On the morning of Tuesday 22 January, the world’s stock exchanges – which had already dropped by several percent on Monday – seemed to be teetering on the edge of a catastrophic decline, plummeting stock values into an abyss. Then, suddenly, an hour before the New York Stock Exchange (NYSE) opened, the US Federal Reserve Bank made its largest interest rate cut for over 25 years, slashing the Federal Funds rate by 75 basis points to 3.5%. Although a slew of sell orders initially forced the NYSE down over 400 points on opening, it bounced back up, to close some 128 points down; the Asian and European exchanges rebounded dramatically. Capitalists breathed a sigh of relief. Crisis seemed to have been averted.
What caused this sudden, violent and dramatic bounce? What created the panic? What made it subside? Is that the end of it or will it recur? If it recurs, can they keep doing this forever? If not, why not?
What’s going on?
First the write-downs of debt by major banks, due to the subprime mortgage crisis, continued. In January it was the turn of Citigroup ($18.1bn) and Merrill Lynch ($15bn). Canadian Imperial Bank of Commerce wrote off some $2.8bn, Washington Mutual $1.6bn, Sovereign Bancorp $1.6bn and JP Morgan had losses of $1.3bn. Bank of America reported a fall in net income of 95% after write downs of $5.28bn, Wachovia reported a drop in net income of 98%. Even Wells Fargo bank, which had minimal exposure to subprime mortgages, had a fall in net income of 38%. According to the Wall Street Journal’s scoreboard, $107bn has now been written down by the banks since the crisis began.
Second, despite the bluster by politicians about the supposed ‘underlying strength’ of the US economy, Citigroup and Merrill Lynch had to turn to foreign capitalists to help prop them up. The Government of Singapore Investment Corporation, the Kuwaiti Investment Authority, Prince Al Waleed bin Talal of the Saudi royal family, the Korean Investment Corporation and the Mizuho Investment Bank of Japan coughed up several billion dollars to help out.
Third, the crisis is spreading beyond mortgages to consumer debt such as credit card and car loans. Capital One, a huge consumer loan company, announced loan loss provisions for the last quarter of 2007 of $1.9bn ($5.9bn for the whole year) and American Express set provisions at $440m. These indicate a larger problem, and are omens of the recession which is underway.
Deep roots of the credit crisis
The fact is that, while buying time, capital has not and cannot fix the deeper problems which the stock market falls reflect. Capitalists are starting to wake up and realise that, sooner or later, they have to face the music. The more prudent and far-sighted representatives of capital already grasp this: following the Fed cut, billionaire speculator George Soros remarked that ‘the current crisis marks the end of an era … the culmination of a super-boom that has lasted for more than 60 years … Everything that could go wrong did.’
From its start, the RCG has insisted on the inherently crisis ridden nature of capitalism, not merely rhetorically, but theoretically. It has consistently explained why capitalism’s inherent tendencies to crisis have not manifested themselves significantly in the developed capitalist countries – by grinding down the living standards of billions of the poorest people in the world, by successfully destroying most socialist countries and by a relentless expansion of credit.1 This expansion of credit was initially undertaken by the state, as war-shattered European imperialist powers rebuilt themselves, but as soon as the capitalists could stand independently, without state aid, they embarked on an orgy of ‘deregulation’ and ‘privatization’. Unable to expand profits through expanding production, a complete shadow banking system has sprouted alongside the formal, tightly regulated banking system. This shadow banking system has devised wild and exotic financial instruments, particularly ‘derivatives’, to assist its speculative activities. It has created unregulated institutions, such as hedge funds and private equity. These developments have pushed debt and credit off the balance sheets of conventional financial institutions into the casino-like world of shadow banking.
Shadow banking unravelling
It is these instruments and institutions which are unravelling now as they reach the limits of their ability to garner profits and interest. Subprime mortgages are collapsing, ‘Structured Investment Vehicles’ (SIVs) are fall ing apart and the wreckage is moving into the orthodox banking system and onto its balance sheets. As a result, the crisis has spread beyond loans to consumers – first for housing, now for credit cards and cars – to strike right at the heart of the credit system: lending between capitalists. We had a first taste of this with the collapse of the ‘Asset Backed Commercial Paper’ market last year (see FRFI 199).
Now a much larger and more serious pile of credit is threatening to collapse: Credit Default Swaps (CDS). A ‘swap’ is a financial contract where two parties agree to exchange liabilities at prices that make the deal advantageous to each other. In the case of bonds, the swap seller promises to pay a substantial sum to the buyer in the event that the bond defaults or undergoes a major fall in value. In return, the buyer makes quarterly payments to the swap seller. If the events don’t happen, the swap just expires when the bond is sold.
Yet, there are no guarantees that the seller can actually pay the buyer in the event of a default: there is no regulatory requirement that the seller hold any kind of reserve funds to cover this happening. The buyer doesn’t even have to own the bond: it’s just a fancy name for a bet on what’s going to happen to the bond. Since the value of the swaps change with changes in perceived risk, they can be bought or sold as a speculative asset.
The entire pile of CDS is about $45 trillion – three times the US GDP, about equal to the entire world’s an nual production, or over half the dollar value of all bank accounts. Obviously, there’s a risk that, when an event happens, the seller of the swap can’t pay up. This ‘counterparty risk’ threatens to bring down a large chunk of the CDS pile, thanks to the activities of the bond insurers.
Bond insurers buckle
Bond insurers provide insurance on the principal and interest of a bond – if the bonds fall in value, the insurers pick up the tab, the interest continues to flow, the value is covered and the fluctuations would not appear in earnings. Traditionally bond insurers have insured municipal bonds, typically states, cities, local governments, prisons, hospitals, and school boards. By purchasing bond insurance, the bond effectively acquires the same credit rating as the bond insurer – AAA – since, in the event of default, the insurer should cover any loss.
The bond insurers used to be relatively conservative financially, but, as shadow banking developed, their investors began to get restless and the insurers branched out into the sub-prime market. Consequently, their actual and expected losses have risen dramatically. This has led the ratings agencies to review their rating, normally AAA. The agencies cut the rating of one of the main insurers, Ambac, to AAB. Its stock price plunged by 70% in two days, down 88% on last year’s high. Both events meant that it was quite incapable of raising any capital to continue its activities, though it could continue to collect on its existing insurance policies. MBIA, the other large bond insurer, managed to raise capital, but that may not be enough. Its stock price fell by 93% on last year’s high.
The potential consequences spread far beyond the insurance company. Bond insurance would become more difficult to obtain and more expensive, constraining new bond issues. Existing bonds worth $556bn covered by Ambac’s insurance would now risk having their ratings cut, since the ability of Ambac to cover losses is put in question. Since many of these down-rated bonds are owned by companies that maintain a prime investment quality AAA portfolio, they would have to be sold, driving their price down and creating further losses and write-downs. Many of the affected bonds are not directly related to subprime at all – just raising money for road building, education and prisons – but would still suffer the consequences. This would reduce the value of assets held by a variety of lenders who would cut back lending or have to find new sources of capital. With the seven major bond insurers covering $2,400bn, the consequential write-downs could reach $200bn.
With bond insurance apparently about to evaporate, bond issuers have been turning to Credit Default Swaps as a form of insurance. One of the principles of traditional insurance is to maintain a certain percentage of the value of insurance contracts in the form of assets used to meet anticipated claims, but with CDS there’s no such assurance. And even if there were, nobody has yet had to unwind CDS in large amounts or swiftly and it clearly isn’t going to be easy.
As a result, the prospect opens up of an abyss which threatens not only to swallow up further losses, but also unwind the leverage which has been responsible for the expansion of the shadow banking system. It was this possibility which drove stock markets to the edge of a precipice.
Stay of execution
Even the Fed rate cut was not enough to push the NYSE back up. It was only when the New York State Insurance Commissioner, Eric Dinallo, announced that he was trying to get the major banks to give $15bn to rescue the bond insurers that the markets bounced back. So huge is the extent of denial about the depth of the crisis and so great the fear of its consequences that the vaguest suggestion of a solution was enough for speculators to hear what they wanted to hear and give themselves reassurance.
But they’re deluding themselves: the bond insurers are not going to get rescued anymore than the SIVs got rescued last year. Why should the very banks who bought the insurance rescue the failed insurers? And, given their recent performance, where are they going to get the capital to do so? Even if they had it, $15bn is not nearly enough to save the industry – it needs at least $200bn. Certainly attempts will be made to rebuild a bond insurance sector, with a much more stringent collateral requirement and restrictions on its ability to speculate. But this will take time and also capital which is just not available right now. There will be further rate cuts by the Fed. But they won’t provide a permanent fix but only, as the Financial Times put it, ‘a stay of execution’. Superficial calm has been bought for a few weeks – but the losses and the slide will soon resume.
Consequences
Soros pointed out the longer-term consequences of the collapse of this credit expansion. It ‘marks the end of an era of credit expansion based on the dollar as the international reserve currency.’ This is likely to bring about:
‘[a] radical realignment of the global economy, with a relative decline of the US and the rise of China and other countries in the developing world. The danger is that the resulting political tensions, including US protectionism, may disrupt the global economy and plunge the world into recession or worse.’2
‘Or worse’? These extraordinary words can only mean…international conflict, world war. Soros dares to think what for most other capitalists – and for the wretched so-called Left – is presently unthinkable: the collapse of the shadow banking system and its strategic consequences: the decline of US imperialism and all that implies.
Steve Palmer, US correspondent
1 See ‘Inflation, the crisis and the post-war boom’, Revolutionary Communist 3/4, at www.revolutionarycommunist.org; FRFI 192, ‘Mr Parasite goes to Washington’.
2 ‘The worst market crisis in 60 years’, Financial Times, (Asian edition) 23 January 2008, p9, our emphasis.
FRFI 201 February / March 2008
