The next financial crisis

By
Wayne Hope
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12
6

Money-whirlpoolFive years after the Lehmans collapse myopic optimism prevails. John Key and Stephen Joyce don`t seem too worried, the Reserve Bank has its eye on financial events as the business media looks for green shoots of recovery.

Such faith is misplaced and dangerous.

Let us not forget what actually happened back then. On Friday September 11, 2008 US investment bank Lehman Brothers reported a US$3.9 billion loss following $7.8 billion of credit write downs. The likelihood of a huge financial failure bought together a weekend meeting of senior bankers and regulators. Treasury Secretary Henry Paulson told them to measure the capital losses of Lehman` real estate and equity holdings and construct a funding mechanism for their bad assets in order to encourage a willing buyer. The scheme failed and on Sunday evening September 14 the US Treasury and Federal Reserve allowed Lehman Brothers to fail.

This was a global news event which sent panic waves through the commercial paper and short term money markets. Thousands of businesses worldwide relied on these markets to cover routine expenses such as payroll and utility bills. When millions of depositors tried to withdraw funds, worldwide business failures appeared imminent. Within 36 hours sharemarket prices plummeted everywhere. The effects of Lehman`s fall on the US banking system were enormous. Merrill Lynch was sold to Bank of America. The Federal Reserve rescued AIG, the world`s largest insurance company. At least 20 other US financial institutions collapsed. Citigroup, once the world`s biggest, most valuable and powerful financial services firm was virtually crippled.

The reality of financial collapse was officially recognised on September 20 when the US Treasury decided to purchase almost $700 billion of worthless securities from troubled banks. The document was initially rejected by the House of Representatives before passing into law. Thus began the Troubled Asset Relief Plan (TARP), an extraordinary, multi-trillion dollar rip–off whereby Federal regulators used taxpayers money to bail out the investment banking system.

The spreading credit crisis forced a similar response from the European Central Bank, the Bank of England and major European governments. Financial collapse reduced bank lending and credit lines to large, medium and small scale firms. Cuts in production, massive layoffs and increased unemployment drove down consumer spending which forced all kinds of businesses to close. Reduced credit flows and falling demand in large Western countries damaged export revenues in China and throughout East Asia.

So, what explains the carnage? Well, in my view we should start by blaming the investment banks. In the 1990s they rapidly expanded their operations. Apart from lending, funds management and trading for clients, they became major speculators in their own right. And, they had the gall to do so with other peoples` money. Here, the repeal of the US Glass- Steagall Act in 1999 was absolutely crucial. Since 1933 this legislation had legally separated commercial banks, which held public deposits and loans, from investment banking. Once this was no longer the case banking conglomerates could draw upon huge resevoirs of depositors` money to manipulate financial markets.

For the biggest players the strategy was to first, enter a particular market to produce a price bubble; second, make huge speculative profits and third, withdraw, collapse the bubble and enter a new market. This explains the 1990s currency bubbles in the UK, Russia, Mexico and South East Asia and the internet `dot com` boom/bust of the late 1990s. It also explains the early 2000`s housing bubble, especially in the United States. In essence investment banks operated as giant private clearing houses for equities, bonds, derivatives, currencies, commodities and mortgages. Even worse, a vast shadow system of inter-bank trading grew out of control.

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This was the bizarre, secret world of Special Investment Vehicles (SIVs) shaped by derivatives and securitisation. Derivatives allowed speculators to bet on the price movements of all capital assets such as stocks, government bonds, physical commodities in any combination whatsoever. Securitisation allowed individual capital assets to be packaged up to be bought and sold. Most disturbingly of all, packages of debt, including household debt (mortgages) could also be traded and speculated against, without official auditing.

Eventually, the shadow banking system, Anglo-American household debt securitisation and mortgaged based derivatives became joined up on a global scale. We all inhabited a massive, virtual pinball machine. Computerised data, money and debt flashed from point to point in real time, as the day of reckoning came closer to hand. Let us now fast forward to November 2008 to see how the newly elected Obama administration caved in to Wall Street.

By then it was obvious that major government intervention was needed to prevent further bank runs, settle the financial system and to counteract the recessionary cycle of diminishing loan finance, economic stagnation and unemployment. The key question was, what form should government intervention take? Two options were on the table. With the `takeover` option the government takes ownership of failing financial institutions in order to delete `toxic` assets and refunction banking operations to support the `real` economy. Old financial managers lose their jobs, shareholders are wiped out and the remaining losses are carried by creditors and taxpayers. Certain banks are closed, others may be returned to the private sector at a later date. The second option can be called `the blank cheque`. Simply put, the government props up surviving financial institutions. Banks are kept afloat in their existing form, managers keep their jobs, shareholders retain some of their stake and creditors receive some protection. This is all funded by the taxpayer. Yet, if certain banks recover, the benefits are confined to managers, shareholders and major creditors. Ordinary people look on, as new forms of speculation and counter-party trading flourish. The preconditions of the next financial crisis are thus put in place.

Obama took the` blank cheque` option under a smokesreen of anti-banker rhetoric. Yes, there was a stimulus package in February 2009. However, as the largest banks returned to their speculative habits second tier banks could not obtain loan money for farmers, manufacturers, construction firms, retailers and start up businesses. Meanwhile, over in the Eurozone, opportunities for financial speculation abounded. The new target was sovereign national debt. The largest banks took derivatives positions via hedge funds against the most indebted European economies; Greece, Spain, Portugal and Ireland. Investors and risk analysts calculated whether or not indebted countries could service their external debts. Would they actually be able to implement brutal austerity programmes? Who really cares, as long as we make a killing.

As the sovereign debt crisis of each country got worse the European Central Bank and the governments of larger economies acted to preserve the loan portfolios of private banks, regardless of the social pain involved. The prospect of a major debt default followed by another, even bigger, financial collapse cannot be ruled out. That in turn could trigger a full blown depression. Where would this leave New Zealand? Well, the Australian banks would have to pay more to fund themselves from global money markets . The costs would be offloaded onto ordinary Kiwi mortgage holders. The risk-return calculations of funds managers would be destroyed, the Kiwisaver scheme could falter as medium risk investments turned sour. General financial anxiety would become the norm.

Economically literate politicians able to think on their feet would be at a premium. If the worst does indeed come to pass within the next five years lets hope that David Cunliffe is Prime Minister.

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12 COMMENTS

  1. Nice article: our biggest problem might not be the ones you have mentioned. When a financial crisis recurs (as it must) the issue for NZ as a trade based economy will be the failure of the instruments of trade. These include letters of credit, and international clearance systems. It happened in the 30s….I suspect a recurrence very probable.

  2. Good article, Wayne. However, the headline – the next financial crisis – suggests that’s what the article is about when in fact it’s more of a historic overview of the 2008 crisis. While I enjoyed learning about this, it would be helpful if you could describe what exactly is happening now that suggests another financial crisis is on its way. I have heard, for example, bits and pieces about a currency war and a gold buy up, but it was from unreliable sources. It would be good to hear what a respected scholar thinks is happening.

  4. I remember hearing an interview with NBR economic commentator Neville Bennett on National Radio a few months wherein he was very gloomy about the current state of affairs. There seems to be a general air around the place that the world economy hasn’t really recovered from 2008 and like a faultline, what seems like the big one may only be a precursor to an even bigger one.

  5. Good article but you forgot one key piece of legislation that in fact marked the bottom of the US stock market in March 2009 almost to the day. Namely, the Kanjorski hearing, after which congress legalised mark to fantasy accounting, i.e. banks could post their technically worthless garbage at 100c in the dollar. All the insolvent banks magically became solvent merely with the stroke of a pen. That day bank balance sheet fraud literally became government policy and this has been the case ever since (i.e. most US banks are STILL factually insolvent, but they no longer have to recognise their insolvency). What could possibly go wrong?

    • The stroke of a pen achieved two brilliant pieces of magic…first wave of the wand transferred all responsibility for debts to the taxpayer worldwide…second wave of the wand said bankers were free to create as much money as they wanted to cover debts, interest on debts, new interest of debt created by creating money in perpetuity, or whatever else they wanted to do.

      From this the bankers have since paid themselves extortionate bonus for wand waving, and enabled truly magic speculation in stocks and shares that have pushed the worlds stock markets to impressive new highs without ever increasing the underlying fundamentals of the businesses in question.

      This fabulous wand waving amounts to the most massive wealth transfer ever….other people less enamoured of witchcraft and wizardry would describe this as larceny. In more certain times the rule of law took primacy, and heads would roll for such things as theft and currency debasement.

      Of course, creating money (credit) from thin air is the equivalent of the emperors new clothes…when belief gets suspended free fall follows as surely as night follows day.

  6. Was it not rather a mixture of the “takeover” and “blank cheque” option the US government applied?

    http://en.wikipedia.org/wiki/Federal_takeover_of_Fannie_Mae_and_Freddie_Mac

    http://en.wikipedia.org/wiki/General_Motors

    http://www.bloomberg.com/news/2012-10-09/ford-would-have-shut-without-auto-bailouts-rattner-says.html

    http://en.wikipedia.org/wiki/Ford_Motor_Company

    “During November 2008, Ford, together with Chrysler and General Motors, sought government bridge loans at Congressional hearings in Washington, D.C. in the face of conditions caused by the 2008 financial crisis.[26] The three companies presented action plans for the sustainability of the industry. Ford opted not to seek government loans.[27] GM and Chrysler received government loans and financing through T.A.R.P. legislation funding provisions.[28]”

    http://en.wikipedia.org/wiki/Financial_crisis_of_2007%E2%80%9308

    But yes, in general it was mostly a “blank cheque” approach, and that was done by “quantitative easing” and thus basically by “printing money”, which has increased the total US debt to unknown levels. Socialisation of debt will mean that no matter what present “growth” scenarios we may experience, they are only going to be temporary, as the underlying problems have not been properly addressed, and the debt burden will come to bear on all, certainly the lower and middle classes.

    Yet a future depression will not be the first one, and while much suffering and hardship will come, there will be a new start again, with re-arranging monetary and other policies, by writing off massive debts, and by leveling out wealth to some degree.

    The US, like other countries, have had their booms and busts, recessions and depressions, that in itself does not necessarily mean that capitalism will be defeated and become obsolete. The capitalist economic system will have their stakeholders and defenders do all the revive “their” system at a lower level, to keep things relative and under “their control”.

    And in all this, New Zealand will be a tiny economy, totally dependent on what will happen globally, unless people will settle for cottage style economic activities, thus a level of self sufficiency. Few in our modern days will be prepared to settle for that, whether we like it or not.

    There is NO true financial and economic security, and much of what we get presented is an illusionary sense of security. A socialist economic system would be an alternative, but it will have its problems also. It is up to the people to decide what they prefer, and only informed people can make wise decisions. How many are informed enough?

  7. I watched the media report on the ‘ housing crises ‘ in Auckland last evening and my jaw dropped so far to the floor , my dog picked it up , ran off with it and buried it outside somewhere .
    You poor suckers . That young couple who were so excited about the small rotting hut they bought for $ 500 k plus . That freaky , giggly real estate agent ! That other real estate woman who looked like Divine from ‘ Girl Trouble ‘ ? Freaky , freaky , greedy bipeds .

    Great Post Dr Wayne Hope .

    We Kiwis have one thing in our favour when the worlds false economy goes tits up . It’s not David ‘ Hugs all round for jonky’ Cunliffe . It’s not our tourism , unless those who will get stranded here when the airline companies go broke over night and can’t afford to put gas in the tank . Those tourists can then work the gruel kitchens for a bed and , yep you guessed it , their very own gruel . It’s not our ‘ Oh I say ! Pass the darkie old chap , polish has gawn awf me shoes don’t cha know ‘ white , patriarchal Old Boys . No , it’s none of those sorts .

    It’s our agricultural infrastructure . Yep , I’m banging on about that again .

    If Cunliffe is serious about us Kiwis surviving and seeing ‘ hope return to the eyes of our young ‘ he’d better get fucking serious about our dying agricultural hinter lands .

    An act of , God only knows what , has seen me now living in my old building in a small , rural township of about 800 . It’s right on the coast , it’s right by a very large river , it’s a few k’s away from SH1 , it’s very near beautiful Dunedin , the area is rich in resources and I would regard the county as being the pistons in the engine that drives our economy .

    My little town was ravaged by roger douglas , raped by the banks , shit on by pig muldoon , vilified by pompous twats , rorted by the local council and loathed by many in that ignorant , ridiculous way that is common within a certain circle of boorish New Zealand colonizers .

    The QV capital value is $57 k . For a 102 year old , two story building with a four bedroom apartment upstairs and is dead in the heart of the productively richest lands in New Zealand and it’s worthless . It’s worthless because the ‘ market ‘ says it’s so . The sheds out the back would fetch $650k each if I could somehow float them up to New Market .
    It would seem to me that it is , in fact , the ‘ market ‘ that is worthless and yet it’s what’s used to enslave the gullible in horrendous ‘ debt ‘ which then steals away with their lives .
    That’s the environment that jonky peddles . If I’d been Cunliffe I’d have slapped that greedy little shits face , not shook his greasy , money fiddling , hand flap . You’d never know who’s pocket it’s been in .

    And David Parker is a fan of Michael Cullen ? Oh God . Why didn’t Cunliffe select some young , vibrant , T shirt wearing genius person to be his deputy instead of a sallow money addict with bleach for blood ?
    It’s Wednesday and it ain’t looking good .
    Michael Cullen ? You have got to be fucking kidding ?

  9. It seems no lessons have been learned from the crash. When you read anything about it, it’s likely to blame sub-prime mortgages, but these were only a symptom. The real problem is the derivatives market, played with fantasy money and run by computers using algorithms based on an equation which the operators don’t understand. Within capitalism, there are no long term solutions, but short term ones could be:
    1. Prison for anyone involved in the derivatives market. Fraud is the only word to adequately describe what they are doing.
    2. A financial transactions tax, which would act to slow down the rate of transactions and damp out the problems a little.
    3. An enforced limit on the number of speculative transactions that any dealer can make over a given time period. One a week might be reasonable.
    4. Computers running trading algorithms should only be available to a trader who can publish an article on financial mathematics and the applicability of the Black-Scholes equation in a peer reviewed mathematical journal. In the hands of anyone else, they are weapons of mass destruction and severe penalties should be applied.

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