The inherent instability of the giant Ponzi schemes underwriting the world economy means financial meltdown is a huge threat.Ann Pettifor
January 28, 2007
SourceAll last week doughty reporters from the UK broadcaster ITV braved the icy remoteness of the South Pole to bring home to us the truth about the role of fossil fuel emissions in melting that continent. Few journalists have shown similar bravery by venturing into the equally remote and secretive world of High Finance. But Gillian Tett, a Financial Times journalist systematically tracking the activities of hedge funds and the credit derivatives industry, last week related a
scary story.
It's the story of everyday life in the world of Haute Finance. Giant Ponzi schemes are being built on a narrow base of real money, and huge sums of borrowed money. The inherent instability of these schemes means that the threat of financial meltdown is comparable to the threat posed by the melting Arctic.
In the case related by Ms Tett, €20,000 worth of real money was invested in a "fund of funds". This money was used to leverage three times the amount in borrowed money. This new sum was then invested in a hedge fund, which invested the capital and the borrowed money into another highly leveraged financial instrument with a leverage ratio of nine. So the final investment of €1m has behind it €20,000 of real money, and €980,000 of debt. As the distinguished New York economist, Nouriel Roubini has
noted, "this is a credit house of cards where $1 dollar of capital is turned into $49 of additional debt to finance an investment of $50."
Most commentators, regulators and politicians are sanguine about this state of affairs. Cassandras and doom-mongers like myself are challenged to offer real-time predictions for the fall of this house of cards; and to predict key "tipping points". This we cannot do. And yes, we were wrong in believing that the financial bubble had "maxed out" in 2003 and should have burst if not then, at least since then. But then this is a truly extraordinary financial bubble. Total debt in the US now stands at nearly 3.6 times GDP. In 1929 it was 2.8 times.
John Succo, who runs a $1.5bn hedge fund, recently
asserted that it is the "guardians of the nation's finances" - central bankers - that have fuelled this debt, and explained how its done.
"If the Fed wants to inject liquidity (credit) into the system they simply call up large broker dealers and buy some of their bonds with credit they create out of thin air ... The dealer then passes this credit on to 'the market' by making loans to mortgage companies ... or whatever ... Because each layer of lender is only required to keep marginal capital on hand, a $1bn repo done by the Fed eventually creates as much as $100bn in new credit to the consumer ... This situation is very unstable in the long run. The Federal Reserve's balance sheet this year alone has expanded by $30bn in this way, and created $3.5trillion of new credit" (for which read debt) "in the US."How much more credit/debt will central banks pump into the system before the strain of repaying 980,000 euros of debt from a tiny pot of €20,000 becomes too great? And how will this year's $3.5 trillion of US debt be repaid? By extracting more assets and depleting the earth's resources further? By exploiting even more intensively the millions of people creating real wealth? Or will it simply not be repaid? Will there be a grand jubilee? Will both the innocent investors that provide small pots of 20,000 euros and the financial system that sustains this house of cards just be bankrupted?
On 11 January, the Bank of England began to exhibit some nervousness about the growth of debt - and
bemoaned its own creation - "credit and broad money growth". Then as guardians of the nation's finances they decided to rein in lending, by once again raising interest rates.
In other words, having encouraged the spread of easy, but costly credit the Bank, supported directly or indirectly by the Treasury, has now decided hurt those hedge funds maxing out on borrowing; and to punish the victims - millions of consumers that have propelled the economy forward and enriched financial institutions by borrowing. It is doing so by gradually turning the handle of the interest rate rack on which these borrowers find themselves stretched.
Where were these stern guardians of the nation's finances when hedge funds were created? Are these reckless borrowers regulated by the government and the Bank? Is the Bank aware of the extent of their liabilities? Are they speculating with our pension funds?
Where were our guardians when, as Creditaction
reveals, banks and other financial institutions made mortgages available at five times income; or 125% of the value of the house; or with a repayment term of over 50 years? What did the government or the Bank of England do when, between September and November last year, banks and other lenders sent out at least 100m unsolicited, but pre-approved credit card application forms? Where were the wise men and women of the Bank of England, when according to uSwitch, almost eight out of 10 borrowers were issued loans without the lender carrying out any checks to verify that they could afford to repay the debt? Over the last 12 months, 763,000 loans were issued, according to Creditaction - a church-based advice centre - for debt consolidation purposes. Yet 91% of these borrowers were not asked to prove that other forms of credit had been closed with the proceeds of the consolidation loan. Where were the guardians of the nation's finances then?
The answer of course is that both the Bank and the government decline to intervene in such unseemly affairs. The reason? The conduct of hedge funds, banks and mortgage companies is regulated by an "invisible hand". And so effective is this invisible hand at promoting competition amongst banks, for example, that the average interest rate on the virtually costless business of credit card lending is about 12% above base rate - 17.02%. According to the British Bankers Association, fully 75% of credit card balances were bearing this average rate of 17% interest in October, 2006.
Debts of €980,000 leveraged on €20,000; and usurious interest rates of 17%. It hardly bears thinking about. Which is why most do not. All hail the few who do.