Wednesday, May 26, 2010

The Causes of the Coming Crash

If you watched the mainstream media and listened to our politicians you would think that the crisis of 2008 is behind us and we are slowly slowly recovering from what was such an unexpected shock!

Please consider the facts below when assessing whether we are in a recovery or not or whether we have more to come.


US Home Mortgages
  • The crisis of 2008 was the result largely of the sub prime mortgage market which was $600 Billion in size.
  • If the subprime mortgages were about lending money to people who really should not be lent to then Alt A mortgages and Option ARM mortgages were about lending too much to people who were normally a good credit risk. These types of mortgages offered an extremely low interest rate for the first few years but then would be reset to a higher rate a few years later.
  • As Alt A and Option ARM loans are being reset people are finding their new payments rising as high as treble their original payment.
  • You have to ask yourself if someone could afford the high payment they would have taken the original higher loan.
  • Total Alt A mortgages = $2.4 trillion, total Option ARM Mortgages =$750 billion. Option ARMs are currently defaulting  at a rate of almost 40%
  • Home owners were able to borrow money against the value of their homes - these are home equity loans, the total home equity loan market is worth $674 Billion


Commercial Real Estate

  • An explosion in consumer credit and the housing boom caused a huge expansion in commercial real estate, malls, warehouse space, office space and so on. Now the bubble has burst this will ultimately have drastic effects 
  • Between 2010 - 2013 $1 trillion of commercial loans will mature and need to be refinanced or paid off.
  • There is currently a 7% delinquency rate



Credit Card Debt 
  • Total outstanding credit card debt  almost $900 billion.
  • Average credit card debt is $15,788
  • Current default rate is 13.01%
  • When this credit card debt was amassed holders were paying 0% on their balance transfers. These days are well and truly over with. Some cards now have APRs of over 30%
  • Total US Consumer debt =$2.45 trillion.
Europe

  • An EU document released in 2009 estimated that $25 trillion would be needed to bail out European Banks of all their bad debts.
  • You have heard of Greece's woes, and know about the PIIG countries, what about Hungary, Latvia, Lithuania, Estonia, Poland and so on.
  • Deutsche Bank have liabilities (loans) worth over $2 trillion, much of these loans are to the PIIG and other Eastern European Countries. $2 trillion is over 80% of the German Economy. Germany would not be able to bail them out alone.
  • The combined liabilities (loans ) of the 2 largest swiss banks is double the GDP of Switzerland.
  • Barclays Bank has liabilities totalling more than the GDP of Britain
  • When we talk about leverage in very simple terms if you have a leverage ratio of 1:1 then you have very very little risk. If you have a leverage ratio of 100:1 then this is extremely high. All European Banks are leveraged higher that US banks. Much higher. Barclays has a leverage ratio of over 60 Deutsche Bank over 80 to name just 2.


Local, State and National Governments.

  • The US government has unfunded liabilities (future payments of social security and medicare etc) of over $100 trillion
  • 32 States in the USA are now insolvent.
  • Countries raise money by issuing bonds  and hope that these bonds are bought up by eager investors.
  • In the last year the US and the UK have been forced to buy most of their their own bonds because no one in the market wants them. This cannot carry on forever. The whole financial system relies on the creation of more and more debt.It is not just that these countries have a lot of debt, they are not really taking steps to reduce it.



The Derivative Market

  • In our explanation of the financial crisis we talked about Credit Derivatives related to the mortgage market. There is another type of credit derivative called a credit default swap. This is a type of insurance on riskier bonds. If the borrower defaults then the investor is insured against loss.  
  • The size of this market is estimated at. $45 trillion.
  • It is totally unregulated.
  • During the hayday anyone and everyone was issuing these Credit Default Swaps, including hedge funds that do not have the assets to pay up should the underlying security default. It's a bit like me offering you car insurance. Everything is great -, you think you are insured and I get $100 a month. Until of course you have an accident and we realize that I dont and never did have the money to cover any accident. 
  • There are many other types of derivatives, ( interest rate swaps, equity derivatives, commodity options and so forth) they are extremely complicated financial instruments created by "rocket scientists" who lead us to believe that they were able to eliminate risk.
  • It was these same rocket scientists and their belief in the end of risk that were the masterminds behind the subprime mortgages Option ARM and ALT A Mortgages. That saw the downfall of Long Term Capital Management and so on.
  • The total derivatives market is worth $1.4 quadrillion, bearing in mind if you sold everything in the world it would have a value of $600 trillion and the derivative market is $1.4 quadrillion!!!
Posted by Andrew at 6:04 PM 0 comments

The Causes of the 2008 Financial Crash

So we have looked at what is money and how it is created and hopefully got a good idea about why the system is so fragile, why we are always at risk of crisis and collapse. But there were specific factors that lead up to the 2008 crash, factors that are still in play and there is a high probability they will play out in further crises too.

Watch this clip - it sums up the essence of the problem at hand.




When Lehmans went bust in 2008 and the market crashed. The talking heads on TV were all coming out with their own complicated explanations about what had happened, this complexity (as we have talked about before) just obscured the basic fact which is - too much money was lent to too many people people who just could not pay it back and never could pay it back.


And when we talk about people what do we mean:
  • Homebuyers, 
  • Credit Card Holders
  • Companies
  • Countries 
  • States, 
  • Local governments,
  • Literally all sectors of life - all over the world


Why was this, don't banks have limits on what they can lend, aren't there rules and regulations to stop this happening? Once again the talking heads on TV will blind you with the science of Credit default swaps, CDOs and so forth. For a simpler answer lets go back to our model of chickens, potatoes and Bob the Banker.

Let's start by looking at how money was traditionally lent.

So lets say my chicken business is going really well and every month I deposit $1000 with Bob the Banker. Bob the Banker can then go and lend this money out to some of his customers. So then Tom is looking to borrow $500 to expand his wheel business so he goes to Bob and applies for a loan. Now Bob does not want to take huge risks he wont just lend to anyone. After all this is his bank's money, his job is on the line and he does not want to lose the money of his customers many of whom he knows personally.

Bob sits Tom down, checks out his history, has he been a good customer, has he repaid his debt on time. Is his business plan sound and so on, and only after serious scrutinization does Bob agree to lend the money. So Tom gets his loan, he has to pay it off in 3 years at 6% interest per year.

Bob the Banker Meets Willie Wall Street...
This was the way things worked for years and years until an investment banker (lets call him Willie Wall Street) arrived on the scene. Now Willie is a very intelligent guy with lots and lots of ways to make money, not only that he has lots of friends with loads of money to invest - everyone was going to be a winner!!!

So Willie says to Bob - instead of keeping that loan of $500 on your books, why don't you sell it to me. I will give you your original $500 back + $5 for your trouble. Bob loves this idea, he gets $5 up front and then has another $500 he can lend out to someone else

Willie then goes to his friends with this great investment offering 4%. They love this so everyone is a winner. Bob get 1% for setting up the deal, Willie's friends get 4% and Willie gets to keep 1% cut.

These investments become so popular that Willie is constantly on the phone to Bob trying to buy more loans from him and even tells him not to worry too much about who he is lending to because they have now got some highly complicated way to manage risk.

Also Willie's friends are just queuing up to get on board, so much so that some of them borrow money to buy these investments - they are such a sure thing.

Who are Willie's friends?

  • insurance companies, 
  • banks, 
  • pension funds, 
  • mutual funds, 
  • investment funds
  •  from all over the world........

This principle of taking a loan and turning it into an investment and selling it to investors  It was applied not only to the mortgage market but to:

  • credit card debt, 
  • corporate loans, 
  • municipal loans 
  • and sovereign (national) loans. 

he term for these investments is credit derivatives and this system of credit derivatives created a huge explosion in world wide debt and because the risk seemed to be dealt with somewhere else or through some complicated means large sums of money was lent to people, corporations and countries who normally would have been too much of a risk!!!!. Not only did the credit derivative market allow for anyone one to borrow money. It also made borrowing money that much cheaper.

In the summer of 2007 we saw the start of the problem in the Credit Crunch caused by the sub prime loan market - this was where mortgages were given to literally anyone who applied for them. As people started to be unable to pay back these loans it became obvious that these "investments" were bad and there was a mass exodus causing the bank lending system to freeze up. This sub prime market was $600 billion in size and it has essentially being the largest contributing factor to the collapse of many banks - Lehman, AIG, Morgan Stanley, Merrill Lynch and so on.

Considering that the total mortgage market in the USA alone is worth $8 trillion, add to that credit card debt, corporate loans big and small, national loans big and small you are looking at a total market size for credit derivatives of $65 trillion - this is the potential size of the problem.

To give a bit of perspective:
  • The world economy produces roughly $55 trillion per year.
  • If you sold everything in the world you would get roughly $600 trillion......
  • This problem is potentially $65 trillion in size.



There are a couple of twists to this story compounding the problem further
  •  Some of Willie's friends borrowed money to so they could invest with Willie, these investments are now worth much less but Willie's friends still need to pay back the same amount. Woops!
  • Because of regulations and risk appetite Some financial institutions were not allowed to or did not want to invest in some of the more riskier investments. To solve this problem another credit derivative was created - it was an insurance on the riskier investments. If the underlying borrower did not pay and the investment went sour the investor (apparently!) would be insured. This was great business and banks, hedge funds and many other institutions offered this insurance - what's more is was completely unregulated. It was great business as long as times were good, however when things started to go south and the investors wanted their insurance this created big problems and was actually the reason why AIG collapsed - we have not heard the end of this story by a long shot.
Further Deeper Collapses.......

Lets look at why we still have more trouble ahead.



Posted by Andrew at 3:36 PM 0 comments

Thursday, May 20, 2010

Gold vs Fiat Money: How is Money Created

Posted by Andrew at 4:07 PM 0 comments

How is Money Created

All Money is Debt - what does that mean? Lets look at how money is created to explain why this is true.

How is Money Created
Every country has a Central Bank, (the Federal Reserve, ECB, Bank of England and so on) the Central Bank is supposed to regulate interest rates and creates and controls the money supply.

This happens as follows.
  • The government decides it needs some money - lets say 10 billion dollars. It then goes to the Central Bank and asks for 10 billion dollars.
  • The government then draws up some official bits of paper called Treasury bonds and gives them to the central bank and the central bank gives the government 10 billion dollars in notes. Because of the nature of this transaction those bank notes are just bits of paper that indicating that the government owes money to the central bank, they are not backed by anything other than the governments promise to repay that money.

  • The government takes its 10 billion dollars and deposits it with their banker - lets call him Bob the banker. The really interesting thing is what Bob does with the money next. Lets call this the Money Multiplier



What is The Money Mutliplier
  • Lets say I deposit $100 with Bob the Banker. Bob has to keep $10 on deposit but is then free to lend out the remaining $90.
  •  Dave comes along and borrows the $90 and buys a new wheel from Tom
  • At this point Tom has $90 and I think I have $100 - a total of $190 but in reality Bob only has the original $100. 
  • When Tom deposits his money at the process continues. Bob keeps $9 on deposit and lends out the remaining $81 - another $81 created.
  • PROBLEM  If Tom and I go to the bank to withdraw our money at the same time Bob will not have the money. 
  • This is the Achilles Heel of the Banking System. If there was a panic and everyone went to the bank to withdraw their money there would not be enough bank notes to cover all withdrawals.
  • This is a run on the bank that no central bank or government wants.


In fact only 3% of all dollars and 6% of all Euros exist in the form of bank notes.

The money supply expands through the expansion of debt, through borrowing therefore the money is just a piece of paper indicating that debt. Money is debt






  • To highlight the ridiculousness of this situation. Lets say you came to work for me for 5 hours at $20 an hour. 
  • At the end of those 5 hours your write me a bill for $100 I then  hand you a $100 bill as payment.
  •  You have given me a piece of paper thats states that someone owes someone else $100.
  •  I then pay you with a $100 bill - another piece of paper that says someone owes someone else $100.

"Ah" but I hear you cry - you can take the $100 bill and then exchange it for goods at a store. True but only because everyone believes that the $100 has value, but beliefs can change very quickly.

If we look here at a chart of the purchasing power of the dollar over the last 100 years you can see that $1 buys today 5% of what it bought 100 years ago. Obviously belief in the value of $1 has changed radically over that time.



If you think of the story of the Emperor's New Clothes, there never were any clothes, it is just everyone was tricked into believing there were clothes and because everybody believed then so did everybody else. But once the little boy pointed out that the Emperor has no clothes on then that belief changed in an instant. There is no intrinsic value to the money we have, it is only supported by our belief that it has value. Our beliefs can change very quickly thus rendering our money worthless and the financial system collapsed.

Once you see that the whole system is supported by just a belief then you will understand why certain events can undermine currencies and collapse financial systems.

It is May 2010 and we are witnessing the start of a sovereign debt contagion - countries unable to repay loans. The media is focussing just on Greece and see how the perceived value of the Euro has plummeted. Confidence in the system is waning and therefore so is the value of the currency. Greece is just the start, it soon will spread to other parts of Europe and then across the world. It is these types of events that attack confidence in the currency often fatally so.


Posted by Andrew at 2:52 PM 0 comments

What is Money

When we talk about financial crisis really what we are talking about is money.In order to explain as simply as possible the causes of the financial crisis we really need to look at what is money. So lets go back thousands of years to a time when people bartered so understand where money came from.

Lets imagine I am a Chicken Farmer 


Lets also imagine that I have a friend Dave who is a Potato Farmer


And another friend called Tom who makes Cart Wheels











Now I like to have potatoes with my chickens and Dave likes to have chicken with his potatoes so we come to arrangement that whenever Dave wants to have a chicken I will swap him one for a bag of potatoes.



Equally I need a new wheel from time to time so I come to an arrangement with Tom that every time I need a new wheel I swap him 2 chickens and get my new wheel.



The problem arises when Dave needs a new wheel for his cart because Tom does not like potatoes they have no value for him. Dave has nothing to offer in exchange for a new wheel so we have a breakdown of the barter system.



So this is where money came in. Communities, societies, countries would find something that was commonly agreed had value and use this as a means of exchange. This has most commonly been gold and silver but tobacco leaves, shells and salt have also been used as a form of currency because they were all perceived as having value. So instead of swapping his potatoes for my chickens Dave could get gold or silver from me and then give that to Tom for a new wheel.


Note this that money is supposed to act as a store of value. I create value by raising chickens but may not wish to immediately exchange that value for other items of value (potatoes or wheels) so the money that we use is therefore used to store that value to be used at a later date. The money itself is not the value, I create value through my work and labor, I am the money, not the pieces of paper.

As time went by people got tired of carrying bags of gold and silver around so they would deposit this with a goldsmith who would then give them a receipt for their gold or silver which they could then use to buy things. This is how the modern banking system developed and even up until the late 1960s you could walk into a bank in the USA and exchange your dollars for gold. The money was considered "as good as gold" because it was redeemable in gold.

Today wherever you live in the world: Europe USA, Australia, Japan, Switzerland, your money is backed by nothing. It is printed out of thin air by governments, it only has value because they tell us it does - and we believe them. The only thing supporting the money is our belief and confidence in governments and the financial system, take away this confidence and the money is worthless.




You could say that it does not matter that they are just worthless bits of paper as long as everyone agrees that this is the method that will be used to do trade. That as long as you only create more paper when I raise another chicken, or Dave grows some more potatoes then everything should work fine.

The reality is is that money is not just worthless bits of paper, it is not just created every time someone creates more value.The fact is all money is debt - it is just a piece of paper saying that someone owes money to someone else

To explain what I mean about this we need to look at how money is created. Which we will go into more detail about in the next part.

Posted by Andrew at 12:50 PM 0 comments

Wednesday, May 19, 2010

Financial Collapse - A Simple Explanation



"The study of money, above all other fields in economics, is the one in which complexity is used to disguise truth or to evade truth, not to reveal it." - JK Galbraith




I don't know if you have ever noticed, but every time we have a market crash, a banking crisis, a currency crisis apparently no one saw it coming. You look in the newspaper, you turn on the TV and there are lots of commentators giving different complicated explanations. When Lehman Brothers collapsed in 2008, the pundits were talking about Credit default swaps, leveraged CDOs - all technical stuff but no one was really there explaining to the average guy on the street what this would mean to him and his family.

In this part I will try and explain in very simple terms the causes of the financial crisis in 2008 and why we could be experiencing further crisis in the future in spite of the media telling us we are in the clear and disaster has been averted.

I have broken this down into 5 parts:

Posted by Andrew at 3:22 PM 0 comments