THIS TIME IT WILL BE DIFFERENT – Yes, far worse!

Chapter 1 - The last crash 2007/2008

Before the last financial crisis in 2007/2008 sub-prime mortgages were all the rage. The idea was that if mortgage lenders put a pot-pourri of mortgages in a parcel, the risks attaching to mortgages at the lower end of the security spectrum would, statistically, be offset by those at the higher end, and the package itself would then be euphemistically labelled a “collateralized debt obligation” (CDO) and classified as a self-standing tradable security carrying its own rating, somewhere between AAA to BBB. (Anything less than BB is classified as “junk”.)

These mortgage packages themselves were “sliced and diced” and flexibly packaged by lenders to be traded between investment banks and mortgage companies. Even the government-backed home loan agencies “Fannie Mae” and “Freddie Mac”, originally established to encourage home ownership among the poorer classes, got in on the act, unwittingly sealing their own demise in the process.

The subliminal theme underlying the perception of low risk at the heart of the entire process was: “Who would be crazy enough to risk their home by not keeping up with mortgage payments? Cutting down on holidays and entertaining bills, maybe even clothes – but missing out on mortgage payments? Never!”

Irresistible terms

Had any objective observer been so mistrusting as to open one of these parcels they would have found that a significant number of its mortgage contracts had been written on terms that betrayed a complete absence of basic commercial sense.

A factory worker earning, say, $25,000 a year, might have been granted a mortgage of $700,000 - on “teaser” terms that sought a trifling initial deposit and delayed commencement; or “flexible” terms that permitted suspension of instalments for a 6-month period; or a lower interest charge and hence reduced repayments if the borrower happened to be in any sort of financial difficulty. Unvarnished defaults led, quite simply, to “renegotiated” terms. Anything, to mask the charade!

Lenders made mortgage terms so generous as to be irresistible. Indeed, when the domestic debt bubble eventually exploded it was estimated that a quarter of all homes in America were in negative equity!

Had any representative of an investment bank, a rating agency, an auditor, or the Securities and Exchange Commission (SEC) as top financial regulator, bothered to sample a parcel’s contents, it would have been obvious to them that the mortgage broker’s sole motivation was to “sell” the loan!

Conflicted rating agencies

The marking system operated by credit rating agencies (Standard & Poor’s, Moody’s and Fitch) was inherently suspect since the agencies themselves were conflicted by being paid by the very banks that submitted the poisonous parcels for grading. Even the SEC turned a blind eye on professional relations between senior staff members and banks whose business they were invigilating. Bernie Madoff, erstwhile Chairman of the NASDAQ exchange, was adviser to the SEC on market regulation while operating his own investment house as a giant Ponzi scheme.

Fees and margins on mortgage packages were so extravagantly lucrative that no one wanted to prick the money bubble. Consequently, everyone – banks, brokers, rating agencies, auditors – claimed to be relying on each other for the purpose of authenticating the solvency of the rump of mortgage parcels. But none of them actually looked at a single mortgage contract - despite the fact that, in some cases, instalments may have been nine months in arrear.

The wilful blindness that gripped financial markets was nothing short of criminal – on a scale not witnessed since the escapades of Horatio Bottomly, or even the South Sea Company (which, Parliament believed, had taken over Britain’s national debt).  Like those legendary episodes, the ensuing mayhem took a commensurate toll. The demise of Bear Stearns and Lehman Brothers, and several smaller entities like Northern Rock in this country, led to the loss of thousands of jobs, homes, savings and pensions – but very few prison sentences.

A familiar refrain

Hank Paulson, head of the US Treasury, and Alan Greenspan of the Fed, among many high ranking officers, issued proclamations claiming that the lessons highlighted by this catastrophe had now been learned. Sadly, however, these lessons were confined to the domestic real estate market that collapsed in 2008 in the maelstrom of sub-prime mania – but they left unheeded the phenomenon that continues to plague monetary activity to this day: mounting debt that can never be repaid.

Chapter 2

What’s happening NOW?

This syndrome outlined in Chapter 1, in a different guise but an equally precarious framework, applies today with apocalyptic force. Instead of domestic mortgages we have corporate and sovereign debt. Instead of the flexibility of “teaser” terms we have “covenant-lite” terms that involve minimal collateral and offer little protection for the lender in the event of default.

 This applies to 80 per cent of the financing provided by private equity in current deals. There has been an explosion in “alternative” funds now offering credit to support a level of borrowing that is more risky and more voluminous than in 2007. Borrowers are taking full advantage of the favourable terms on offer from lenders so obsessed with the lure of deals that they impose no potentially restrictive terms, no threats of repossession or foreclosure - despite the backdrop of a precarious economic outlook, mounting sovereign debt, and near-certain defaults.

Notwithstanding all the vapid reassurances of Greenspan and Paulson, the reason why the lesson of ten years ago cannot possibly have been “learnt” is obvious: our economies are still operating on “funny money”, which is the cause of credit cycles. These cycles must – MUST – lead to a bust. This law has been proved every time central banks have tried to stimulate an ailing economy – not by addressing the reasons for its ailment, but by conjuring up swathes of yet more fiat money, representing nothing more substantial than the paper it’s written on.

The scale is mind-blowing

The scale this time is unprecedented – even the language tells the story. Remember when the biggest financial number we conceived of was a “million” (pounds or dollars)? Now, owners of modest and unexceptional suburban dwellings with a suitable postcode find that they have become “millionaires”. Then we got used to seeing “billion” (1,000 million) whenever large financial numbers were being reported. Now, government finances are reported in so many “trillion” (1,000 billion). Next? Any guesses when we shall see “quadrillion” in the headlines? After all, it’s only monopoly money!

The tortured process of credit expansion (technically speaking, the process of unwinding previously created malinvestments and distortions) simply lays bare the extent of distortion caused by successive rounds of central bank intervention. As I have explained many times in earlier posts, when the newly created confetti money is pumped into the system, its distribution follows a path that can be rationally explained - but it certainly is not equitable.

How QE money enters the system, and the “Cantillon effect”

The monetary conjuring trick employed after the last crisis required central banks to purchase government bonds from pension funds and insurance companies, paying for these financial assets with the newly printed money so that it then flows into the banking system. Simple. It’s called “quantitative easing”. No, it’s not a laxative - just a straightforward conjuring trick of teasing money (that looks like real money but is counterfeit) out of thin air!

The early receivers of this money, usually in the form of bank loans or similar instruments of indebtedness, benefit hugely because prices in the economy have not yet risen in response to the latest monetary influx, and are based on the earlier, pre-dilution, quantity of money. The tendency is for the first receivers of the new money to spend it – after all, there’s no point in saving it when, by now, the central bank is shredding interest rates. So the newly enriched class will lash out on assets previously unaffordable, creating bubbles in real estate, equities, luxury goods and works of art, prices of which now go through the roof. 

The losers (there are always losers!) are, of course, those now facing the higher prices prevailing in the wake of the money injection. The government’s manic measures, far from stimulating the economy, have left it exactly where it was, but in the process have enriched some and impoverished many others – particularly those who subsist on low wages, benefits and fixed incomes, notably retirees!

The 17th Century economist Richard Cantillon explained the concept of “relative inflation”, or a disproportionate rise in prices among different goods in an economy, now known as the Cantillon effect.

A repeat performance wearing different masks

The space between credit crises seems to be just long enough to blunt memories. One needs to be reminded of even the very first lesson: that statistics lie! Inflation of the money supply inevitably works its way through the economy and triggers price inflation that the Consumer Prices Index reliably under-reports. Treasury statisticians change the ingredients that constitute its measures – aided by commercial pressures that cause “shrinkflation”: the bars in a Kit-Kat are shorter and the gaps between humps in a Toblerone bar are wider! All contriving to delude consumers that like-for-like price inflation (which, correctly measured, is far closer to 10%) is somehow manageable!

But, as the old saying goes, you can’t fool all of the people all of the time. Consumers don’t need graphs to confirm what they already know instinctively - that official inflation figures have been artificially contrived. The central bank, to avert a crisis of confidence and a loss of purchasing power, is compelled to raise interest rates. The markets are no longer prepared to play ball with the official disregard of time-preference values that represent the real relationship between immediate and delayed gratification of material needs and wants.

Chapter 3

New sense of risk awareness

The unmasking of the charade described in Chapter 2 reveals the extent to which capital has been misallocated since the previous bust and highly geared financial intermediaries find themselves at risk. New business start-ups delay their launch dates in the pervasive atmosphere of risk-aversion, heralding a potentially systemic risk for the banks. Individuals and small businesses now favour liquidity over bank deposits, contrary to the efforts of central bankers to discourage cash holdings by promoting electronic transfers, contactless cards and uttering threats of tax evasion charges.

The risk that a bank holding customer deposits will prove unable to vouchsafe their withdrawal, customers will switch banks to one deemed safer, while the central bank will shore up the dodgy ones by recycling surplus deposits held elsewhere – all behind closed doors to conceal the extent of the problem.

Reaction from a banking coterie facing systemic collapse is just about foreseeable. But how will the endgame play out? In a recent issue of “Goldmoney Insight”, Alasdair Macleod, whose own insights have inspired much of this essay, countenances the possible demise of fiat money as valid currency worldwide within the next 18 months, and as an amateur in this game, I am in no position to gainsay him.

But there are indeed signs and portents that collectively militate in favour of Alasdair’s timescale.

My own take supports this:

(i) The numbers are too vast to have any recognisable meaning: global debt (that is ALL debt, consumer, business, and government) stands at an estimated $247 trillion, which is over a quarter of $1 quadrillion – there, I got in first! The interaction between this incomprehensible level of debt, totalling close to one-third of global GDP, and the rapidly spreading trade war being waged among our idiot leaders is, putting it mildly, explosive: these debts, owed mainly to financial institutions and sovereign wealth funds that conspired to facilitate its growth in the first place, collectively form a bloated circular bubble – but any pretence that it can be serviced demands rising incomes, a virtual impossibility when incomes are being squeezed by the expanding trade war.

(ii) The impact on business profitability of rising interest rates is undoubtedly a current factor. It is true that rates have been suppressed for so long that interest charges have been denied their place in the economic firmament, and the choice of timing their reappearance is irrational and haphazard. Banks, unanchored to principle, will act indiscriminately and seize the opportunity to get as much as they can from businesses already beleaguered by straitened circumstances.

(iii) High Street retailers whose business models are just beginning to acclimatize to the severe impact of internet shopping are now facing the additional punishment of losing basic credit insurance from underwriters sniffing the spread of retail decline. Retailers are granted normal credit terms (usually from 1 to 3 months) by their suppliers, provided those suppliers can buy insurance against default. Even an enforced reduction from 3 month’s credit to one month will have a material impact on a store group’s working capital requirements. A reduction in affordable credit insurance may therefore have been a strong contributor to several store closures, or near-closures, by household names such as Multiyork, BHS, Toys ‘R’ Us, Mothercare, Maplin, Poundland, Palmer & Harvey, Jaeger, Austin Reed, Beales, MFI, Woolworths, Debenhams, Carpetright and House of Fraser – now acquired by Mike Ashley of Sports Direct.

(iv) These and related factors (including onerous lease terms) will combine to create a state of affairs implacably averse to the restitution of normal terms of trade and, notwithstanding empty reassurances from the great and good, the trust implicit in any workable system will evaporate - and it will be each for himself.

[The breakdown will be followed, of course, by reassurances from the usual suspects, Lagarde, Draghi, Carney, Hammond et al, that this time the lessons have been learnt, and mechanisms have been put in place to ensure that the credit cycle will not wreak havoc ever again! If you believe this, you are condemned to studying my series of “Economic Perspectives” and “Going Postal” posts.