Economlc crisis - towards the chaotic "hard landing" of a bankrupt system?

Sept/Oct 2008

This September started with the London stock market experiencing its worst ever week since the "dotcom" speculative bubble crashed, seven years ago. By the end of that week, the FTSE 100 index of the 100 largest companies listed in the City, had fallen by 7%, thereby wiping out over £100 billion of share value. By what seemed to be a paradoxical twist, given the surge in commodity prices over the past months, the shares which were hardest hit and leading the market's sharp fall, were those related to mining (which lost 14%) and those connected to oil and gas (down by 8%).

But, as it turned out, the following week was to be even more ugly. Only, this time, the eye of the storm shifted to Wall Street.

Ironically, however, that week started with what seemed to be positive indications. Market operators were relieved by the announcement made by the US Treasury and the Federal Reserve Bank, on September 8th, that a bail out package had been put together for the country's two largest mortgage lenders - Fannie Mae and Freddie Mac - which were on the verge of insolvency. In fact, this bail-out was as close as it could get to nationalising the two lenders, together with the mortgages they held or guaranteed (half of all US mortgages!), without saying it formally. Indeed, in return for what amounted to a capital injection worth £110 billion, the US government had reserved the right to take over ownership of 80% of the lenders, without having anything more to pay for it.

Another storm and more casualties

At first, this announcement kick-started an otherwise gloomy Wall Street stock market and share prices rose sharply on the news of the bail-out. But less than two days later financial shares began to lose ground. By the end of the week, the shares of Lehman Brothers, the fourth largest US investment bank, had lost 77% of their value. Those of Merrill Lynch, the world's largest brokerage firm, had plunged by 33%, as did the shares of Washington Mutual, a major mortgage lender. Nor was this sudden fall confined to the banking sector. For instance, the shares of two large insurance companies - American International Group (AIG) and MBIA, which both made heavy losses in their debt insurance business - lost 45% and 22% of their value respectively.

This abrupt fall in financial shares led the US government to embark on a frantic spell of activity over the weekend. Ten of the world's largest banks were prompted to set up a voluntary joint £35bn-fund designed to intervene on the financial markets in case trading was suddenly frozen for one reason or another - as such a freeze would merely precipitate the stock market's downward trend and propel interest rates even higher.

For the first time since the beginning of the credit crisis, the Federal Reserve Bank announced that it would lend cash to banks, in the form of easily negotiable state bonds, in return for any kind of shares, and not just debt bonds as had been the case before. Obviously the US authorities feared the impact that financial institutions could have if they started offloading their devalued shares on the stock exchange in order to raise cash and avoid further losses - this could only push share prices even further down, with unforeseeable consequences.

While insurer AIG was seeking a £20bn emergency loan, first from the Federal Reserve Bank and then from its shareholders, in order to offset its losses, the news broke out that Lehman Brothers was filing for bankruptcy. This was the largest US investment bank to go to the wall since the downfall of Drexel Burnham Lambert, in 1990, following the collapse of the aptly called "junk bond" market. But Lehman was not the last of that week's casualties. Almost at the same time came the announcement that Merrill Lynch was to disappear, being bought by the giant Bank of America for just under one third of its 2007 valuation.

Thus, over just this weekend (13-14 September), two of the USA's leading banks have disappeared. This brings the total of major US banking casualties of the credit crisis to five, following the end of mortgage lender Bear Stearns (acquired in March by the JP Morgan bank, on the instigation of the US financial authorities, which backed up the operation with a £15bn state loan) and the twin lenders Fannie Mae and Freddie Mac, by then virtually nationalised.

Navigating on sight

What these failed banking institutions had in common was to have accumulated billions of pounds worth of mortgage-backed bonds on their books. When the speculative housing bubble finally burst in the US, many of these bonds became virtually valueless and had to be written off - for a total of £25bn in the case of Merrill Lynch and £22bn in the case of Lehman Brothers - thereby pushing their balance sheets into the red.

In order to make up for these losses, the banks had to borrow large sums on the money market, whether by selling some of their credit-worthy assets, by issuing new debt bonds or by resorting to frequent short-term borrowing from other banks. But whichever method they used, they were faced with a market in which many financial institutions were themselves short of cash due to their exposure to bad debts and were therefore unwilling to lend, while other potential lenders were unwilling to part with their cash unless they were offered a big risk premium.

This situation was highlighted, for instance, when, in late August, Merrill Lynch decided to raise fresh cash by selling a big portfolio of debt bonds. Although these bonds were not considered "risky", there was no buyer for such a large quantity on the free market. So the bank had no option but to make a deal with speculative fund Lone Star, whereby the latter bought the whole portfolio for only 22% of its £15bn theoretical market value - a loss of nearly £12bn for Merril Lynch!

However, while Merrill Lynch and Lehman Brothers are the latest casualties (and the biggest so far) of the credit crisis, it does not follow that they will be the last ones. Indeed, judging from the total £250bn worth of worthless mortgage bonds which have been written off by banks so far in the rich countries, many other banks have admitted to have suffered large losses due to the collapse of the housing bubble. And no-one can say whether these banks are really safe.

For instance, HSBC, Britain's largest bank, may appear to be a minor delinquent compared to Merril Lynch, with "only" £5bn written off its books. But then this does not make HSBC less dependent on the money market than most other banks, for the financing of its investment business. Nor does it make it less exposed to defaulting customers - in particular among corporate customers since HSBC is a big player in corporate lending. So even a bank with a relatively small exposure to the housing bubble crash itself, could very well end up being severely thrown off balance at some point.

Will the US financial authorities' intervention stop a further worsening of the situation on the financial markets and banking system? Will it prevent more partial or total bankruptcies from taking place? And if it does not, will it prevent the snowball effects that such events may have? No-one knows for sure, least of all these authorities themselves, which have been navigating on sight, obviously reacting to problems as they presented themselves, rather than according to any kind of thought-out plan.

But then, it is true that trying to design a rational strategy to protect this economic system against the current crisis, amounts to trying to protect it from its own chaotic and irrational workings, which is much like trying to square a circle! So that there can only be more uncertainties than certainties, as regards what will come next in the present crisis.

More financial chaos in store?

In fact, even some of those who live off the financial markets acknowledge these uncertainties as a fact. Thus a market operator quoted by Reuters commented after Lehman Brothers went to the wall: "this just confirms that we are nowhere near the end of the crisis. And it could get really ugly in the next six months or so, because there is a lot more to be uncovered." Hardly an optimistic assessment of the US authorities' fire-fighting exercise!

Indeed, there is every reason to think that, despite the efforts made by the financial regulation authorities of the rich countries to convince bankers - and even entice them, using hundreds of billions of pounds of public money as was the case in Britain - into coming clean about the real volume of worthless debt bonds they still hold in their coffers, they probably still hide a lot more of those than they have written off, using the myriad of legal accounting tricks at their disposal. After all, the "bad" debts written off by the banks so far represent only a minuscule proportion of the total debt issued over the past years. To give an order of magnitude, they represent less than 17% of the debt bonds issued in 2006 alone!

So, the odds are indeed that "there is a lot more to be uncovered", especially as the bulk of these bonds are not actually traded on regulated markets, but in so-called OTC (over-the-counter) markets, where there is no actual control nor reliable statistics. It is on these markets that much of the speculation on debt bonds takes place, using so-called "derivative instruments" (in other words large bets financed on credit) in a way which is completely opaque. In the early 1990s, the "junk bond" crash had a devastating effect because so many punters were involved - including many respectable banks - and because a speculative bubble had developed behind the scenes on the junk bond market, which suddenly burst without warning.

The same could happen again on the OTC market for debt bond derivatives, as was explained to Reuters by the chief investment officer of a fund operating in this market: "The risk of an immediate tsunami is related to the unwinding of derivative and swap-related positions worldwide in the dealer, hedge funds and buyer universe." In other words, if operators in OTC markets come to the point of considering that, due to the on-going banking failures and freeze in the regulated money market, the going is getting too rough for their taste and that their safest bet is... to get out of their current bets, it could spell a much bigger financial "tsunami" involving considerably larger volumes of debt bonds.

They knew it was going to happen

There is a stark contrast between today's rather pessimistic assessments of the credit crisis, over a year after it broke out, and those which were made at the time, last summer, when most economic "experts" explained, in unison with the heads of the state's central banks, that there was nothing to worry about. They claimed that it would be a mere "re-adjustment" in the housing and mortgage market, something that should be welcome, because it would make the economy healthier and houses more affordable, and, anyway, it would not last long.

Hindsight makes commentators wiser, of course. But now that the crisis has settled down to last, it also makes them a bit more honest. From this point of view, it was worth reading some of the countless analyses of the crisis which were published in August for its first "anniversary".

Thus the Financial Times published a series of 4 full-page articles entitled "The big freeze". This series starts by admitting that "the sense of pressure on western banks has risen so high that by some measures this is now the worst financial crisis seen in the West for 70 years" - i.e. since the 1929 Crash and the banking crisis which followed.

Then comes the explanation for the crisis: "Over the past decade, western banking has experienced an extraordinary burst of innovation, as financiers have discovered ways to slice and dice their loans - such as the now controversial subprime mortgages - and then turn these into securities that can be sold to investors all over the world. Tracking the scale of this activity has always been hard, since much of it occurs in private deals. However industry data suggest that between 2000 and 2006, nominal global issuance of credit instruments rose twelvefold to £1,500 billion a year, from £125 billion. This activity appears to have become particularly intense from 2004, partly because investors were searching for ways to boost returns after a long period in which central banks had kept interest rates low."

In other words, the purpose of this astronomical development of debt bonds was both to conceal the real nature of the debt (by slicing and dicing) and to generate a large artificial market in which lenders could "subcontract" their loans to others more easily - and therefore lend more to their customers. Meanwhile investors could make significant gains by speculating on this huge volume of paper which was circulating at great speed across the world.

Of course, all this was a purely artificial framework in which paper value was created without having any counterpart in the real world. The Financial Times acknowledges that before the crisis broke out, "some policy makers and investors were uneasy about the scale of this explosion. In particular there was growing concern that slicing and dicing was fuelling a credit bubble, leading to artificially low borrowing costs." So much so, says the FT, that officials from the Bank of International Settlements, the regulator of the world banking system, "warned that risked dispersion might not always be benign." By the January 2007 economic summit in Davos, "Jean-Claude Trichet, the governor of the European Central Bank complained about the opacity of some financial innovation and warned that there could soon be some 'repricing of credit risk'." In other words, the experts of capital knew all along that there was a speculative bubble in the making and that at some point or another, this would result in a crash, in which low-cost credit (i.e. subprime mortgages in the housing market) would be the first victim and credit costs would rise again, at the expense of all borrowers.

In fact, adds the FT, financial experts knew this so well that, as early as 2006, Deutsche Bank, for instance started to put its money on the expected crash, by betting on subprime defaults, while US bank JP Morgan and a number of speculative funds stopped buying debt bonds from the beginning of 2007.

None of this is really surprising, of course. The capitalist class has enough consultants and experts to be warned against the risks to its own system resulting from its frantic search for profits. What is instructive, though, is the fact that the very people who are supposed to "regulate" the financial system of capital, actually regulate nothing, despite knowing exactly what the risks are. Ultimately their only function is to act as fire-fighters once it is too late and the damage is done, on an adhoc basis, as Trichet did in Europe and Darling in Britain, by injecting massive funds into the financial system, after the crisis had already broken out, and as the US regulators are doing today, by underwriting the bailing out of failing banks.

If anything, this is a lesson that is well worth meditating on, for all those who argue that all that is needed for the capitalist system to work without such "hitches" is tighter regulation.

From finance to the real world

A graphic illustration of the cost of the bursting of the credit speculative bubble is provided by the collapse of the XL Leisure group, Britain's 3rd largest tour operator, on 12 September. As the media reported, it left 85,000 holiday makers stranded across the world, due to the grounding of XL's aircraft fleet. Most of them will get no compensation because such circumstances are usually not covered by travel insurances. By the same token, it will mean that the company's 1,700 employees will lose their jobs without any compensation.

The media was quick to blame the rising cost of kerosene for XL's financial difficulties. However, a very different story soon filtered through, pointing to the decision of one of XL's banks to terminate its on-going line of credit. Overnight, the tour operator found itself unable to pay its bills and went straight to the wall.

Now, why would a bank end its line of credit to one of the country's biggest tour operators, which has enough customers to guarantee that it pays its debt off, in due time? Why, if not because, due to the current credit crisis, the banks are having a hard time raising the cash they need to offset their losses and have, therefore, to reduce their outlays. Not that the banks have no responsibility in all of this, of course, since it was their greed which was instrumental in creating the credit bubble in the first place.

But the fact is that credit is the oil that is needed in order for the cogs of the capitalist economy to operate smoothly. If it was not for the vast amount of credit available - which is nothing but the redistributed cash and savings of the population - the economy would come to a standstill, purely and simply. And when credit becomes difficult to obtain, or too expensive, the result is to cause casualties among those, individuals or companies, who need it to keep going. From this point of view, Alistair Darling was telling the truth, for once, when he declared to the Guardian that the current crisis was the worst since 1929.

Through this mechanism, the credit crisis spreads into the real economy and claims its toll. To be sure it has already been the case for months in housing and the construction industry. The number of house starts is now only a fraction of what it was last year, while building sites are mothballed in the hope of a future recovery in the housing market. Mortgage authorisations are at an all-time low and only middle-income families which can fork out a 35% deposit have any chance of getting one. As to remortgages and personal loans, they are scarcely available at all, except for the better-offs.

Meanwhile an estimated 50,000 workers in construction and related industries have now lost their jobs. The retail and leisure industries are shedding jobs left, right, and centre, as a result of lower spending by consumers. Every bankruptcy in finance comes with its load of redundancies. Thus Lehman Brothers stands to shed 26,000 jobs worldwide, out of which 5,000 are in the City. And many of these jobs are not the high-flying high-bonus jobs that the media describe, but low-paid back office jobs - and the workers losing them will have a hard time finding alternative employment.

There have been numerous warnings about rising unemployment lately. Even the government's carefully massaged jobless figures are beginning to show this increase. And a number of bodies which are closely linked to the political or business establishment, and therefore unlikely to show much sympathy for workers, are now estimating that the number of unemployed as defined by the ILO (seeking work and available for it, excluding older workers close to retirement and those on disability or sickness benefit) should go over the 2 million mark by the end of 2009. Taking into account those casual workers who are chronically under-employed, this may mean a real jobless army of 4m+ workers.

Such is the cost of this dysfunctional social organisation, in which the greed of a tiny minority of capitalist parasites can spell chaos and hardship for the overwhelming majority of workers who produce everything in this society and without whose labour nothing would work. If there was ever a case for getting rid of this bankrupt system, with its private profiteering and chronic crises, and for replacing it with a social organisation at the service of the entire population, this is it!