With the financial crisis engulfing the
developed world a couple of months old its origins, causes and possible effects
can now be assessed as many of the underlying factors have become clear. Khilafah.com
in this two part series will asses the instability of the financial markets in
the West and its impact on the wider global economy and what the Khilafah has
to offer as an alternative.
Panic and turmoil gripped the world's financial markets in August as the US housing market bubble burst. The crisis threatens a worldwide economic slowdown, bringing to a halt more than a decade of increasing prosperity and employment for western economies. Such were the far-reaching consequences its effect was felt in the UK recently as Northern Rock (Britain 5th largest Bank) faced a bank ‘run' where many customers attempted to withdraw their savings in anticipation of its collapse. Its fortunes had its origins from the US housing market crash.
Understanding the Banking System
The obvious question to ask is how
Northern Rock found itself in a situation where it was forced to borrow from
its central bank, the Bank of England.
The answer to this question lies in
understanding the way in which banks in the developed world fund themselves.
Northern Rock funded itself by borrowing in the wholesale money markets (this
is the market where banks lend money to each other at a rate of interest lower
than the mainstream interest rate). Northern Rock as well as many other banks
issue mortgages and loans to customers at commercial interest rates; making a
minimum of 1% profit due to the difference between the wholesale (LIBOR) interest
rate and the commercial interest rate. This has been very good business for the
last decade due to two factors; the fact that demand for mortgages and loans
have been at an all time high due to Europe's appetite for housing and
expensive consumer goods, and also due to the fact that banks were very happy
to lend money to each other due to the general state of the credit markets
across the world, which meant that they could always recoup any losses quickly.
The problem with this financial model
is that borrowing at short term rates and lending at long term rates exposes
banks to changes in the inter-bank lending rate (LIBOR)
relative to the commercial rate in a downturn in the financial market. As most
banks around the world borrow what they lend such a downturn can have severe
repercussions. In the case of Northern Rock only 20% of its lending came from
deposits, thus 80% of what they lent was borrowed from the wholesale market!
Over recent months with credit markets
in turmoil, banks became increasingly wary about lending to each other as there
was a very good possibility that those who were exposed to the sub-prime sector
in the US would find themselves in a position where they would be unable to pay
any of their debts. The wholesale money markets that Northern Rock normally
turns to froze up, because such actions forced the LIBOR rate to reach 6.74%,
while the commercial rate in the UK was 5.75%. This means that it is now
costing more to borrow at the wholesale rate than at the commercial rate.
The Sub-Prime Mortgage Market
Many experts have been bewildered at
the effect the mortgage market collapse in the US has had on markets across the
world. Stock market prices in Europe collapsed, credit markets in South East
Asia froze and the UK economy has been drastically affected by events across
the Atlantic. This can be understood if one looks at how the sub-prime market was created,
structured and funded.
The US Sub-prime market was created
when the mainstream mortgage market became saturated and reached its peak of
profitability. Those with patchy credit histories and of low income were turned
away from mainstream mortgages at a time when the market was buyout due to
consumer spending and borrowing. The Sub-prime market was carved out after this
point as 25% of the US population fell into this category and represented a
market opportunity. Hence US lenders gave mortgages to people who had little
means to pay for a mortgage and charged them a rate of interest much higher
than the commercial rate for that privilege. They issued these mortgages safe
in the knowledge that if the buyer defaults, then they would be able to
repossess the property, and sell in a buoyant property market. By the start of
2007, the sub-prime market was valued at more than $1.3 trillion.
Many companies to ensure they didn't
lose out at possible money making opportunities in the sub-prime market
developed complex products so they could all have a share of the pie. This was
achieved by banks, hedge funds, investment banks and credit houses breaking
down the value of the sub-prime mortgage market and mashed up various home loans
into financial sausage meat - just as wholesome as the real-world equivalent -
and sold them on to the institutions, i.e. debt (money an individual owes you)
was sold to a third party, who would then receive the loan repayments and pay a
fee for this privilege. Thus debt becomes tradable just like a car.
With all bubbles they continue to grow
until an event brings to realization that the bubble has grown as big as it can
and then bursts in spectacular fashion. In the case of the sub-prime market it
reached a level where many borrowers reached a point where they were unable to
meet their monthly payments, thus they defaulted. The volume of defaulters
reached such a level that it deflated the whole property market; bringing down
the price of homes and creating the phenomena known as negative equity. This is
where selling the home on the open market would be less than the original
mortgage given to the lender. This then meant that repossessing properties and
selling them off would lead to a loss for the lender, since the value of
property has fallen. The net result of this led to New Century Inc the largest
sub-prime mortgage lender in the US to declare bankruptcy and by the end of
August half of the 25 sub-prime companies in the US collapsed and filed for bankruptcy.
The wider financial industry was
affected by the crisis in a number of ways in essentially what is an American
problem. The three common methods were as follows:
1. Mortgage-backed securities (MBS) - Many
were exposed to the sub-prime sector because they were owners of
mortgage-backed securities which were created out of the repackaging of these
sub-prime loans for consumption by investors. In simple terms this is where a
bank has sold a mortgage to a homebuyer, who then owes regular payments to the
bank in order to pay off the debt. This mortgage debt that banks are owed are
sold to buyers as an IOU; this means that this debt owed to the mortgagor is
sold to a buyer, who then receives the monthly mortgage payments. The problem
is that often this type of debt is sold as mere debt or a pool of mortgage
based debts lumped together into a form of asset or bond, each with different
degrees of risk attached to them. Thus owners of MBS's actually do not know the
source of where the payments are coming from or even which sectors they're
being exposed to. Those companies who bought MBS's were not clearly told that
they are dealing in risky sub-prime mortgage debt, which is considered a risky
security, but thought they are buying a less risky debt based security. MBS's
are worth over $1 trillion in the US.
2. Collateralised debt obligations (CDO's)
- Many institutions were exposed to the sub-prime market due to holding
collateralised debt. These are bonds created by another process of
deconstructing and re-engineering the mortgage-backed securities. This
essentially works by providing investors with access to the regular payments
received from mortgage payers in return for paying to have access to the CDO as
well as managements fees. The difference between this type of investment and
the one above is mainly that this investment is collateralised because the bank
puts the mortgage as collateral (since it is a mortgage backed security) much
like someone puts their house as collateral when they take out a big loan.
The problem is that many other debts
such as insurance agreements, loan agreements or even bonds are combined within
the same CDO; the idea being that if you spread the types of debt that the CDO
is based on, you spread the risk and lower the effect of a downturn in one of
its constituents. However, nobody counted on the whole mortgage sector
collapsing in this way, and since the CDO is spread over varying types of debt,
it became unclear to investors the extent of exposure to sub-prime mortgage
debt. As investors got jittery they started making cash calls to banks or began
pulling out before it was too late, causing big names such as Bear Stearns
Asset Management (an asset management company affiliated with a top US
investment bank) to suffer huge losses. For this reason, CDO's need to be rated
by a credit ratings agency, to qualify the risk it carries. Charlie McCreevy,
EU internal market commissioner puts CDO's as the main reason behind the
crisis; He states; "The origins of the current turmoil are very
simple...loans were made to people who didn't have the wherewithal to repay
them and all these thousands of loans have been packed off into CDOs
[collateralised debt obligations] sold off to others all over the world."1
1. Hedge funds
- suffered losses due to direct or indirect exposure to sub-prime loans.
A Hedge fund is a financial vehicle that invests in a particular product
portfolio or company, but hedges or protects its bets by ensuring that the risk
they are exposed to is minimised by other financial measures such as short
selling. Hedge funds are controversial because they are very secretive about
their workings and because legislation governing them is very lax.
Hedge funds brought into the various
types of mortgage products off-setting one loan against the other in the hope
losses could be minimised. The effects of exposure to sub-prime mortgage debt
to hedge funds is quite significant, since overall hedge fund activity is now
worth $1.7 trillion as of March 2007.
The Role of Central Banks
International institutes who poured
their money into the US realised they will not actually receive their money
that they loaned out to investors as individual sub prime mortgage holders have
now defaulted on mass on such loans and this then means all those who took
positions in the housing sector will not actually be in a position to pay the
institutes they borrowed money from. It was for this reason central banks
across the world intervened in the global economy in an unprecedented manner
providing large amounts of cash to ensure such banks and institutes do not go
bankrupt. The European Central Bank, America's Federal Reserve and the Japanese
and Australian central banks injected over $300 billion into the banking system
within 48 hours in a bid to avert a financial crisis. They stepped in when
banks, such as Sentinel, a large American investment house, stopped investors
from withdrawing their money, spooked by sudden and unexpected losses from bad
loans in the American mortgage market, other institutions followed suit and
suspended normal lending. Intervention by the world's central banks in order to
avert crisis cost them over $800 billion after only seven days.
Ever since there has been much
controversy in the media regarding the role of central banks, much criticism
was directed at Mervyn King, Governor of the bank of England and it has been
suggested that he should have acted sooner like the world central banks in
easing liquidity and in bailing out Northern Rock and guaranteeing the deposits
of its savers, since the Bank of England is the lender of last resort, which
essentially means that it is willing to extend credit when no one else will.
However this issue has political and economic motivations from the banking
industry.
There debate centres on the issue that
should government or central banks bail out institutions who find themselves in
financial trouble. Critics point to the ability of having a lender of last
resort as a temptation for an institution to take on more risk. A lender of
last resort provides a safety net to insulate the institution from the full
consequences of their risk. According to pure capitalist theory, if we have
such a situation where there is a credit crunch, the market should be left to
correct itself, even if it leads to pain and suffering for society. Central
banks and government interference is seen as a distortion to the flow of goods
and services around the economy, as they distort the free market, and they
should only be involved in the economy to regulate against fraud and other such
discrepancies.
Ironically, the most staunch advocate
of these free market views are the very same companies that are calling for
government interference. Hedge funds are renowned for their insistence that
governments do not intervene to stop their activities; they insist on keeping
their activities a secret. Many top FTSE 100 firms railed when governments
bought in legislation restricting the practice of asset stripping (which is the
buying of an ailing company at a cheap price and then repackaging its assets
and selling them on). Financial services reform after the last crisis in
1999 was met with resistance from global companies as it added another layer of
bureaucracy into the system. In short, the majority of these financial instruments
are predatory, manipulative and merciless in their quest for profits, and they
dislike any government restricting them from exploiting the markets.
It is for this reason that there is a
strong sentiment, even amongst western economists, that these companies shouldn't
be bailed out; they should be left to fester, and default as a lesson to
others. The Bank of England held similar views (although less extreme),
however, the reason why they pumped in billions into the financial system is
because the system is actually very volatile and as explained above the
collapse in one market has a negative effects on the share prices across the
markets. It also freezes lending between banks, as banks do not want to
lend to another bank whose exposure to sub-prime mortgage debt is unclear.
The net effect of this is that such a
negative effect on share prices and banking confidence will inevitably have an
effect in the real economy. The key to this is expectations; firm will adjust
their spending, investment and recruitment strategies according to what they
expect to occur within the economy in the coming years. If they are
expecting a collapse or significant downturn, they will begin to lay of staff
and spend less. As more and more companies do this, we get a vicious circle of
less spending, higher unemployment and less tax revenue for the government.
The Role of Credit Rating Agencies
The list of casualties in Europe and
elsewhere is expected to grow as it becomes clearer who holds debt which was
lent to the sub-prime sector. Many companies have already been affected due to
being tied to US mortgage defaults such as IKB, of Germany, and France's BNP
Paribas, as well as HSBC, Barclays and Northern Rock and Citigroup, some
companies have attempted to absorb losses by making redundancies.
US home loans had been pooled and
packaged into tradable securities by Wall Street banks, before being sold on to
financial institutions around the world. As they were bought and sold, these
mortgage-backed securities were valued according to the ratings given to them
by the credit rating agencies. Credit agencies (dominated by the big
three; Moody's, Standard & Poor's and Fitch) classify the risk of these
repackaged securities according to their exposure to risky markets. Critics of
the agencies have suggested the three firms were slow to downgrade ratings as
low quality US mortgage defaults increased. Some sub-prime-backed securities
for a time carried the same risk rating as high grade US Treasury bonds.
Other critics have raised deeper questions
about the relationship between Wall Street's highly paid financial engineers,
and the credit rating agencies. There is much skepticism about the independence
and motives of credit agencies, a sentiment expressed by a spokesperson for the
European commission said: "We have some concerns about the speed at
which the agencies acted [in response to the deteriorating US sub-prime
market]. Our review will be quite broad: it will look at the performance of
ratings and at the management of potential conflicts of interest." 2
It is not the first time credit
agencies' credibility has been called into question. Spotlight was thrown on
the industry after the 2001 collapse of Enron - a firm built on securitizations
as well as the role of credit rating agencies in the financial crash in the
Asian markets in the 1997. Charlie McCreevy, EU internal market commissioner
commented: "What's the common denominator between Enron, Parmalat,
special purpose vehicles, conduits and the like? They are off-balance sheet
vehicles where the risk has theoretically gone with them: tooraloo,
adiós."3
It is believed the amount of mortgage debt from the US housing market that has been repackaged and sold on is anywhere between £50bn and £250bn. The debt is sitting on the balance sheets of banks in the US, Europe and Asia. Since this debt is not easy to pin down, and currently it is not clear how this debt has been packaged and in what form it has been packaged, banks across the world, as well as Britain's major banks signalled that they were reluctant to lend money to rivals except at premium rates while the extent of the loans debacle in the US remained unknown. In effect, banks do not trust each other's financial dealings and hence any debt they take out could be backed by sub-prime mortgage debt directly or indirectly, and any money they borrow can potentially be lost due to other banks collapsing. Hence this is what is causing the credit crunch. Many economists are arguing that any restrictions on lending are likely to bring an economic slowdown next year or worse economic collapse as most of the growth in the world economy in the last decade has been funded by debt.
Understanding the collapse of the Financial Markets
The cumulative effects of all the above vehicles resulted in huge losses for all the institutions exposed to the sub-prime sector through the various complex products. The constituent elements of such products resulted in many holders of such debt to sell other investments in order to balance losses incurred from exposure to the sub-prime sector. This is what caused the collapse in share prices across the world in August, with the market getting into a vicious circle of falling prices, leading to the further sale of shares to shore up losses. This type of behaviour is what caused world-wide share values to plummet. What made matters worse was many investors caught in this vicious spiral of declining prices did not just sell sub-prime and related products; they sold anything that could be sold. This is why share prices have plummeted across the board and not just in those directly related to sub prime mortgages.
Furthermore, when liquidity (the
ability to sell assets and convert them into money) dries up in this way, all
sorts of "normal" relationships between different classes of assets
change. And that can lead to unexpected losses for many different institutions,
especially those which trade on the basis of computer models created from
processing past inter-relationships between markets or securities. Just
recently Bloomberg has reported just such losses for funds managed by Goldman
Sachs.
This explains why the sub-prime
mortgage market collapse has caused a crisis in the whole financial system, and
has had far-reaching effects much wider than just one market or sector.
The fragility, weakness and
vulnerability of the financial markets exist across the board in the capitalist
financial system; these can be seen from many perspectives.
- The first aspect of fragility is that the financial markets are built on illusionary factors which consistently cause uncertainty and instability. Most investment products are built upon debt; this includes mortgage debt, bonds and derivatives and other such things. Many financial assets have been built not only on debt, but on debt recycled at high velocity, a form of turbo-debt. This works by a company borrowing money to invest, such investments will include a wide verity of different debt based products, this debt will then be used as a basis to borrow more money, hence £1 of debt can act as equity to finance more than £100 of credit through complex leveraged financing (debt based financing). What this means is that borrowers in turn become lenders by effectively lending borrowed money! This releases a massive financial energy through a chain reaction of a tiny amount of initial equity, if that exists in the first place.
- Essentially the financial markets are a parallel economy which exists alongside the real economy and affects the real economy through various styles although it produces nothing tangible. The real economy consists of housing, land and property, factories, cars and goods etc these are tangible goods which can be traded, leased and sold i.e. they are physical goods which are produced, people are employed to make them and can be converted to other items which adds value at each stage.
The financial economy consists of
tradable paper which has financial values which rise and fall based upon the
value people give to them. They have become so sophisticated that various products
have been created which allow an investment in a paper based upon another paper
based upon another paper with no real asset represented. This side of the
economy is valued higher then the real economy, the size of the worldwide bond
market is estimated at $45 trillion. The size of the world's stock markets is
estimated at $51 trillion. The world derivatives market has been estimated at
$480 trillion, more then 30 times the size of the U.S. economy and 12 times the
size of the entire world economy.4
The problem with all of this is that
the financial side of the economy doesn't produce anything that can be
consumed, however most individuals and their wealth ends up in the markets in
the hope of handsome returns. Turbo-debt by definition is generated by practically
no equity and if debt is serviced mostly by the wealth generated from
debt-propelled asset appreciation, this creates a financial bubble which may
create short term gains, but is a crash waiting to happen.
For example, the financing of internet
companies during the dot.com bubble enabled the rapid growth of online
companies during the late 1990's. Many companies were financed by either
venture capitalists that saw record-setting rises in stock valuation and
therefore moved faster and with less caution than usual, choosing to hedge the
risk by starting many contenders. Many companies also turned to the stock
exchange to raise finance by floating on the stock exchange even thought future
earnings were unrealistic and many years away from profitability. When those
earnings did not bear fruit the dot.com bubble burst as the debt based investment
simply couldn't be met. The novelty of these stocks, combined with the
difficulty of valuing the companies, sent many stocks to dizzying heights and
made the initial controllers of the companies wildly rich on paper.
- The fragility of the financial markets is systematic; this is because speculation forms one of the basic motivations for institutions and individuals to pour money into the markets. The foreign exchange market trades $1.8 trillion daily, only 5% of this is for trade purposes, 95% is purely speculative, i.e. currency is being traded not to be used for trade but in the hope of selling at a higher and profitable rate. $1.26 trillion is traded daily in derivatives this is the market in which paper is brought betting on the price of other paper such as shares, currency, interest rates and bonds. This market represents speculation at its highest peak, and the sheer size of it shows the amounts individuals are prepared to speculate with. The dot.com boom, telecoms boom, the railways boom in the 1880's and the automobile boom share one very worrying characteristic which continues to fuel financial market activity. That is money was borrowed and poured into the markets which fuelled the bubble, the price of the assets rose to levels which were well above the real value of the asset. Many institutions continued to pour money in order to make profits with the money mostly being borrowed, and then an event occurred which proves to everyone that prices have reached a level where they will not continue rising, at this point the bubble bursts. Speculation inflated the price of housing in the sub-prime sector not the demand for housing by homebuyers, as a result the boom and bust in economies and markets will continue as speculation is a herd activity were making profits is placed above all else. Taking on risks, companies taking on risky ventures and people speculating with more and more of their money cannot be dealt with any amount of regulation or legislation. This is why markets crash regularly, and every boom is followed by a crash or a downturn.
- All sectors of the economy feed into such speculation. Banks invest the money received for Pensions on the financial markets and use the returns to pay out pensions. Insurance companies use the proceeds from premiums and invest on the markets. High street banks use their customer's deposits and place the money on the financial markets and use the profits made to make interest payments owed to their customers. Companies place substantial amounts of their profits and reserves to accumulate returns from the stock exchange. Everyone's money in some form or shape ends up in the financial markets weather directly placed by themselves or not. For these reasons institutions make the returns but the average person suffers the consequences of such speculative bubbles by higher prices, higher interest rates and on many occasions unemployment. Every strata of society has a stake in the parallel economy weather they like it or not, and because everyone is trying to make a killing speculation is always an inevitable matter. Instability will always exist as long as such markets exist.
- Greed is enshrined within the financial markets. Greed is the motivation that led to predatory mortgage brokers selling mortgages to people that have no way in paying it back, and then increasing the rates of interest until the buyer defaults. Greed is also the motivation that led the credit ratings agencies to rate the investments less risky than they were, and also to conceal that the risk was based on sub-prime mortgage debt. Hedge funds demonstrated greed in the way they seek to provide astonishing returns to their customers, and greed is the motivation even for individual shareholders that want to capitalize on the falling share prices across the economy, even though it can lead to problems for thousands of people. The effect of this is devastating; since each element within the system puts their benefit before ethics, morals and the impact on the wider economy, this is why we have a situation where even though the effect of investment decisions can lead to a downturn in the economy, companies are prepared to make those decisions anyway. The biggest problem here is that this motivation is seen as a virtue. Greed is good; so we are told, and hence we can see that this is a systematic problem; i.e. it is enshrined in the financial system.
Muhammed (saw) defined this well when
he said; "If the son of Adam had one valley of gold, he would want
another"
- The existence of the financial markets is a key factor that leads to wide disparities in wealth distribution in the West. Most wealth remains amongst a circle of people, while risks are suffered by the masses. The last two decades has seen an unprecedented level of wealth generated by the financial markets. Companies make billions of dollars each year, and this is deposited into the accounts of shareholders in the shape of dividends. The likes of Warren Buffet, Donald Trump, and Bill Gates earn more each year than the GDP of some of the poorest countries. Yet we find that this newly generated wealth is not distributed around the economy and very little of it reaches the average person, since progressive taxation is not reflective of the wealth generated, and in most cases the wealthy can avoid taxes through creative accounting, offshore accounts and other measures. The UK generated wealth (GDP) of £2.2 trillion in 2005, this was an increase from the previous year. However if we look at how much the 60 million population of the UK received of this generated wealth we see there are huge disparity, 2005 statistics from HM Revenue and Customs show that the richest 10% have more then 50% of the nation's wealth and that 40% of the British population shared in only 5% of this wealth. This has resulted in the majority of the population resorting to borrowing to fund their lifestyles hence UK consumer debt is more the £1.3 trillion, even more then Britain's GDP. The US situation is even worse, the US may generate $12 trillion a year in wealth but National debt is $8.5 trillion. This means US citizens are funding their lifestyles by borrowed money rather then the $12 trillion the economy generated. In a 2005 Harvard report it was calculated that 60% of earned income in the US was by the top two highest earning brackets (i.e. minority of the population). The report also highlighted the majority of people in the US only received 40% of income that was generated.
Because there is no motivation for
direct investment around the economy newly generated wealth goes back into
interest bearing investments; and hence out of circulation around the economy.
The risks associated with bad investments are then borne by the masses in the
shape of rising inflation, increased house prices, as well as recessionary
effects. The average person deposits their money into banks that use his
deposits to finance the banks investments via fractional reserve banking, and
yet they don't see the gains from that, but stand to lose their deposits if the
bank collapses.
- The western system creates a mindset that only cares for making profits however they are made. Very little attention is paid to the suffering and misery that such actions can cause, and perversely we have a situation where companies prey on the suffering of the people. In the search for profits and increased profits we see the suffering of the masses whether from Nigeria to Indian to Uzbekistan. Even in western countries companies ruthlessly prey on the consumerism of the masses. The sub-prime housing sector is exactly that, it is an act of exploitation as companies offer big loans to people with bad credit histories as long as they offer their house as collateral! Since the targeted people are the most likely to have a spending problem, these loan companies will then repossess the house and sell it to obtain their money plus the extortionate rate of interest added on top.
From this exposition it should be clear
that the current crisis proves once again that the financial markets for all
its glitz and glamour constantly crash bringing misery for many, only a handful
of rich capital owner's benefit from the markets due to the influence they
yield. What needs to be discussed is how an alternative system will solve such
problems and provide opportunities for investment.
In part 2 an outline will be provided on the Islamic economic system and how it will solve the problems we have witnessed in the financial markets, how it will provide investment opportunities, a stable economy and wealth for the people.
Or,
No comments:
Post a Comment