In past issues of FRFI we have shown how capitalism has been staving off its inevitable crisis in part by propping itself up through a massive expansion of credit and loans. This has taken a wide variety of forms: the US state has been financing itself by borrowing from foreign lenders and US consumers have kept spending by taking out loans against their houses for example. This credit has helped sustain the expansion of US capital, despite its inherent tendency toward crisis, by financing production beyond the limits which would normally be set by profitability. Steve Palmer reports
Credit and speculation
This expansion of credit has sharply increased in the last two years. The US ‘money supply’, the sum of the most liquid forms of money: cash, checking and saving accounts, money market accounts etc, has grown by some 12.6% since January 2005, about the same rate as production. But other, slightly less liquid forms of money, such as eurodollars, ‘Repos’ (repurchase agreements) and large time deposits, have been growing much faster than the basic money supply: by 31.8%, 44.1% and 67.6% respectively over the same period. This is a symptom of a sharp credit expansion, largely outside the normal banking system.
An example is the New York Stock Exchange, where so-called ‘margin debt’ has increased by an astonishing 67% in the year to June 2006, to $378.2bn, helping to fuel the current run up in stock prices. Margin debt is an example of ‘leverage’: a buyer arranges with a broker to borrow ‘on the margin’, enabling them to purchase up to twice as much stock as their actual cash reserves would permit. Instead of spending $10,000 on stocks, the buyer can spend $20,000. If the stock goes up by 10%, he’ll make $2,000 by borrowing on the margin instead of $1,000.
This sort of leveraging is going on everywhere. Private equity funds borrow money to purchase companies which they expect to reorganize and resell – so-called ‘Leveraged Buyouts’ (LBOs). Hedge funds use leverage to purchase exotic financial instruments – forms of fictitious capital. While investors in these funds may gain, their managers always do.
Both types of funds grew out of the massive ‘deregulation’, which, beginning in the 1980s, enabled such financial organisations to emerge alongside banks to engage in lending and borrowing of all kinds. Free of the tight restrictions on the banks, they are able to provide better rates and more attractive options, usually at the expense of increased risk to both borrower and lender.
Since capitalism cannot operate in any kind of planned manner, speculation serves as a vital mechanism redistributing and concentrating capital. Yet this mechanism also helps inflate the prices of assets and fictitious capital. These leveraging activities, for the most part, simply redistribute surplus-value amongst capitalists, but do nothing to increase it. Indeed, their in_crease is itself a symptom of the underlying decline in profitability which is going on. At some point these speculative activities run up against hard barriers created by the crisis of profitability. This is what is happening with the ‘sub-prime’ mortgage crisis.
The sub-prime mortgage crisis
There has been a massive growth in US residential mortgage lending in the last two decades. Initially this was for house purchase, then ‘refinancing’ developed to borrow against the remaining equity in a house. When those opportunities began to dry up mortgage lenders turned to those who normally found it impossible to get a mortgage – the poor and risky borrowers, selling them what are called ‘sub-prime’ mortgages. The most popular variety sets initial interest rates low to enable the borrower to buy a house. But, after a period of time (2-5 years), the loan ‘resets’ and a much higher rate of interest is charged. Perhaps a quarter of all mortgages in the US are sub-prime.
Another innovation has been to ‘securitize’ the loans. Traditionally, the lender would hold the loan until it was paid off. With securitization, as soon as the loan is made, the mortgages are packaged up and sold off to investment bankers as Mortgage Backed Securities (MBS) – some $2bn alone last year. The lender gets its hands on a bundle of money, which it can promptly lend out again to other borrowers and repeat the process. Since the mortgages are of high and varying risk, MBS are difficult to sell on, so the investment bankers slice, dice and shuffle the MBS, sorting them into ‘tranches’ – slices. These are now packaged up and renamed as Collateralised Debt Obligations (CDO) with tranches of varying risk. The issue of CDOs has shot up from $25bn in the first quarter of 2004 to $158bn in the first quarter of 2007. The safest are called investment-grade, rated AAA. Even if there are failures, these bonds will be fully paid – in theory. So-called ‘mezzanine’ bonds, and equity bonds carry greater risk with far less likelihood of payback in the event of failure. The price changes, due to the changes in house prices, is concentrated in the equity portion of the CDO – indeed, in the event that house prices rise, the price of the bond can rise above its original purchase price. This makes them a particularly attractive asset.
The investment grade bonds are relatively easy to unload onto more conservative financial organizations. The riskiest bonds – equity and mezzanine, say 30% of the original MBS, are cheerfully known in the industry as ‘toxic waste’. The problem is: where to dump this stuff?
The investment banks go to the large public sector pension funds which got burnt during the tech boom, and offer them this high-risk, high-return tranche of the CDO. Or they may sell to or even initiate a hedge fund which buys up the toxic waste. With house prices rising, the hedge fund uses the now higher-priced equity CDO as collateral to borrow money, its total value increases, attracting money drawn by its apparently high rate of return. The pension fund manager loads up with more of this sludge. Everyone gets excited, wants to join the party, scared of ‘missing the bus’ (a sure fire sign that they already have). More money gets thrown to the funds, prices go up and, it seems, we have money creating money creating even more money. Pension and hedge funds have taken 7% of the investment grade CDOs, but slurped down 28% of the toxic sludge.
But, like all wild parties, sooner or later, the music and the dancing have to stop. Far away from Wall Street, across the US, borrowers’ mortgages are being reset. Unable to meet the payment increases – which can be 50%, 100% or more – the borrowers default, the banks foreclose on the loan and sell off the houses. In June, 164,444 foreclosure notices were issued – up 87% over the year. Generally house prices have grown at a similar rate to general inflation, but in the decade from 1996, the consumer price index rose by 28%, while the house price index rose by 208%. This housing bubble has now popped and is in free-fall. Not only is the revenue stream on mortgages disappearing, but the underlying assets which are supposed to act as collateral are collapsing in price. The former home owners are now homeless, and still in debt.
Back on Wall Street, the CDOs, which have been flying high, are now of unknown value. This was the position that two of investment bank Bear Stearns’ hedge funds found themselves in at the end of June. The bankers who supplied the leverage debt turned round and demanded their money back. When Bear Stearns couldn’t come up with the money, some banks grabbed the securities as collateral. When Merrill Lynch tried to auction off the $850m of bonds it seized, it could only unload $100m. There is no open market for these illiquid securities, where they could be traded and ‘marked to market’, so nobody knows what the price should be. Indeed, the pricing of the assets is so complicated that it took Bear Stearns’ best and brightest three weeks before it could announce to investors that the ‘high grade’ were almost or entirely worthless.
What is significant about this is that the ‘high grade’ funds had invested in AAA or AA – investment grade – CDOs, not toxic waste. Remember: these are the CDOs which are supposed to return their premium no matter what. Pension and hedge funds clutching toxic waste CDOs, at the other end of the scale, are now holding ‘assets’ that are little better than toilet tissue. This is just the first round of financial musical chairs which is going to shake out these risky assets. The wave of foreclosures has only just begun and will continue as long as resets continue. The housing market is in near paralysis, since, with falling prices, only the desperate are ready to sell. House prices have reached nothing like the bottom we can expect to restore the parity with consumer prices in general.
Where, when and how this is going to end is impossible to predict. But we know that it is the poor and oppressed, the working class, who will be expected to bear the weight of this collapse. It has begun with the workers who have been enticed into buying homes with sub-prime mortgages. It will extend further, cutting the pensions of teachers, fire-fighters and others whose pension funds have tried to play at the capitalist poker table.
How far this will spread this time round we cannot know. It is easy to throw around comparisons with the stock market crash of 1929, the precursor to the great depression of the 1930s. But the similarities are striking: 1928-29 saw a surge in ‘broker loans’ (margin debt); there was a speculative real estate boom and a huge increase in agricultural credit which ended up driving farmers off the land. As with ‘The New Economy’, the 1920s were thought to be a ‘New Economic Era’ – ‘We were assured that we were in a new period where the old laws of economics no longer applied’.
Like the blinded, seething Samson, contradiction-wracked capitalism is tugging at its own pillars, threatening to pull down upon itself its own edifice. The cracks have started to show and are growing wider. The working class must apply its own leverage to these cracks to ensure that the entire rotten tottering system is not only brought down, but never rises again.
FRFI 198 August / September 2007
