they’ll do it if they see profit for themselves.
I don’t believe either that the rot in the banking systems is solely to blame for our current economic difficulties. I have never believed that particular story. The turmoil in our financial systems is, I believe, a symptom of underlying economic instability rather than its cause. Banks may play a big part in that system and be central to its functioning but they do not exercise any overall control of the economy itself, but supply a service to it. The service is debt, more normally called credit. The realisation or appreciation of assets, or the prospect of future earnings offsets the credit risk. Credit is at risk, when economies contract, assets depreciate and earnings do not grow or diminish. When credit goes bad, banks make losses.
The so-called sub-prime crisis may not have happened unless the value of homes, of mortgage collateral, was called into question. The asset value of homes fell which meant that banks were unable to realise the security they had taken in return for the credit that they had extended.
My real concern is for the average person on the street. I don’t know a massive number of people, but I have talked to so many who are suffering or have suffered major economic hardship now. They have lost their jobs, their homes and in one case, I know someone who will be facing bankruptcy in the next couple of weeks. He was formerly a capable and successful businessman. I don’t need government to say, “We’re in recession. It’s official!” I know that to be the case as financial difficulties are multiplying around me all the time. I can see them with my own eyes. Everyone I know, every single person knows someone who is suffering real hardship now.
So what’s the answer? There are possibly two answers, but both amount to the same thing. It’s not that difficult. The answer is about democracy. In the dictionary definition, democracy "is government by the people in which the supreme power is vested in the people and exercised directly by them or by their elected agents under a free electoral system." In the phrase of Abraham Lincoln, democracy is a government "of the people, by the people, and for the people."
We need to decide whether democracy is what we want and be prepared to do something about it. We have to decide what we want in this world, if it’s public welfare or not. The wellbeing of banks does not and will not necessarily bring about public welfare or alleviate personal financial hardship. They will willingly take taxpayers’ money then spend it in achieving their own ends whether that’s mergers, acquisitions or anything else, so long as it feeds their own self-interest.
The free market ideology was upheld until big businesses started to flounder. Now everyone is talking about increased regulation and control of big business by government. I might ask, in order to achieve what end and for whose benefit?
The political process has become divorced from the people both in the UK and the USA. I do not know anyone who believes they have any real influence over the democratic process. Government is, therefore, no longer democratic or to use Chomsky’s words “there is a democratic deficit”. Whether it’s Republican or Democrat, New Labour or Conservative, nothing will change until we recover the essence of Lincoln’s dictum and we assume and take responsibility for public well-being.
Obama will not make a difference unless he works within some overall social organisation that restores democratically representative government. The real power structures within our society have little to do with government, but are capable of being transformed by government if it has the political will to do so. These power structures that are founded on economic self-interest will resist change by using every means at their disposal. It’s no small challenge.
I believe in democracy. I also believe in freedom, personal and social responsibility and self-determination. That’s about all.
I mentioned two options: First. we can pull out of free market economics to an extent and endeavour to restore economic equilibrium through increased government control and regulation. I am not sure it will work. Democratic government represents the will of the people. Business corporations represent their own interests. They are neither the same nor are they necessarily compatible. Our economic systems are failing. It may be that government intervention keeps the market, which is fundamentally unstable and inherently inefficient, on “life support”, but I wonder if the patient will ever recover. This is the first option. It’s about big government and government control. Nevertheless, it requires a fundamental re-alignment of the conduct of government with overall public interest and wider democratic participation.
I’ve had a number of personal crises in my life. They have all been about change and the need to change. I’ve never had a benevolent philanthropist throw money at me so I could carry on living as before. I have had to change. There is a lot of nonsense talked about the Chinese etymology of the word crisis saying that it signifies two words, “danger” and “opportunity”. This is incorrect. In fact the Chinese word crisis is derived from the something closer in meaning to “an incipient moment”, a moment in which something is in the process of becoming. I believe that a crisis is closely connected, not with catastrophe but, with the process of change itself.
My second option is also my preferred one and it involves turning the bailout on its head. It goes like this: We leave the markets and businesses alone to find their own solutions. They may or may not. It matters little. Government provides a safety net to the people and directs its resources entirely for the benefit of the people affected by any systemic economic failure. $700 billion should do it easily, and it would not be a bottomless pit either. In practical terms, this means that it would need to guarantee not the wellbeing of banks, but the safety of people’s money in those banks. It means that it would not legislate massive state initiatives to create jobs like the “new deal”, but support economic initiatives by the people themselves for the benefit and wellbeing of themselves and their own communities. It might even go further and promote work in environmental, health, education and ‘care for the elderly’ initiatives.
The key difference would be one of focus and of catering for people directing their efforts and resources for their own wellbeing, rather than for the benefit of the small minority who control large corporations. Large corporations may or may not survive in such a world. Their survival would be influenced by different factors, not by how much profit they made, but by how well they served a social need or purpose. I would vote for such a world.
It may be that the right solution is a hybrid of these two options. I would not rule out the direct intervention by government in a bank's administration or in facilitating a take-over in order to act in the public interest. My problem is in government using taxpayer's money to buy banks out of a problem that achieves little by way of improving corporate responsibility, and offers no obvious social benefit.
Sadly, I doubt if the answer will come with Barrack Obama, but he does offer the best chance of change. I hope he's not just different icing on the same old cake. There isn’t a hope in hell of getting out of this mess with McCain and Palin.
In conclusion, here’s today’s economic update from Europe. Shares in Europe’s main markets are down between 7% and 8% this morning.
The Bank of England deputy governor, Charles Bean said, "This is a once in a lifetime crisis, and possibly the largest financial crisis of its kind in human history."
The price of gold, typically, the place people put money in times of crisis has fallen by five per cent.
The USA is the largest economy in the world with an annual Gross Domestic Product of $13.8 trillion, that represents about 25% of the world’s total economic output. The UK is the fifth largest economy with a GDP of $2.8 trillion. Ranking at positions of 2, 3, and 4 are Japan, Germany and China. China’s economic importance is growing fast but the size of its economic output is a little over 25% of that of the USA.
These are a lot of numbers I know. I wanted to write them down so I got some perspective on what it is we are talking about.
The size of the UK bank-bail out if it was looked at on the scale of national economies would rank at 13th in the international GDP table. The amount of money that the UK is making available to its banks is greater than the GDP of some 166 other countries.
With the cost of the bailout, the size of the national debt of USA and UK has soared during 2008. Under the Bush administration, the size of the national debt as a proportion of GDP has risen from 60% to around 115%. In the UK, the national debt may reach 100% of GDP or more this year.
Another alarming statistic (Source: BBC Business news 24 October 24, 2008) is that the UK aggregate of national debt, corporate and personal borrowing is three times that of the country’s annual economic output.
So what’s happening now? We’ve had runs on banks and international markets. Now there’s a new game on the streets. We’re having runs on national economies. Banks, hedge funds and mutual funds are demanding repayment from economies that they perceive to be at risk, either because of their reliance on foreign borrowings or because they are net importers of goods and services or both.
The UK pound has fallen 20% against the dollar in the past three months. South Korea’s currency, the won, has fallen by 29%. There are some obvious candidates like Hungary, Ukraine and Iceland lining up in the financial emergency room too.
The South Korean problem is complex and again, whilst the issues are in the banking systems, they have nothing to do with mortgages, housing or sub-prime loans but wholesale capital withdrawals resulting from imprudent deals struck by banks in currency hedges (Currency hedges are intended to offset risk through the simultaneous sale and purchase of forward currency contracts).
South Korea is a strong exporter. Its trading performance and its balance of trade is healthier than UK’s and probably the USA’s too albeit on a smaller scale. It ranks thirteenth in the world in terms of economic output.
Other countries suffering substantial capital withdrawals are South Africa and Argentina.
It’s expected that the UK will announce economic contraction today or “negative economic growth” as the city boys like to call it. It will get worse, possibly much worse as the UK has moved out of manufacturing industries to an economy where its mainstay is the fast contracting financial services sector. The financial services sector in the UK while it only accounts for 4% of total employment represents 30% of the UK’s GDP.
As Mr. Bush Sr. said, “It looks like we’re in deep doo doo now.”
It’s not only about the sub-prime issue anymore. When markets start dealing in national economies, it affects us all. Historically, national instability on a wide scale has tended to result in conflict and wars. Let’s hope we’ve learned some lessons from the past.
I’ve heard lots of arguments about reducing taxation and the bailout bringing benefits from the “trickle down” effect. Trick or treat more like! The treat is that the wealthy benefit, and the trick is that the poor suffer. Trickle down has been argued since Hoover in the twenties. It didn’t work then, it doesn’t work now. There is nothing to support the argument that it has ever worked.
In principle, I am strongly opposed to the bail out now. I have changed my mind about it. I am opposed to it since it is fundamentally undemocratic. To use, Chomsky’s words, “private corporations are tyrannies who account to no one other than themselves.” They are run for their own profit, not the benefit of the world or the public. In short, they are in it for themselves and no one else. If banks want to play Russian roulette with national economies, they’ll do it if they see profit for themselves.
I don’t believe either that the rot in the banking systems is solely to blame for our current economic difficulties. I have never believed that particular story. The turmoil in our financial systems is, I believe, a symptom of underlying economic instability rather than its cause. Banks may play a big part in that system and be central to its functioning but they do not exercise any overall control of the economy itself, but supply a service to it. The service is debt, more normally called credit. The realisation or appreciation of assets, or the prospect of future earnings offsets the credit risk. Credit is at risk, when economies contract, assets depreciate and earnings do not grow or diminish. When credit goes bad, banks make losses.
The so-called sub-prime crisis may not have happened unless the value of homes, of mortgage collateral, was called into question. The asset value of homes fell which meant that banks were unable to realise the security they had taken in return for the credit that they had extended.
My real concern is for the average person on the street. I don’t know a massive number of people, but I have talked to so many who are suffering or have suffered major economic hardship now. They have lost their jobs, their homes and in one case, I know someone who will be facing bankruptcy in the next couple of weeks. He was formerly a capable and successful businessman. I don’t need government to say, “We’re in recession. It’s official!” I know that to be the case as financial difficulties are multiplying around me all the time. I can see them with my own eyes. Everyone I know, every single person knows someone who is suffering real hardship now.
So what’s the answer? There are possibly two answers, but both amount to the same thing. It’s not that difficult. The answer is about democracy. In the dictionary definition, democracy "is government by the people in which the supreme power is vested in the people and exercised directly by them or by their elected agents under a free electoral system." In the phrase of Abraham Lincoln, democracy is a government "of the people, by the people, and for the people."
We need to decide whether democracy is what we want and be prepared to do something about it. We have to decide what we want in this world, if it’s public welfare or not. The wellbeing of banks does not and will not necessarily bring about public welfare or alleviate personal financial hardship. They will willingly take taxpayers’ money then spend it in achieving their own ends whether that’s mergers, acquisitions or anything else, so long as it feeds their own self-interest.
The free market ideology was upheld until big businesses started to flounder. Now everyone is talking about increased regulation and control of big business by government. I might ask, in order to achieve what end and for whose benefit?
The political process has become divorced from the people both in the UK and the USA. I do not know anyone who believes they have any real influence over the democratic process. Government is, therefore, no longer democratic or to use Chomsky’s words “there is a democratic deficit”. Whether it’s Republican or Democrat, New Labour or Conservative, nothing will change until we recover the essence of Lincoln’s dictum and we assume and take responsibility for public well-being.
Obama will not make a difference unless he works within some overall social organisation that restores democratically representative government. The real power structures within our society have little to do with government, but are capable of being transformed by government if it has the political will to do so. These power structures that are founded on economic self-interest will resist change by using every means at their disposal. It’s no small challenge.
I believe in democracy. I also believe in freedom, personal and social responsibility and self-determination. That’s about all.
I mentioned two options: First. we can pull out of free market economics to an extent and endeavour to restore economic equilibrium through increased government control and regulation. I am not sure it will work. Democratic government represents the will of the people. Business corporations represent their own interests. They are neither the same nor are they necessarily compatible. Our economic systems are failing. It may be that government intervention keeps the market, which is fundamentally unstable and inherently inefficient, on “life support”, but I wonder if the patient will ever recover. This is the first option. It’s about big government and government control. Nevertheless, it requires a fundamental re-alignment of the conduct of government with overall public interest and wider democratic participation.
I’ve had a number of personal crises in my life. They have all been about change and the need to change. I’ve never had a benevolent philanthropist throw money at me so I could carry on living as before. I have had to change. There is a lot of nonsense talked about the Chinese etymology of the word crisis saying that it signifies two words, “danger” and “opportunity”. This is incorrect. In fact the Chinese word crisis is derived from the something closer in meaning to “an incipient moment”, a moment in which something is in the process of becoming. I believe that a crisis is closely connected, not with catastrophe but, with the process of change itself.
My second option is also my preferred one and it involves turning the bailout on its head. It goes like this: We leave the markets and businesses alone to find their own solutions. They may or may not. It matters little. Government provides a safety net to the people and directs its resources entirely for the benefit of the people affected by any systemic economic failure. $700 billion should do it easily, and it would not be a bottomless pit either. In practical terms, this means that it would need to guarantee not the wellbeing of banks, but the safety of people’s money in those banks. It means that it would not legislate massive state initiatives to create jobs like the “new deal”, but support economic initiatives by the people themselves for the benefit and wellbeing of themselves and their own communities. It might even go further and promote work in environmental, health, education and ‘care for the elderly’ initiatives.
The key difference would be one of focus and of catering for people directing their efforts and resources for their own wellbeing, rather than for the benefit of the small minority who control large corporations. Large corporations may or may not survive in such a world. Their survival would be influenced by different factors, not by how much profit they made, but by how well they served a social need or purpose. I would vote for such a world.
It may be that the right solution is a hybrid of these two options. I would not rule out the direct intervention by government in a bank's administration or in facilitating a take-over in order to act in the public interest. My problem is in government using taxpayer's money to buy banks out of a problem that achieves little by way of improving corporate responsibility, and offers no obvious social benefit.
Sadly, I doubt if the answer will come with Barrack Obama, but he does offer the best chance of change. I hope he's not just different icing on the same old cake. There isn’t a hope in hell of getting out of this mess with McCain and Palin.
In conclusion, here’s today’s economic update from Europe. Shares in Europe’s main markets are down between 7% and 8% this morning.
The Bank of England deputy governor, Charles Bean said, "This is a once in a lifetime crisis, and possibly the largest financial crisis of its kind in human history."
The price of gold, typically, the place people put money in times of crisis has fallen by five per cent.
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Chomsky on the economy
23/10/08 11:25 Filed in: Economic Crisis
This is an interview with Noam Chomsky that was published in the last two days. It is by no means a comprehensive reflection of his views that I find to be both intelligent and refreshing.
Chomsky comes in for a lot of criticism. From the raving right, he's called a loony leftie, and from the loony left, he's called an establishment reactionary! He has something positive to say about participatory democracy and that in my view makes him someone worth listening to:
Chomsky comes in for a lot of criticism. From the raving right, he's called a loony leftie, and from the loony left, he's called an establishment reactionary! He has something positive to say about participatory democracy and that in my view makes him someone worth listening to:
Bail-out latest!
08/10/08 18:05 Filed in: Economic Crisis | Economy
This afternoon, the UK government has announced a bank bail-out plan of £500 billion or US $880 billion. Funds are to be made available to banks by way of capital, loans and loan guarantees in return for interest bearing preference share holdings.
The FTSE 100 UK stock exchange index fell by 5% today. The French and German stock exchanges fell by approximately 6%.
Banks throughout the world have co-ordinated a reduction in interest rates to try to stave off the crisis.
Those are the facts. This time, I'm speechless. I predicted a crisis in the financial sector this time last year. This is far beyond anything I had envisaged.
Since writing this short post, that is based on news reports from the state-owned BBC, differing estimates on the size of the UK bail-out have been published. These vary between £400 billion and £500 billion or $692 billion and $880 billion. Whichever it is, it's a very sizeable amount from an economy that is significantly smaller than that of the USA.
UK GDP = $1.93 trillion
USA GDP = $13.13 trillion
(2006 estimates)
Update - Thursday 9th October 2008
There is still some confusion about how big the UK bail-out is. According to my reckoning, it is the higher figure of £500 billion or $880 billion. Here's how it stacks up:
- Up to £50bn of taxpayer money to buy preference shares - £25 billion will be released initially with a further £25 billion at a later date
- An extension of the Special Liquidity Scheme introduced after the collapse of Bear Stearns to allow £200 billion of funds to be made available to banks
- A guarantee of the debt issued by banks of up to £250 billion
As conventional economics goes, it looks like a more intelligent plan than the US bail-out that focused simply on buying "toxic" assets at undermined prices. It seems to address the three main issues of the banks that are capital, funding and liquidity that the US plan fails to do (in my opinion).
I like to get some perspective on these amounts as they are simply fairy tale numbers to me. Here's the bail-out deal compared with UK spending on health and education:
European stock markets in UK, France and Germany fell again today.
The FTSE 100 UK stock exchange index fell by 5% today. The French and German stock exchanges fell by approximately 6%.
Banks throughout the world have co-ordinated a reduction in interest rates to try to stave off the crisis.
Those are the facts. This time, I'm speechless. I predicted a crisis in the financial sector this time last year. This is far beyond anything I had envisaged.
Since writing this short post, that is based on news reports from the state-owned BBC, differing estimates on the size of the UK bail-out have been published. These vary between £400 billion and £500 billion or $692 billion and $880 billion. Whichever it is, it's a very sizeable amount from an economy that is significantly smaller than that of the USA.
UK GDP = $1.93 trillion
USA GDP = $13.13 trillion
(2006 estimates)
Update - Thursday 9th October 2008
There is still some confusion about how big the UK bail-out is. According to my reckoning, it is the higher figure of £500 billion or $880 billion. Here's how it stacks up:
- Up to £50bn of taxpayer money to buy preference shares - £25 billion will be released initially with a further £25 billion at a later date
- An extension of the Special Liquidity Scheme introduced after the collapse of Bear Stearns to allow £200 billion of funds to be made available to banks
- A guarantee of the debt issued by banks of up to £250 billion
As conventional economics goes, it looks like a more intelligent plan than the US bail-out that focused simply on buying "toxic" assets at undermined prices. It seems to address the three main issues of the banks that are capital, funding and liquidity that the US plan fails to do (in my opinion).
I like to get some perspective on these amounts as they are simply fairy tale numbers to me. Here's the bail-out deal compared with UK spending on health and education:
European stock markets in UK, France and Germany fell again today.
The big banking bail-out
02/10/08 15:04 Filed in: Economy | Economic Crisis
Here you are – a comprehensible background to the big banking bail-out in one blog post!
What’s the problem?
Apparently the main problem from a market and banker’s viewpoint is the accumulation of potential bad debt based largely on the USA mortgage market.
Major banks and other financial institutions around the world have reported losses of approximately US$435 billion as at 17 July 2008.
The U.S. mortgage market is estimated at $12 trillion with approximately 9.2% of loans either delinquent or in foreclosure in August 2008.
Exposure to the bad debt risk means that a bank’s available liquid funds are reduced. This in turn has a negative impact on business that relies on bank credit to support its trading activities. In short, prospective bad debt has a negative impact on the bank’s ability to trade and lend.
The initial response of banks to the liquidity crisis was to attempt to generate more funds by increased share and stock issues. These were not fully subscribed and given their exposure to bad debt risk, their share prices fell.
In the UK, the stock market value of Halifax Bank of Scotland (HBOS) who were not known for reckless or sub-prime high risk lending, but who had heavy exposure to the UK mortgage market, looked as though it was heading for failure when its share price fell to 88 pence ($1.65) from a year high of approximately £7.78 ($15). The failure might be attributed to the bank’s lack of success in attempting to raise additional cash to support its liquidity via a rights share issue and a rumoured abortive attempt to gain funding from other sources (including the Bank of England). It was taken down more by negative market speculation rather than any actual deterioration in its trading position, although that is an unqualified personal opinion. Its lending policies were thought to constitute a higher risk than some other more conservative UK banking institutions. It made conventional home mortgage loans to what might be described as “average families.”
So what’s the real problem?
The boom and bust housing market
A very significant part of the problem has been the “boom and bust” housing markets both in the USA and the UK. In the USA, house prices rose by 124% between 1997 and 2006.
As a result of booming house prices, there was excessive speculation in the market. In 2006, 36% of all USA house purchases were for investment purposes or vacation homes. (Source: National association of realtors) People moved into the housing markets and treated homes like stocks and shares.
In 2006, the US housing bubble burst. There had been massive overbuilding of homes to satisfy speculation in the market that caused an excess of supply which led to a fall in house prices.
Suddenly there were people everywhere who had made a mint of money based on the value of their home. In the UK, there was a glut of property millionaires. Many decided to cash in on their speculative gains taking out second mortgages that funded increased consumer spending. This was economic growth based on fool’s gold as no real new economic value had been created. Most increased consumer demand was based on increased borrowing and more consumer debt.
In the UK, it was a housing shortage that drove up prices. But prices surpassed affordability. They grew at rates far in excess of inflation and salary and wage increases. The continuing boom was unsustainable. Prices are now falling and their rate of decline is accelerating.
House prices in early 2008 were considered to be overvalued by 40% in the USA and 25% in the UK.
The decline of house prices is hitting borrowers hard. In the US, an estimated 8.8 million homeowners — nearly 10.8% of total homeowners — have zero or negative equity as of March 2008, meaning their homes are worth less than their mortgage. This provides an incentive to "walk away" from the home, despite the negative credit rating impact.
The house price boom was a fool’s paradise.
Now for the bankers
Bankers cashed in on a growth market, but with little forethought or cautious consideration other than a regard for profit.
The sub-prime mortgage came into being for those who were unable to qualify for conventional home loans (for reasons of status, credit standing, low income etc.) and willing to pay the premium price by way of higher interest rates. Sub-prime mortgages are high-risk loans.
Bankers also sought to defray their exposure to risks via a process known as securitisation (credit default swaps – CDS) whereby they aimed to retain profit and sell parts of their security-backed debt to an insurer or another financial institution. Often this involved whole chains of transactions with companies passing on risk one to another, each believing that they had retained some element of profit.
The risk business is complex. Risk has several dimensions: in default (the credit risk), in the diminution of the asset value (the falling house price), and the counterparty risk (the risk of failure of the party under-writing the debt), and a risk in liquidity where companies have been able to gain access to short-term funding because of their perceived exposure to, or reducing market attractiveness within, the mortgage market.
So when the house boom went flat, banks found themselves holding securities that no one wanted to buy. This is a key fact. It’s not that homes became worthless or that massive numbers of people faced foreclosure. It’s about the way our financial and trading system works and no one is proposing to change that.
Here’s a big clue. I understand that Merrill Lynch was sitting on about $30 billion of sub-prime mortgage securities. No one wished to buy them. “Mark to market” accounting meant that they were required to value this asset at what the market was willing to pay for it. The value that the market gave to these securities was 78% below their face value. According to accounting conventions, Merrill Lynch had to mark their value down to 22% of their estimated original worth. Neither the quality of the homes nor the status of the debt determined whether that valuation was appropriate. It was what the market was willing to pay and suddenly Merrill Lynch was sitting on one enormous book loss. It did not reflect reality. I suspect any fool might have realised more than that market valuation of those securities in homes and mortgages in real terms. Consider HBOS. Markets are like casinos that value profit, mainly short-term profits. Reality has little to do with it.
No one knows if the bail-out fund of $700 billion is going to be big enough yet. Freddie, Fannie and AIG have already had the benefit of $300 billion of taxpayer funds taking the total bail-out cost to $1 trillion. This crisis and the sums of money involved get worse and larger by the day.
Here’s the big bail-out plan…
The bail-out plan appears to be simple. The US Government will buy distressed securities (mortgaged assets i.e. homes) in credit default from the mortgage provider or underwriter at a discounted value.
So home loan X is in default, government buys home that is the security at substantially less than its face value in the hope it may subsequently sell it back to market investors.
The bank’s take a loss on disposal of their security, but it’s a relatively small loss. Their balance sheet is cleared of the liability that represents a bigger exposure or loss to the bank. Their liquidity improves and as a result, trading confidence is restored.
I’ll just hold that thought one moment. In order for government’s intervention to be worth anything, it must pay a price for the troubled security above market valuation otherwise there would be no point in buying it. Hang on! Doesn’t that mean that the difference between the market price and the government price is profit? Correct. So might the bank’s share prices be increased for the benefit of its stock-holders as a result of this…what should I call it…liability alleviation or profit on market price? Yes. Will taxpayers get a chance to enjoy shareholder gains without participating in further risk therefore? No. Are there any legal instruments that would permit such participation in shareholder profits? Yes…but sssch…better keep quiet about those, else we’ll demoralise and disincentivise the shareholders.
The act says:
Its purpose is to:
“immediately provide authority and facilities that the Secretary of the Treasury can use to restore liquidity and stability to the financial system of the United States; and to ensure that such authority and such facilities are used in a manner that:
(A) protects home values, college funds, retirement accounts, and life savings;
(B) preserves homeownership and promotes jobs and economic growth;
(C) maximizes overall returns to the taxpayers of the United States; and
(D) provides public accountability for the exercise of such authority.”
It all sounds laudable enough. Remember Merrill Lynch? So is government going to pay above the market valuation to stem the turmoil? Probably. I’m not sure how good government is at playing banker either. I have no confidence in it fulfilling that role. What if the house market doesn’t recover in the short term? Will government defy corporate convention and take a longer-term view? I doubt that too. US governments are in office for 4 years and that’s not long-term. Sadly I suspect what might happen is that the government sells back its securities to the market at a loss in which case the banks may make a further profit on their intervention. That sounds more likely. The market has no social conscience, nor does it have any regard for the taxpayer or their welfare. Whatever government sets out in its objectives, it is entering a market-driven game now.
Here’s another idea. I’m not in favour of the bail-out bill at all. But if USA must do it, then why not have government guarantee “distressed securities” rather than buy them. It serves the same purpose but forces banks to work with their problems and solve them, like grown-ups, rather than relieving them of their difficulties, like an errant child.
I have one big nagging doubt about the bail-out bill. It isn't only banks that are suffering economic hardship at present. The bill does nothing for the underlying economy or the collapsing housing market. It may be a very expensive remedy that achieves very little. I suspect that lack of market confidence may return in a relatively short time.
This is my view today. The world may have changed by tomorrow.
Till the next time…au revoir.
What’s the problem?
Apparently the main problem from a market and banker’s viewpoint is the accumulation of potential bad debt based largely on the USA mortgage market.
Major banks and other financial institutions around the world have reported losses of approximately US$435 billion as at 17 July 2008.
The U.S. mortgage market is estimated at $12 trillion with approximately 9.2% of loans either delinquent or in foreclosure in August 2008.
Exposure to the bad debt risk means that a bank’s available liquid funds are reduced. This in turn has a negative impact on business that relies on bank credit to support its trading activities. In short, prospective bad debt has a negative impact on the bank’s ability to trade and lend.
The initial response of banks to the liquidity crisis was to attempt to generate more funds by increased share and stock issues. These were not fully subscribed and given their exposure to bad debt risk, their share prices fell.
In the UK, the stock market value of Halifax Bank of Scotland (HBOS) who were not known for reckless or sub-prime high risk lending, but who had heavy exposure to the UK mortgage market, looked as though it was heading for failure when its share price fell to 88 pence ($1.65) from a year high of approximately £7.78 ($15). The failure might be attributed to the bank’s lack of success in attempting to raise additional cash to support its liquidity via a rights share issue and a rumoured abortive attempt to gain funding from other sources (including the Bank of England). It was taken down more by negative market speculation rather than any actual deterioration in its trading position, although that is an unqualified personal opinion. Its lending policies were thought to constitute a higher risk than some other more conservative UK banking institutions. It made conventional home mortgage loans to what might be described as “average families.”
So what’s the real problem?
The boom and bust housing market
A very significant part of the problem has been the “boom and bust” housing markets both in the USA and the UK. In the USA, house prices rose by 124% between 1997 and 2006.
As a result of booming house prices, there was excessive speculation in the market. In 2006, 36% of all USA house purchases were for investment purposes or vacation homes. (Source: National association of realtors) People moved into the housing markets and treated homes like stocks and shares.
In 2006, the US housing bubble burst. There had been massive overbuilding of homes to satisfy speculation in the market that caused an excess of supply which led to a fall in house prices.
Suddenly there were people everywhere who had made a mint of money based on the value of their home. In the UK, there was a glut of property millionaires. Many decided to cash in on their speculative gains taking out second mortgages that funded increased consumer spending. This was economic growth based on fool’s gold as no real new economic value had been created. Most increased consumer demand was based on increased borrowing and more consumer debt.
In the UK, it was a housing shortage that drove up prices. But prices surpassed affordability. They grew at rates far in excess of inflation and salary and wage increases. The continuing boom was unsustainable. Prices are now falling and their rate of decline is accelerating.
House prices in early 2008 were considered to be overvalued by 40% in the USA and 25% in the UK.
The decline of house prices is hitting borrowers hard. In the US, an estimated 8.8 million homeowners — nearly 10.8% of total homeowners — have zero or negative equity as of March 2008, meaning their homes are worth less than their mortgage. This provides an incentive to "walk away" from the home, despite the negative credit rating impact.
The house price boom was a fool’s paradise.
Now for the bankers
Bankers cashed in on a growth market, but with little forethought or cautious consideration other than a regard for profit.
The sub-prime mortgage came into being for those who were unable to qualify for conventional home loans (for reasons of status, credit standing, low income etc.) and willing to pay the premium price by way of higher interest rates. Sub-prime mortgages are high-risk loans.
Bankers also sought to defray their exposure to risks via a process known as securitisation (credit default swaps – CDS) whereby they aimed to retain profit and sell parts of their security-backed debt to an insurer or another financial institution. Often this involved whole chains of transactions with companies passing on risk one to another, each believing that they had retained some element of profit.
The risk business is complex. Risk has several dimensions: in default (the credit risk), in the diminution of the asset value (the falling house price), and the counterparty risk (the risk of failure of the party under-writing the debt), and a risk in liquidity where companies have been able to gain access to short-term funding because of their perceived exposure to, or reducing market attractiveness within, the mortgage market.
So when the house boom went flat, banks found themselves holding securities that no one wanted to buy. This is a key fact. It’s not that homes became worthless or that massive numbers of people faced foreclosure. It’s about the way our financial and trading system works and no one is proposing to change that.
Here’s a big clue. I understand that Merrill Lynch was sitting on about $30 billion of sub-prime mortgage securities. No one wished to buy them. “Mark to market” accounting meant that they were required to value this asset at what the market was willing to pay for it. The value that the market gave to these securities was 78% below their face value. According to accounting conventions, Merrill Lynch had to mark their value down to 22% of their estimated original worth. Neither the quality of the homes nor the status of the debt determined whether that valuation was appropriate. It was what the market was willing to pay and suddenly Merrill Lynch was sitting on one enormous book loss. It did not reflect reality. I suspect any fool might have realised more than that market valuation of those securities in homes and mortgages in real terms. Consider HBOS. Markets are like casinos that value profit, mainly short-term profits. Reality has little to do with it.
No one knows if the bail-out fund of $700 billion is going to be big enough yet. Freddie, Fannie and AIG have already had the benefit of $300 billion of taxpayer funds taking the total bail-out cost to $1 trillion. This crisis and the sums of money involved get worse and larger by the day.
Here’s the big bail-out plan…
The bail-out plan appears to be simple. The US Government will buy distressed securities (mortgaged assets i.e. homes) in credit default from the mortgage provider or underwriter at a discounted value.
So home loan X is in default, government buys home that is the security at substantially less than its face value in the hope it may subsequently sell it back to market investors.
The bank’s take a loss on disposal of their security, but it’s a relatively small loss. Their balance sheet is cleared of the liability that represents a bigger exposure or loss to the bank. Their liquidity improves and as a result, trading confidence is restored.
I’ll just hold that thought one moment. In order for government’s intervention to be worth anything, it must pay a price for the troubled security above market valuation otherwise there would be no point in buying it. Hang on! Doesn’t that mean that the difference between the market price and the government price is profit? Correct. So might the bank’s share prices be increased for the benefit of its stock-holders as a result of this…what should I call it…liability alleviation or profit on market price? Yes. Will taxpayers get a chance to enjoy shareholder gains without participating in further risk therefore? No. Are there any legal instruments that would permit such participation in shareholder profits? Yes…but sssch…better keep quiet about those, else we’ll demoralise and disincentivise the shareholders.
The act says:
Its purpose is to:
“immediately provide authority and facilities that the Secretary of the Treasury can use to restore liquidity and stability to the financial system of the United States; and to ensure that such authority and such facilities are used in a manner that:
(A) protects home values, college funds, retirement accounts, and life savings;
(B) preserves homeownership and promotes jobs and economic growth;
(C) maximizes overall returns to the taxpayers of the United States; and
(D) provides public accountability for the exercise of such authority.”
It all sounds laudable enough. Remember Merrill Lynch? So is government going to pay above the market valuation to stem the turmoil? Probably. I’m not sure how good government is at playing banker either. I have no confidence in it fulfilling that role. What if the house market doesn’t recover in the short term? Will government defy corporate convention and take a longer-term view? I doubt that too. US governments are in office for 4 years and that’s not long-term. Sadly I suspect what might happen is that the government sells back its securities to the market at a loss in which case the banks may make a further profit on their intervention. That sounds more likely. The market has no social conscience, nor does it have any regard for the taxpayer or their welfare. Whatever government sets out in its objectives, it is entering a market-driven game now.
Here’s another idea. I’m not in favour of the bail-out bill at all. But if USA must do it, then why not have government guarantee “distressed securities” rather than buy them. It serves the same purpose but forces banks to work with their problems and solve them, like grown-ups, rather than relieving them of their difficulties, like an errant child.
I have one big nagging doubt about the bail-out bill. It isn't only banks that are suffering economic hardship at present. The bill does nothing for the underlying economy or the collapsing housing market. It may be a very expensive remedy that achieves very little. I suspect that lack of market confidence may return in a relatively short time.
This is my view today. The world may have changed by tomorrow.
Till the next time…au revoir.