Wednesday, 8 October 2008

Help! Nobody knows anything!

You can accuse the Germans of many things, but not of being unmethodical nor of failing to master the facts. It was thus with a distinct chill I heard their Finance Minister a week ago smugly say that the financial markets meltdown was a US problem and wouldn’t affect Europe. This foreboding was reinforced as I listened to Angela Merkel yesterday on TV, when it became clear that she hadn’t a bulls notion about what was going on.

Unless something was, as the man said, lost in translation, she didn’t understand not even the basic concept of derivatives. Given that she heads the most powerful economy in Europe, and as she’s apparently a regular reader of this blog, I have taken time out to explain some of the basic concepts underlying the disaster.

Now Angela, the underlying malaise, present all the way through, was massive conflict of interest at all stages. The politicians stripped away regulatory constraints, the Republicans to see to their paymasters in Wall St. and to appease the frothing free market fundamentalists, while the Democrats gained by using it to enable minorities to buy houses they couldn’t afford. Conflict of interest

Leroy, resident under the bridge at 42nd St. is approached by mortgage huckster. “Hi there. Would you mind putting away that meths bottle for a moment? Now – while this place is nice and central, the traffic overhead is a pain. How’d you like to own a palatial mansion in the Hamptons instead?”

“You would? Great. Just sign here, and the key is yours”

Thus was born the sub prime crisis. The huckster gets his commission and heads off for the next mark. Conflict of interest. His bosses also make money, but they recognise that Leroy might have some difficulty in meeting his $4000 a month repayments, so they’d like to offload it. They also know that not even a sociology professor would be stupid enough to take this on, even at a premium. So what to do?

Now Angela, are you paying attention? Under this scheme a whole series of asset-backed securities (like Leroy’s mortgage) are pooled to make - in theory - otherwise minor and uneconomical investments worthwhile, while also reducing risk by diversifying the underlying assets. Securitisation makes these assets available for investment to a broader set of investors.

These asset pools can be made of any type of receivable, like credit card payments, auto loans, and mortgages, to esoteric cash flows such as aircraft leases, royalty payments and movie revenues. Typically, the securitized assets might be highly illiquid and private in nature. would be packaged together And the trick here is to mix in some good stuff with the crap, ‘securatise’ it and offload it at a profit. More conflict of interest.

Ok, you might get the sociology professor to buy this, but not the sophisticated money markets – the real target. Now for the conflict of interest piece de resistance. Enter the rating agencies, Standard & Poor, Moodies and Fitch. These are always described as highly respected, prestigious, blue chip and independent. Just like Arthur Andersons was before the Enron collapse.

Now these agencies gave these crocks of shit instruments AAA or aaA ratings, as good as it ratings can get. Surprised? Why? For a start, it’s the issuers of these ‘instruments’ that pay the fees of those agencies, not the people who use their advice! And it gets better. The same rating agencies worked with the crooks issuing banks in designing these ‘instruments’. So, they’re paid by the banks to rate their products, having already raked in massive fees for developing those products in the first place!

The numbers looked compelling. "Buy this investment-grade collateralized debt obligation and you get a return of up to 10 percent - almost 25 percent more than the average yield on a similarly rated corporate bond". Just like a Ponzi scheme, everyone’s a winner. Sell them and you get commission, buy them and you get commission as well for ‘sourcing’ good products. And just like a Ponzi scheme, reality intruded with increasing force until the whole deck of cards collapsed.

And the underlying conflict of interest was the fact that the main perpetrators, the likes of Lehman’s Richard Fuld and Merrill Lynch’s Stan O’Neal, awarded themselves hundreds of millions of dollars while the going was good. Even middle managers could take in a million bucks a year. So what if the whole thing went belly up – you still had millions stashed away and could crawl out from under your stone in a few years when the storm clouds had passed. Just like happened with the mountebanks who hustled the dotcom bust, in the full knowledge of what they were doing.

So that’s what happened Angela. And it means that the people fixing the problem are know-nothing politicians working with the Wall St. crooks who caused the problem initially. I think it’s officially time to panic.

Now where did I leave my brown trousers?


Anonymous said...

That's a superb explaination.

Anonymous said...

Angela Merkel; science postgraduate, first 36 years of her life spent [toeing the line] in East Germany. I have wondered how well she truly grasps economics.

Anonymous said...

You lost me,
Angela Merkel

Anonymous said...

Not directly linked to this post but I've been thinking about this banking crisis and immigration. Now that we're in trouble, the idea of cheap labour to fuel the economy has become the expensive burdon on our budget in a time for counting the pennies.

I think the banks need to change from national entities to international entities. This would help stop economic migration from Africa, Islamic States etc.

Banks discriminate between who they lend money to based on risk assessment. Government in recent years have tried to force banks to ignore certain requirements for high risk categories e.g. in the US where legislation aimed at banks providing finance to black citizens from a certain income level who were being discriminated against. Risk assessment is great but I think it is flawed because the banks fail to look at their operations from a holistic view and focus on their confined national operations.

Majority of immigrants to the US and Europe are migrating for economic purposes. They come to earn money in a strong, stable currency which can allow them to buy nice things & have a better life. I think the problem is that they are still economic mules but not in a legal or moral sense. This means they do the undesirable jobs but now their presence has more of an ability to impact on society.

A strong economy needs raw materials e.g. copper to grow. Most of the superpowers do not have sufficient raw materials to supply their demands. African immigrants come from countries rich in raw materials. We need to form a relationship whereby they are dependent on the US or Europe's financial system and can thus provide their raw materials quid quo pro.

With investments a key principle for stability is the idea of keeping a diversified portfolio. We don't like economic migrants but they will come as long as our continent has and their continent has not. Banks should therefore loan to people outside of its country of registration - to diversify their debt portfolio.

The account and interest payments will all be based in say Ireland or UK and denominated in European currency but they get sent a credit card to give them a reliable/stable source of finance.

Banks are xenophobic and won't give credit to people on other continents who are ALL classified as risky. They should form relationships with banks in Nigeria, Kenya, Uganda, Sierra Leone, Ghana, Mozambique, Malawi, South Africa, Zimbabwe, Zambia as well as certain distant Asian communities and start to discriminate between risky and non-risky borrowers on a more magnified basis. Some members of society in those countries are incredibly low risk, hold stable jobs and lives - why ignore the potential return from them based on geography?

That would prevent the need for economic migrants to come to UK, it would satisify our need for raw materials. This idea has the additional benefit of potentially preventing banking crisises because a recession in Europe doesn't mean e.g. South Africans will struggle to make thier interest payments. It will reduce the risk of banks struggling with cash flows and liquidity in times of recession.

Banks have recently been riding a wave and lending without recourse or thinking about failure nationally. As long as times are good they ignore the possibility and risk of failure - now look at us!

The idea behind their excessive lending is that it is viable as long as economic activity is festering. In simple countries, you are paid your salary and there is a relatively limited amount of areas you can spend it on and in these countries banks are not heavily leveraged. In the complex countries (esp. US) you have a huge variety of businesses e.g. cheerleading is a multi-million dollar busines, you can make millions off selling buttons. There are huge potential profits for any seemingly random business. There are more people and more businesses for expenditure to filter through until someone's initial salary is finally completely returned to the bank. So the multiplier effect from economic activity allows many more people to make interest payments for their debt and, therefore, creating the opportunity for banks to lend LOADS of money. People will borrow up until the point they struggle to make the interest payment, capital repayment is not in their mind. More businesses, more income - MORE LOANS. So when there is a recession and economic activity dies down you have people who cannot handle their obligations.

Now providing credit to countries where immigrants come from will encourage economic activity in their countries. It will make their currency more stable and more businesses will offer more services and goods with the aim of securing a portion of their credit money. It will provide them finance to start up their businesses. This will convince them to stay in their country of origin. The return will convince us to keep lending. Essentially creating a new form of economic mule without the disadvantage of the mule living in your house, sort of speak.

I really think this idea would work best in Ireland. I think Ireland should focus on transforming their economy into a hugely financial-orientated / exclusive financial hub type environment.

Some of the banks in UK started this on a relatively small scale - basing their business on maximizing value and making loans to African/Asian individuals who held decent profiles. Surprise, surprise they have come out of this crisis less battered than the others.

What do you think? European credit for the masses or not?