All over Britain, from 13 to 17 September, queues of people desperate to withdraw their savings from Northern Rock bank demonstrated deep distrust of authority and the clear belief that whoever the British government represents, it isn’t ordinary people. After watching the Labour government’s enthusiastic encouragement of finance capital, of extravagant borrowing and lending while a minority benefit, ordinary working people no longer believe what politicians say. Only when all deposits were guaranteed by the government did the queues disperse. Steve Palmer explains the tremors that are shaking the system.
Why Northern Rock? Traditional building societies would accept deposits from customers, then use these as a basis for mortgage lending. Northern Rock pursued a different strategy of borrowing wholesale from the capital markets to finance its lending. The ratio of borrowing to assets was over 70%. Close behind Northern Rock stand the Alliance and Leicester, and Bradford and Bingley, both with ratios of around 50%. Northern Rock was relying on short-term financing to support its long-term loans, but when the credit crisis struck, it could no longer find lenders to renew its debts, driving it into a crisis, setting it on the hunt for funds. The Bank of England was asked to step in and the queues formed.
Normally, when the poor and unemployed are really suffering and need help, capitalists blather on about the ‘free market’, attack ‘state interference’ and indignantly condemn welfare ‘handouts’ and ‘the nanny state’. They justify their monster salaries, bonuses and profits by pointing to the ‘risks’ they take with ‘their’ money. Yet the moment their billions are under threat, they run to the government, squealing to be bailed out. So, although both Mervyn King, Governor of the Bank of England, and his US counterpart, Ben Bernanke, Chairman of the US Federal Reserve Bank, the US central bank, initially resisted taking action, they were both forced to change course, King having to execute a particularly sharp U-turn.
‘Maybe our boy has righted the ship’ enthused Robert Toll, CEO of the largest US luxury homebuilder, in obvious relief on 19 September. ‘Our boy’ Ben Bernanke had just cut the Federal Funds Rate from 5.25% to 4.75%. Only weeks ago, Wall Street insiders were deriding Bernanke as an ‘academic outsider’, ‘out of touch with reality’. Brokers literally cheered and the New York Stock Exchange leapt some 350 points on the news. What a difference a day makes, particularly when it brings such gifts!
Now, with the rate cut, the world’s stock exchanges have leapt upwards, the parasites are smiling once more and the day of reckoning has been postponed. But nagging questions remain: how has the US subprime mortgage crisis wormed its way onto the high streets of Britain? Who else is going to be affected and how? Is this rate cut the end of this panic? Can the capitalists contain this and keep expanding the market for ever?
The mortgage crisis
FRFI readers know that the real culprit is capitalist imperialism and its contradictions. In FRFI 198, we described in detail how the massive expansion of credit, which keeps capitalism afloat, has resulted in a speculative bubble in the US housing market; how aggressive lenders have made millions of subprime mortgage loans, many of which are going to default. The US working class, of course, is bearing the brunt: over 100 mortgage lenders have evaporated, throwing more than 50,000 financial workers out of work and a similar number of construction workers, many of them undocumented immigrants.
According to Realtytrac, in August there were 243,947 foreclosure filings, up 36% from July and 115% from a year ago. A higher proportion were bank repossessions, meaning that the properties are going back to the banks, instead of being sold off. House sales in California were down by 35%. Since millions of mortgages are going to ‘reset’ – increase interest rates – in the next 18 months, this foreclosure rate of more than two million per year can be expected to rise. All indications point to declining house prices. Hovnanian Enterprises – a large homebuilding company – sold 2,100 houses in a weekend ‘Sale of the Century’ – almost as many as in the previous three months – but only after slashing prices by up to $100,000. George Bush’s promised reforms will only help some 80,000 of the most creditworthy homeowners – when there are millions of mortgages about to reset. So we can expect continuing upsets for the credit system from mortgage-backed securities. Nothing ‘our boy’ Bernanke can do is going to alter that.
Commercial Paper
But what about the wider liquidity and credit crisis? To understand what’s going on, we need to understand the market for ‘Commercial Paper’ (CP). ‘Commercial Paper’ sounds dull and unremarkable – and that’s the way it used to be until recently. CP has its origins back in the earliest days of US capitalism. In other countries, banks were nationwide institutions. This enabled surplus funds in one part of the country (say from harvest sales in East Anglia) to be lent out to capitalists in other parts of the country (manufacturers in Birmingham or Manchester, perhaps). By contrast, banks in the US were restricted to a single state. This limited the ability of capitalists to circulate surplus funds, restricting the availability of credit elsewhere. In order to avoid high local interest rates, capitalists might raise funds in New York by selling CP – essentially IOUs. CP is unsecured debt, dependent on the history and reputation of the borrower. CP was typically used for short-term funding to cover day-to-day operations: a company might need money to pay expenses such as this week’s payroll or to purchase raw materials but not receive payment for products until the following week and have to borrow to bridge the gap for a few days.
CP is generally cheaper than a bank loan. Since it is short-term (falling due within nine months, usually within days or weeks) it isn’t subject to scrutiny by the securities regulator, the US Securities and Exchange Commission (SEC). While CP is unsecured, borrowers still have to maintain a line of credit with a bank as insurance. In the supposedly unlikely event that it cannot buy back the paper, the issuer turns to the bank which has to pay up. Normally this is just insurance, and never gets called down.
CP and arbitrage
The lower rate of interest on CP aroused the interest of ‘arbitrageurs’ – capitalists who profit from the difference in prices between different markets. They buy and sell large volumes of some commodity simply to profit from the slight price differences. In the financial world, they seek to profit from slight difference between two interest rates – the so-called ‘spread’ between them. Financial firms became involved from the 1920s after General Motors Acceptance Corporation (GMAC) started to use CP to finance consumer car loans. GMAC would borrow at the low CP rate and lend the money to the customer to buy the car, charging a higher rate and making money on the difference in rates. This kind of CP is called ‘financial’ CP, by contrast with the ‘non-financial’ or ‘industrial’ CP which originated the market.
Starting in the mid-1980s, banks started to offer CP type financing to their corporate customers, secured against that company’s trade receivables (expected payments). These became known as ‘Asset Backed’ CP (ABCP). With deregulation ABCP has gone wild: on 8 August, total value of ABCP peaked at $1,174.3bn – 53.7% of a CP total of $2,186.6bn. Much of this reflects creative ‘financial engineering’ where banks have created ‘conduits’ financed with CP and ‘Structured Investment Vehicles’ (SIVs) which use CP and medium term debt to support a portfolio of high yield assets.
Deregulation in the 1990s opened new opportunities for financial ingenuity, but banking regulations made it impossible for banks to engage directly in these more exotic activities. Banks were therefore forced to set up other entities to pursue them. The conduits and SIVs they created are ‘off Balance Sheet’ – do not appear in the banks’ assets or liabilities. Indeed, they are frequently described as ‘bankruptcy remote’, meaning that if they fail, that is not going to directly impact the bank.
Although the banks tried to push risk out of the front door, they have quietly allowed it to creep back in, round the side, by providing lines of credit for ABCP. Typically CP matures and is often immediately reissued – ‘rolled over’ – without problem for
a further period. However, some $300bn plus of ABCP assets contain securitized mortgages. We explained in FRFI 198 why these are turning out to be of uncertain value, even worthless. This reduces the value of assets dramatically. Since the SIVs no longer have adequate assets to back the Commercial Paper they have issued, lenders are refusing to buy their CP when it is due so it cannot be rolled over. By 12 September outstanding ABCP had fallen to $945.1bn – down $229bn and falling. So the conduits and SIVs are turning to the banks and activating the line of credit. When that happens, the ‘off balance-sheet’ liabilities suddenly get dumped on the banks’ books and then it’s the banks’ turn to come up with the financing. They suck up available funds, creating a liquidity problem: there’s a shortage of loanable funds, leading to cutbacks in lending, increased rates and tighter conditions.
This spilled over from the most speculative ABCP to the whole Commercial Paper market, threatening to gum up day-to-day functioning of some of the world’s best known corporations, like Volkswagen and Sainsbury’s. They rely on CP for working capital so they can operate without interruptions, and some have been forced to go to the banks for more expensive and less flexible loans. The Federal Reserve was forced to step in, and reduced the rate it charges for emergency borrowing by banks – the discount rate.
That cut relieved the liquidity crisis somewhat and has enabled the CP market for non-financial CP to keep flowing. Wall Street has been clamouring for Bernanke’s cut in the Federal Funds Rate, the rate charged to banks needing overnight money to meet statutory reserve requirements. The idea is that this would somehow unclog the pipes and get credit flowing again. There are problems with this. Tweaking interest rates is not going to change the risk of dubious mortgage backed securities: a batch of canned food contaminated with botulism is no healthier at half the price. Subprime mortgage based financial assets are just far too risky and their value so uncertain that small changes in the interest rate will fail to coax lenders into buying them.
The CP crisis is over; the conduits and SIVs will be reorganized and their assets revalued or sold over the next few months. This will be bumpy, yet not fatal. The biggest speculators have been bailed out and will gear up to inflate the bubble even more, probably in the commodities market. Bernanke has bought time – at the expense of inflating the bubble further.
Before long another puncture will appear, and similar problems will come to the fore. The fault lines are already visible, though where exactly it will fracture we can’t tell.
• Leasing: 31% of business equipment in the US is leased, compared to around 10% in Britain, and is therefore particularly vulnerable to credit problems. Important areas of leasing in the US are aviation, information technology and new vehicles.
• Owners of apartment blocks, offices, and retail premises are starting to report financing constraints of various kinds.
• The fall in property prices will cut state and local property taxes. At the same time municipal bonds (‘munis’) are encountering difficulties in the market: there has been difficulty selling munis at full price and there have been some sell offs, driving prices further down. Cuts in state and local services can be expected.
• Apparently sovereign nations have been digging deep into sub-prime debt. The vaunted growth of a number of ex-socialist states is simply credit-card capitalism built on cheap credit. Latvia is running a massive current account deficit of 30% of GDP and has had its credit ratings cut. Lithuania, Estonia, Romania and Bulgaria are in a similar, if less severe, state. They are highly dependent on the rate of exchange to keep loans coming: any sharp falls, and their ability to repay will immediately be challenged.
• There is a hangover of some $350bn of debt needed to finance leveraged buyouts – half the debt for the Boots deal is still stuck in the banks. Deals have been cancelled, delayed and repriced. These debts too are showing up on bank balance sheets now.
• Loans which earlier would have been securitized and sold off a few months ago are remaining ‘warehoused’ with their originating institution, stalling part of the credit ‘pipeline’.
The ‘real economy’
For weeks bourgeois commentators with serious faces have been assuring us that this is ‘just a problem in the housing sector’, ‘just a liquidity problem’, ‘just a problem in the money markets’. Something called the ‘real economy’ is just fine, ‘the fundamentals are fine’, that ‘the world economy is growing at a record rate’. By ‘real economy’ they seem to mean where serious things, like cuckoo clocks and cluster bombs and wall-mounted, plasma-screen TVs, are being made, rather than frivolous stuff like banks and stock exchanges.
But the ‘real economy’ is also a money-making economy: that the money and credit system are not just froth on top of the ‘real economy’ but the glue, nuts and bolts, the connecting rods, the lubrication, which hold it together and keep it running and are just as much part of the ‘real economy’ as hammers and sickles, factories and farms. So when the banking and credit system have problems, so does the real economy.
This ‘real economy’ is in real trouble.* In the last 50 years, we can see two dramatic shifts in the US economy. First, it has become more parasitic. In 1951, interest and dividends – money paid to owners of capital who take no part in production and just live off its profits – was just over 27% of the total profits plus interest of US capital. This grew gradually during the 1960s and 1970s to reach 64% in 1981 and to over 70% in 2001. This is a colossal shift from capitalist industry to capitalist idleness and consumption, which is of course reflected daily in the consumerism depicted in TV advertising. Second, the share of profits and interest coming from abroad has increased over the same period. Income from abroad (property income, royalties, license fees, other services) has grown from around 10% in 1961, to over 46% (second quarter, 2007). In other words, the US economy has grown more and more parasitic – and more and more parasitic on the rest of the world. It gets even worse: the US economy is not just in real trouble, it’s in real, REAL trouble: the growth in income from abroad, as a share of profits and interest, grew from ‘just’ 31% in 2002 to 46% this year, largely due to the decline in the dollar against other currencies. US non-financial corporate net borrowing grew steadily from just $12.8bn in 2002 to $625.9bn (annual rate) in the second quarter of 2007. As a proportion of non-residential fixed investment by nonfinancial corporations (a measure of investment in ‘productive’ capital), this borrowing shot up from 1.4% to 58.2%, meaning that the continued growth of productive investment is increasingly dependent on credit. In short, in the last five years, the parasitism, the dependency on international parasitism – imperialism – and on borrowing to keep the US economy going has intensified.
If this were a piece of machinery, being run under these stresses, it would be screaming, smoking and glowing red hot. If this were an individual, their financial adviser would be giving them a stern lecture about impending disaster and bankruptcy. But this is US imperialism, so it just drops interest rates a little, pops open a few more bottles of champagne, turns up the music, shoots more Iraqis, deports more undocumented workers, puts it all on the tab and keeps partying as if this is never going to stop.
* All figures calculated from internet accessible National Income and Product Accounts and International Transactions tables at www.bea.gov and the latest US Federal Reserve Bank Flow of Funds accounts at www.federalreserve.gov/ releases/z1/ Tables F1, F6.
FRFI 199 October / November 2007
