Global financial crisis: September shockwaves
by Raphie De Santos
The effective nationalisation by the US government of Freddie Mac and
Fannie Mae highlights the very origin of the current global financial
and economic crisis.
These two agencies control almost half of the US
mortgage market. They were originally set up by the US government to
stimulate the housing market and hence the market for credit.
They were the pioneers of repackaging house loans into mortgage backed securities (MBS). These MBS were forerunners of the CDOs which are at the centre of the so called sub-prime credit crunch. Both entities faced the prospect of not being able to renew over £200 billion of borrowings on the money markets in September 2008.
Because house prices are still falling in
the US their mortgage book looks very unattractive to both investors
and lenders of cash to them.
It this drying up of credit to consumers
and the fall in their house prices that is reducing demand for goods
and the driving force in slowing world economies.
House prices and have fallen by over 20% from their
peak in the US and by nearly 13% in the UK. As we have shown, that along
with Spain, these are the housing markets with the largest house price
bubbles.
These declines will continue as the supply of money available
to lend to potential house owners shrinks and banks remain reluctant
to lend when the asset (the house) they are using as security is declining
in price.
Demand for mortgages is falling to as recession bites and people are losing their jobs or not feeling their job is secure. Brown’s removal of stamp duty on house purchases will do nothing to change the supply of funds for house purchases or the falling demand for houses.
This means that a prolonged recession or slump (more than two successive months of negative GDP growth) is on the card for the world’s major mature economies. In the second quarter of 2008 all the major mature economies slipped into negative GDP growth or flat growth apart from the US.
The US has escaped a decline in GDP because it cut interest rates very aggressively, pumped money into the money markets, gave tax cuts and the declining value of the US dollar meant that its export revenues came in higher.
All these factor have disappeared and the US is almost certain to have negative GDP growth in third and fourth quarters of 2008. The other major economies have reacted less swiftly to the crisis and have focused on fighting inflation by keeping interest rates high and have not cut taxes. They have paid the price with negative or flat growth and any measures they take now will have a much smaller positive effect on their economies.
The financial system is paralysed and despite central banks – the US and European in particular - pumping money into the system, lending has not increased. Instead banks have hoarded money to replenish their capital against further potential losses from complex derivatives.
Several medium sized banks – Lehmans and Merrill Lynch – are in trouble because their smaller capital base and exposure to complex derivatives make them potential bankrupts. Investors are unwilling to pump fresh capital into them because of this risk.
A second complex instrument hangs over the whole banking
industry: credit default swaps (CDSs).
These have been heavily sold by
banks to insure against companies going bankrupt. The prices of these
instruments has been rising hitting the balance sheets of the banks.
The
real crunch comes when companies start to go bankrupt and the banks have
to pay out on the insurance.
These products were sold in large volumes
from 2001 onwards when the global economy had just comes out of recession
– it is estimated that there is over $30 trillion of this insurance outstanding.
As we enter a recession the rate of bankruptcies will increase and the
recovery of assets from bankrupt companies will likely to be lower than
estimated in pricing these CDSs. Banks will take big hit globally – up
to £5 trillion worldwide. This is likely to take some banks down with
a domino effect through the banking system.
This is why the financial markets are so worried about Lehmans because it has exposure with CDSs and other mortgage related securities to other banks and financial institutions.
The major emerging economies – China, India and Brasil - have been hit
by the global downturn in the mature economies.
China’s GDP and manufacturing
growth rates have slowed down as the demand for their exports has slowed.
While not in recession these big slow downs have resulted in pain for
Chinese workers as factories have closed and workers have been laid of.
Domestic demand has been dampened in these economies as their governments
have chosen to raise interest rates to quell inflation. China’s massive
infrastructure spending programme is keeping its economy growing and
also keeping up demand for natural resources globally.
Inflation – both food and natural resource – hangs over the capitalist
system. Food inflation will continue as climate change affects crops
and the demand from China for western style foods will only diminish
slightly as the rate of Chinese economic growth only slows.
Natural resource
inflation is likely to slow after the speculative bubble of the last
two years had burst and global demand from the mature economies slows
as they slide into recession. However, we expect it to continue rising
at the rate of growth that we saw from 2000 to the middle of 2006 when
natural resources as whole saw their prices rise by 250%. This is largely
as a result of the massive infrastructure programmes going on in China
and the other emerging economies. This will give capitalism little room
for manoeuvre.
Lehman Brothers effective bankruptcy in filing for chapter 11 protection
marks the second leg of the greatest financial and economic crisis that
capitalism has faced since the great depression of the 1930s.
Lehman
Brothers is the largest financial bankruptcy in US history. On the same
day one of the big three investment banks, Merrill Lynch, was taken over
by Bank of America.
The Thundering Herd as Merrills was once known, does
not have as much mortgage backed exposure as Lehmans and the Bank of
America’ capital base could easily absorb any further potential losses
that Merrills may incur. On the same day the major bond insurer AIG failed
in its bid for buyout of its trouble hit business and is now looking
for a short-term loan of $40 billion from the US government!
Such were
the unknown extent of Lehmans future potential losses on mortgaged backed
securities and other derivative instruments that no bank or institution
was willing to step in and buy it for virtually nothing. The US government
has taken the gamble that the global financial system can absorb the
losses that investors all around the world will be hit with as a result
of Lehmans defaulting on its obligations.
The implications for the financial system and hence the global economy are far reaching. The money markets have frozen up again with short dated interest rates rising as nobody knows who has exposure to Lehmans and more importantly credit default swaps (CDS). CDS are the second leg of this great financial crisis. CDSs are insurance sold by banks to protect against companies going bankrupt. This price has risen from about 1.5% to 2% overnight wiping about $150bn off banks’ balance sheets.
We will come to be as familiar with CDSs as we are with sub-prime collateralised
debt obligations (CDOs). As we have pointed out some $30 trillion has
been sold over the last seven years by banks to investors.
There is a
double whammy as bankruptcies rise the value of these contracts increases
to the investors and the banks have to pay out any of the debt not recovered
when a company or companies on which the CDSs have been sold goes bankrupt.
The banks that have sold these products have seriously underestimated
the bankruptcy rate – not foreseeing a recession at or one of this severity
and overestimated the rate of recovery of a bankrupt company’s assets.
We could well see losses to the global banking industry of $5 trillion. As nobody knows who has sold these CDSs – they are unlisted, unregulated instruments – or on what companies, banks will be reluctant to lend to each other no matter if interest rates are cut or money is pumped into the money markets by central banks. This will dry up lending and push up the cost of credit. This will lead to further declines in house prices and the removal of credit as a tool to try and reflate the global economy.
The global recession will therefore be deeper and more prolonged with natural resource prices falling as the financial markets anticipate much reduced demand for them. Several medium and small banks are almost certain to go down as a result of CDS’s losses with the possibility that one of the major banks will follow leading to a domino meltdown of the global financial system.
Capitalism’s solutions to the crisis are unlikely to work. Tax rebates will be used to clear credit or be hoarded for that rainy day. Budget deficit spending will be inflationary and carried out on a modest scale. Much of the demand for materials from such projects will not benefit local economies but the natural resource companies and add further inflationary pressure. Energy savings’ packages proposed by governments will be passed back to the poor with higher energy prices.
The workers and poor of the world are starting to fight back and say it is not our crisis and we won’t pay for it. Workers from Boeing in the US to council workers and civil servants in the UK are striking for higher pay to maintain their living standards. The very poorest of our fellow civilians, who make up the overwhelming majority of the world’s 6.6 billion population, are marching and demanding basic foods in wake of shortages.
Capitalism has runs its course and its latest crisis has shown the emptiness
of neo-liberalism. It has opened up a debate about housing, the financial
system and the right to affordable food and energy. Socialists have an
opening to put the case for a rationale society based on meeting the
needs of the entire world’s population and that can use our finite resources
in a sustainable way. It is one we should all go out and seize.