So it’s official. The credit squeeze is going to tighten in the next 3 months, the Bank of England now admits. So just how bad is it going to get, and what are the solutions available? Can the present international finance system indeed survive, even with radical reform, or are we on the cusp of fundamental reformulation of the current neo-liberal world economic order?
The causes of the gathering banking crisis go very deep. First, a prolonged period of low interest rates produced an excess of cheap money which encouraged huge borrowing for massive private equity buy-outs and an emphasis on super-charged short-term gains. By 2007 private equity deals accounted for more than a third of all takeover deals in the US, compared with only 4% in the last such takeover boom in 2000. Such deals are however highly vulnerable to any significant rise in long-term interest rates which also hits hard the banks providing the loans as well as the stockmarkets riding on takeover fever.
Second, the pressure to secure very rapid gains was substantially intensified by major fiscal concessions to the City. Whereas Nigel Lawson had fixed the rate for capital gains tax at 40%, the same as for higher-rate income tax, in order to preclude any tax incentive artificially to switch between them, Gordon Brown in 1998 introduced ‘taper relief’ which slashed capital gains tax to just 10% for people owning shares in their own companies, provided they had owned the asset for at least 10 years. The real bonanza took off in 2002 when, after further City lobbying, the Treasury reduced the 10 year wait to only 2 years. Then when all companies with very highly paid employees started setting up elaborate ‘share-based’ schemes to disguise income as capital gains to get the huge tax benefits, the Treasury was forced to block the loophole. But (extraordinarily for a Labour Government) private equity was exempted from the new rules. At this point the gravy train really started to roll.
Apart from the exuberance in buy-outs on borrowed money that then followed, a third component at the heart of the credit crisis has been the systematic manipulation of complex derivatives such as structured investment vehicles (SIVs), collateralised debt obligations (CDOs), and others lss regulated known as Siv-lites or conduits. As private-equity groups borrow money for their latest acquisition from syndicates of private lenders, including hedge funds, risks can be converted into these opaque securities, sliced up, repackaged, sold on, and then sliced up again ad infinitum. And as the risk of borrowers’ defaults is laid off, lenders are freed up to lend more, almost endlessly. Indeed, starting from 1987, this computer-driven frenzy of activity has now produced contracts in interest-rate and currency derivatives with a staggering total value of more than $200 trillions – 16 times US GDP – plus more recently a further £23 trillions in credit default swaps which enable bond investors to lay off the risk of issuers defaulting.
Whilst the theory behind securitisation was that it would stabilise the global economy by dispersing risk to those who could best afford it, derivatives have increasingly ended up with those seduced by very high yields they did not want to miss out on, but which they did not understand. As a result, the hyperactive shuffling of money, the divorce between original author and eventual lender, and the mathematical complexity of many derivatives have left many at the end of the line finding themselves palmed off with assets next to worthless. Entire markets for securitised assets have shrivelled. As a result, write-downs by banks and other financial institutions are now expected to exceed $500 billions.
More recently, this crisis has been exacerbated by a fourth factor, the unravelling of the sub-prime (i.e. risky) housing market in the US. By offering mortgages to bad-risk customers who were never likely to be able to repay their debt, and then securitising these bad loans on an enormous scale across the world, the collapse of the US housing market has seriously aggravated the underlying derivatives mess. Deutsche Bank has estimated overall sub-prime losses at up to $400 billions, for which $130 billions will fall on banks. Even that may be an under-estimate when the total of sub-prime loans originated between 2004-6 amounted to $1.3 trillions, and more than a third of that debt may be unrecoverable.
The cracks extend further. The knock-on effect of the sub-prime mortgage crisis is now seriously undermining the monoline insurers whose single function (hence their name) has been to insure municipal bonds. But again, with reckless disregard of the risks entailed, they have branched out in the last few years into a host of exciting new products with eye-watering yields, including the SIV/CDO markets and sub-prime mortgages. Now the monolines which insure the $2.5 trillion US municipal-bond market have been told they might lose their invaluable triple A ratings unless shareholders raise their capital base – implying that the financial markets no longer have a safety net that is secure. In the case of the UK, this downgrading of the monolines could mean that PFI-driven local hospital and schools building projects could become prohibitively expensive.
The fifth factor in this breakdown potpourri is clearly the comprehensive failure of regulation. The FSA’s reputation as a light-touch regulator was destroyed by its failure to recognise that Northern Rock’s aggressive mortgage policy, in effect turning the bank itself into an SIV vehicle, was an accident waiting to happen. The inadequacies of an incompetent chairman and ineffective non-executive directors in failing to restrain an out-of-control chief executive laid bare the shortcomings of current bank governance. The much-acclaimed tripartite system of regulation set up in 1997, sharing responsibility between the Treasury, Bank of England and FSA, collapsed at its first real test. Rating agencies whose job was to serve the market with accurate information turned out to have first loyalty instead to the issuers who were paying their fees.
So what should be done? Financial self-regulation, and the light-touch supervision so ardently cultivated for the City’s benefit by New Labour, have manifestly failed. The doctrine that markets correct themselves, even if plausible with this scale of breakdown, cannot be sustained when the follies of global finance impact so disastrously on the wider economy – when banks in the pursuit of prodigious self-enrichment over-reach themselves and the ensuing credit crunch leads to a global economic downturn threatening the livelihood of billions of workers and consumers. The collapse of accountability in financial markets combined with the monumental rewards for insiders putting the world economy at risk for their own greed is now raising the whole question of the political legitimacy of modern finance capitalism.
The Government’s neo-liberal agenda (which it shares with the Tory Opposition) – that economies work best when markets, deregulation and privatisation hold unfettered sway – is breaking down before our eyes, probably terminally. The free market excesses of the 1920s were followed by the credit-crunch depression of the 1930s, which led to necessary regulation to tame the destructiveness of wsayward financial markets. Re-regulation adapted to the very different conditions today is now just as necessary. A clear line must now be drawn between deposit-taking retail banks and investment banks. New detailed rules on transparency should be rigorously monitored and enforced. Capital adequacy requirements reflecting the state of the economic cycle should be designed to prevent wild booms and busts in lending. The whole constellation of credit derivatives should be regulated to optimize simplicity, clarity and fitness for purpose, and to penalise misfeasance. And the banks, like utilities, now need tight regulation – not least as a quid pro quo for bailing them out – but even more so because their errors and their greed can have such disastrous consequences globally.
Above all, when the banks have failed the public interest so badly and still even now continue to pursue so single-mindedly their commitment to privatise their gains whilst socialising their losses, would not a publicly owned bank be the most effective way of changing the current corrosive financial culture of short-termism, lower investment, house price inflation, and insider enrichment at the expense of systemic fragility for everyone else? Perhaps we should not return Northern Rock to the private sector after all.
This article originally appeared in The Tribune on 8 August 2008: