Thursday, December 06, 2007

The Fragility of the Financial Markets in Capitalism

With the financial crisis engulfing the developed world a couple of months old its origins, causes and possible effects can now be assessed as many of the underlying factors have become clear. Khilafah.com in this two part series will asses the instability of the financial markets in the West and its impact on the wider global economy and what the Khilafah has to offer as an alternative.
Panic and turmoil gripped the world's financial markets in August as the US housing market bubble burst. The crisis threatens a worldwide economic slowdown, bringing to a halt more than a decade of increasing prosperity and employment for western economies. Such were the far-reaching consequences its effect was felt in the UK recently as Northern Rock (Britain 5th largest Bank) faced a bank ‘run' where many customers attempted to withdraw their savings in anticipation of its collapse. Its fortunes had its origins from the US housing market crash.

Understanding the Banking System

The obvious question to ask is how Northern Rock found itself in a situation where it was forced to borrow from its central bank, the Bank of England.The answer to this question lies in understanding the way in which banks in the developed world fund themselves. Northern Rock funded itself by borrowing in the wholesale money markets (this is the market where banks lend money to each other at a rate of interest lower than the mainstream interest rate). Northern Rock as well as many other banks issue mortgages and loans to customers at commercial interest rates; making a minimum of 1% profit due to the difference between the wholesale (LIBOR) interest rate and the commercial interest rate. This has been very good business for the last decade due to two factors; the fact that demand for mortgages and loans have been at an all time high due to Europe's appetite for housing and expensive consumer goods, and also due to the fact that banks were very happy to lend money to each other due to the general state of the credit markets across the world, which meant that they could always recoup any losses quickly.

The problem with this financial model is that borrowing at short term rates and lending at long term rates exposes banks to changes in the inter-bank lending rate (LIBOR) relative to the commercial rate in a downturn in the financial market. As most banks around the world borrow what they lend such a downturn can have severe repercussions. In the case of Northern Rock only 20% of its lending came from deposits, thus 80% of what they lent was borrowed from the wholesale market!

Over recent months with credit markets in turmoil, banks became increasingly wary about lending to each other as there was a very good possibility that those who were exposed to the sub-prime sector in the US would find themselves in a position where they would be unable to pay any of their debts. The wholesale money markets that Northern Rock normally turns to froze up, because such actions forced the LIBOR rate to reach 6.74%, while the commercial rate in the UK was 5.75%. This means that it is now costing more to borrow at the wholesale rate than at the commercial rate.

The Sub-Prime Mortgage Market

Many experts have been bewildered at the effect the mortgage market collapse in the US has had on markets across the world. Stock market prices in Europe collapsed, credit markets in South East Asia froze and the UK economy has been drastically affected by events across the Atlantic. This can be understood if one looks at how the sub-prime market was created, structured and funded.

The US Sub-prime market was created when the mainstream mortgage market became saturated and reached its peak of profitability. Those with patchy credit histories and of low income were turned away from mainstream mortgages at a time when the market was buyout due to consumer spending and borrowing. The Sub-prime market was carved out after this point as 25% of the US population fell into this category and represented a market opportunity. Hence US lenders gave mortgages to people who had little means to pay for a mortgage and charged them a rate of interest much higher than the commercial rate for that privilege. They issued these mortgages safe in the knowledge that if the buyer defaults, then they would be able to repossess the property, and sell in a buoyant property market. By the start of 2007, the sub-prime market was valued at more then $1.3 trillion.Many companies to ensure they didn't lose out at possible money making opportunities in the sub-prime market developed complex products so they could all have a share of the pie. This was achieved by banks, hedge funds, investment banks and credit houses breaking down the value of the sub-prime mortgage market and mashed up various home loans into financial sausage meat - just as wholesome as the real-world equivalent - and sold them on to the institutions, i.e. debt (money an individual owes you) was sold to a third party, who would then receive the loan repayments and pay a fee for this privilege. Thus debt becomes tradable just like a car.With all bubbles they continue to grow until an event brings to realization that the bubble has grown as big as it can and then bursts in spectacular fashion. In the case of the sub-prime market it reached a level where many borrowers reached a point where they were unable to meet their monthly payments, thus they defaulted. The volume of defaulters reached such a level that it deflated the whole property market; bringing down the price of homes and creating the phenomena known as negative equity. This is where selling the home on the open market would be less then the original mortgage given to the lender. This then meant that repossessing properties and selling them off would lead to a loss for the lender, since the value of property has fallen. The net result of this led to New Century Inc the largest sub-prime mortgage lender in the US to declare bankruptcy and by the end of August half of the 25 sub-prime companies in the US collapsed and filed for bankruptcy.The wider financial industry was affected by the crisis in a number of ways in essentially what is an American problem. The three common methods were as follows:-

1) Mortgage-backed securities (MBS) - Many were exposed to the sub-prime sector because they were owners of mortgage-backed securities which were created out of the repackaging of these sub-prime loans for consumption by investors. In simple terms this is where a bank has sold a mortgage to a homebuyer, who then owes regular payments to the bank in order to pay off the debt. This mortgage debt that banks are owed are sold to buyers as an IOU; this means that this debt owed to the mortgagor is sold to a buyer, who then receives the monthly mortgage payments. The problem is that often this type of debt is sold as mere debt or a pool of mortgage based debts lumped together into a form of asset or bond, each with different degrees of risk attached to them. Thus owners of MBS's actually do not know the source of where the payments are coming from or even which sectors they're being exposed to. Those companies who bought MBS's were not clearly told that they are dealing in risky sub-prime mortgage debt, which is considered a risky security, but thought they are buying a less risky debt based security. MBS's are worth over $1 trillion in the US

2) Collateralised debt obligations (CDO's) - Many institutions were exposed to the sub-prime market due to holding collateralised debt. These are bonds created by another process of deconstructing and re-engineering the mortgage-backed securities. This essentially works by providing investors with access to the regular payments received from mortgage payers in return for paying to have access to the CDO as well as managements fees. The difference between this type of investment and the one above is mainly that this investment is collateralised because the bank puts the mortgage as collateral (since it is a mortgage backed security) much like someone puts their house as collateral when they take out a big loan.
The problem is that many other debts such as insurance agreements, loan agreements or even bonds are combined within the same CDO; the idea being that if you spread the types of debt that the CDO is based on, you spread the risk and lower the effect of a downturn in one of its constituents. However, nobody counted on the whole mortgage sector collapsing in this way, and since the CDO is spread over varying types of debt, it became unclear to investors the extent of exposure to sub-prime mortgage debt. As investors got jittery they started making cash calls to banks or began pulling out before it was too late, causing big names such as Bear Stearns Asset Management (an asset management company affiliated with a top US investment bank) to suffer huge losses. For this reason, CDO's need to be rated by a credit ratings agency, to qualify the risk it carries. Charlie McCreevy, EU internal market commissioner puts CDO's as the main reason behind the crisis; He states; "The origins of the current turmoil are very simple...loans were made to people who didn't have the wherewithal to repay them and all these thousands of loans have been packed off into CDOs [collateralised debt obligations] sold off to others all over the world."1

Hedge funds - suffered losses due to direct or indirect exposure to sub-prime loans. A Hedge fund is a financial vehicle that invests in a particular product portfolio or company, but hedges or protects its bets by ensuring that the risk they are exposed to is minimised by other financial measures such as short selling. Hedge funds are controversial because they are very secretive about their workings and because legislation governing them is very lax.

Hedge funds brought into the various types of mortgage products off-setting one loan against the other in the hope losses could be minimised. The effects of exposure to sub-prime mortgage debt to hedge funds is quite significant, since overall hedge fund activity is now worth $1.7 trillion as of March 2007.

The Role of Central Banks

International institutes who poured their money into the US realised they will not actually receive their money that they loaned out to investors as individual sub prime mortgage holders have now defaulted on mass on such loans and this then means all those who took positions in the housing sector will not actually be in a position to pay the institutes they borrowed money from. It was for this reason central banks across the world intervened in the global economy in an unprecedented manner providing large amounts of cash to ensure such banks and institutes do not go bankrupt. The European Central Bank, America's Federal Reserve and the Japanese and Australian central banks injected over $300 billion into the banking system within 48 hours in a bid to avert a financial crisis. They stepped in when banks, such as Sentinel, a large American investment house, stopped investors from withdrawing their money, spooked by sudden and unexpected losses from bad loans in the American mortgage market, other institutions followed suit and suspended normal lending. Intervention by the world's central banks in order to avert crisis cost them over $800 billion after only seven days.

Ever since there has been much controversy in the media regarding the role of central banks, much criticism was directed at Mervyn King, Governor of the bank of England and it has been suggested that he should have acted sooner like the world central banks in easing liquidity and in bailing out Northern Rock and guaranteeing the deposits of its savers, since the Bank of England is the lender of last resort, which essentially means that it is willing to extend credit when no one else will. However this issue has political and economic motivations from the banking industry.

There debate centres on the issue that should government or central banks bail out institutions who find themselves in financial trouble. Critics point to the ability of having a lender of last resort as a temptation for an institution to take on more risk. A lender of last resort provides a safety net to insulate the institution from the full consequences of their risk. According to pure capitalist theory, if we have such a situation where there is a credit crunch, the market should be left to correct itself, even if it leads to pain and suffering for society. Central banks and government interference is seen as a distortion to the flow of goods and services around the economy, as they distort the free market, and they should only be involved in the economy to regulate against fraud and other such discrepancies.Ironically, the most staunch advocate of these free market views are the very same companies that are calling for government interference. Hedge funds are renowned for their insistence that governments do not intervene to stop their activities; they insist on keeping their activities a secret. Many top FTSE 100 firms railed when governments bought in legislation restricting the practice of asset stripping (which is the buying of an ailing company at a cheap price and then repackaging its assets and selling them on). Financial services reform after the last crisis in 1999 was met with resistance from global companies as it added another layer of bureaucracy into the system. In short, the majority of these financial instruments are predatory, manipulative and merciless in their quest for profits, and they dislike any government restricting them from exploiting the markets.It is for this reason that there is a strong sentiment, even amongst western economists, that these companies shouldn't be bailed out; they should be left to fester, and default as a lesson to others. The Bank of England held similar views (although less extreme), however, the reason why they pumped in billions into the financial system is because the system is actually very volatile and as explained above the collapse in one market has a negative effects on the share prices across the markets. It also freezes lending between banks, as banks do not want to lend to another bank whose exposure to sub-prime mortgage debt is unclear.

The net effect of this is that such a negative effect on share prices and banking confidence will inevitably have an effect in the real economy. The key to this is expectations; firm will adjust their spending, investment and recruitment strategies according to what they expect to occur within the economy in the coming years. If they are expecting a collapse or significant downturn, they will begin to lay of staff and spend less. As more and more companies do this, we get a vicious circle of less spending, higher unemployment and less tax revenue for the government.

The Role of Credit Rating Agencies

The list of casualties in Europe and elsewhere is expected to grow as it becomes clearer who holds debt which was lent to the sub-prime sector. Many companies have already been affected due to being tied to US mortgage defaults such as IKB, of Germany, and France's BNP Paribas, as well as HSBC, Barclays and Northern Rock and Citigroup, some companies have attempted to absorb losses by making redundancies.US home loans had been pooled and packaged into tradable securities by Wall Street banks, before being sold on to financial institutions around the world. As they were bought and sold, these mortgage-backed securities were valued according to the ratings given to them by the credit rating agencies. Credit agencies (dominated by the big three; Moody's, Standard & Poor's and Fitch) classify the risk of these repackaged securities according to their exposure to risky markets. Critics of the agencies have suggested the three firms were slow to downgrade ratings as low quality US mortgage defaults increased. Some sub-prime-backed securities for a time carried the same risk rating as high grade US Treasury bonds.

Other critics have raised deeper questions about the relationship between Wall Street's highly paid financial engineers, and the credit rating agencies. There is much scepticism about the independence and motives of credit agencies, a sentiment expressed by a spokesperson for the European commission said: "We have some concerns about the speed at which the agencies acted [in response to the deteriorating US sub-prime market]. Our review will be quite broad: it will look at the performance of ratings and at the management of potential conflicts of interest." 2It is not the first time credit agencies' credibility has been called into question. Spotlight was thrown on the industry after the 2001 collapse of Enron - a firm built on securitizations as well as the role of credit rating agencies in the financial crash in the Asian markets in the 1997. Charlie McCreevy, EU internal market commissioner commented: "What's the common denominator between Enron, Parmalat, special purpose vehicles, conduits and the like? They are off-balance sheet vehicles where the risk has theoretically gone with them: tooraloo, adiĆ³s." 3 It is believed the amount of mortgage debt from the US housing market that has been repackaged and sold on is anywhere between £50bn and £250bn. The debt is sitting on the balance sheets of banks in the US, Europe and Asia. Since this debt is not easy to pin down, and currently it is not clear how this debt has been packaged and in what form it has been packaged, banks across the world, as well as Britain's major banks signalled that they were reluctant to lend money to rivals except at premium rates while the extent of the loans debacle in the US remained unknown. In effect, banks do not trust each other's financial dealings and hence any debt they take out could be backed by sub-prime mortgage debt directly or indirectly, and any money they borrow can potentially be lost due to other banks collapsing. Hence this is what is causing the credit crunch. Many economists are arguing that any restrictions on lending are likely to bring an economic slowdown next year or worse economic collapse as most of the growth in the world economy in the last decade has been funded by debt.

Understanding the collapse of the Financial Markets

The cumulative effects of all the above vehicles resulted in huge losses for all the institutions exposed to the sub-prime sector through the various complex products. The constituent elements of such products resulted in many holders of such debt to sell other investments in order to balance losses incurred from exposure to the sub-prime sector. This is what caused the collapse in share prices across the world in August, with the market getting into a vicious circle of falling prices, leading to the further sale of shares to shore up losses. This type of behaviour is what caused world-wide share values to plummet. What made matters worse was many investors caught in this vicious spiral of declining prices did not just sell sub-prime and related products; they sold anything that could be sold. This is why share prices have plummeted across the board and not just in those directly related to sub prime mortgages.Furthermore, when liquidity (the ability to sell assets and convert them into money) dries up in this way, all sorts of "normal" relationships between different classes of assets change. And that can lead to unexpected losses for many different institutions, especially those which trade on the basis of computer models created from processing past inter-relationships between markets or securities. Just recently Bloomberg has reported just such losses for funds managed by Goldman Sachs.This explains why the sub-prime mortgage market collapse has caused a crisis in the whole financial system, and has had far-reaching effects much wider than just one market or sector.The fragility, weakness and vulnerability of the financial markets exist across the board in the capitalist financial system; these can be seen from many perspectives.

The first aspect of fragility is that the financial markets are built on illusionary factors which consistently cause uncertainty and instability. Most investment products are built upon debt; this includes mortgage debt, bonds and derivatives and other such things. Many financial assets have been built not only on debt, but on debt recycled at high velocity, a form of turbo-debt. This works by a company borrowing money to invest, such investments will include a wide verity of different debt based products, this debt will then be used as a basis to borrow more money, hence £1 of debt can act as equity to finance more than £100 of credit through complex leveraged financing (debt based financing). What this means is that borrowers in turn become lenders by effectively lending borrowed money! This releases a massive financial energy through a chain reaction of a tiny amount of initial equity, if that exists in the first place.

Essentially the financial markets are a parallel economy which exists alongside the real economy and affects the real economy through various styles although it produces nothing tangible. The real economy consists of housing, land and property, factories, cars and goods etc these are tangible goods which can be traded, leased and sold i.e. they are physical goods which are produced, people are employed to make them and can be converted to other items which adds value at each stage.

The financial economy consists of tradable paper which has financial values which rise and fall based upon the value people give to them. They have become so sophisticated that various products have been created which allow an investment in a paper based upon another paper based upon another paper with no real asset represented. This side of the economy is valued higher then the real economy, the size of the worldwide bond market is estimated at $45 trillion. The size of the world's stock markets is estimated at $51 trillion. The world derivatives market has been estimated at $480 trillion, more then 30 times the size of the U.S. economy and 12 times the size of the entire world economy.4

The problem with all of this is that the financial side of the economy doesn't produce anything that can be consumed, however most individuals and their wealth ends up in the markets in the hope of handsome returns. Turbo-debt by definition is generated by practically no equity and if debt is serviced mostly by the wealth generated from debt-propelled asset appreciation, this creates a financial bubble which may create short term gains, but is a crash waiting to happen. For example, the financing of internet companies during the dot.com bubble enabled the rapid growth of online companies during the late 1990's. Many companies were financed by either venture capitalists that saw record-setting rises in stock valuation and therefore moved faster and with less caution than usual, choosing to hedge the risk by starting many contenders. Many companies also turned to the stock exchange to raise finance by floating on the stock exchange even thought future earnings were unrealistic and many years away from profitability. When those earnings did not bear fruit the dot.com bubble burst as the debt based investment simply couldn't be met. The novelty of these stocks, combined with the difficulty of valuing the companies, sent many stocks to dizzying heights and made the initial controllers of the companies wildly rich on paper.

The fragility of the financial markets is systematic; this is because speculation forms one of the basic motivations for institutions and individuals to pour money into the markets. The foreign exchange market trades $1.8 trillion daily, only 5% of this is for trade purposes, 95% is purely speculative, i.e. currency is being traded not to be used for trade but in the hope of selling at a higher and profitable rate. $1.26 trillion is traded daily in derivatives this is the market in which paper is brought betting on the price of other paper such as shares, currency, interest rates and bonds. This market represents speculation at its highest peak, and the sheer size of it shows the amounts individuals are prepared to speculate with. The dot.com boom, telecoms boom, the railways boom in the 1880's and the automobile boom share one very worrying characteristic which continues to fuel financial market activity. That is money was borrowed and poured into the markets which fuelled the bubble, the price of the assets rose to levels which were well above the real value of the asset. Many institutions continued to pour money in order to make profits with the money mostly being borrowed, and then an event occurred which proves to everyone that prices have reached a level where they will not continue rising, at this point the bubble bursts. Speculation inflated the price of housing in the sub-prime sector not the demand for housing by homebuyers, as a result the boom and bust in economies and markets will continue as speculation is a herd activity were making profits is placed above all else. Taking on risks, companies taking on risky ventures and people speculating with more and more of their money cannot be dealt with any amount of regulation or legislation. This is why markets crash regularly, and every boom is followed by a crash or a downturn.

All sectors of the economy feed into such speculation. Banks invest the money received for Pensions on the financial markets and use the returns to pay out pensions. Insurance companies use the proceeds from premiums and invest on the markets. High street banks use their customer's deposits and place the money on the financial markets and use the profits made to make interest payments owed to their customers. Companies place substantial amounts of their profits and reserves to accumulate returns from the stock exchange. Everyone's money in some form or shape ends up in the financial markets weather directly placed by themselves or not. For these reasons institutions make the returns but the average person suffers the consequences of such speculative bubbles by higher prices, higher interest rates and on many occasions unemployment. Every strata of society has a stake in the parallel economy weather they like it or not, and because everyone is trying to make a killing speculation is always an inevitable matter. Instability will always exist as long as such markets exist.

Greed is enshrined within the financial markets. Greed is the motivation that led to predatory mortgage brokers selling mortgages to people that have no way in paying it back, and then increasing the rates of interest until the buyer defaults. Greed is also the motivation that led the credit ratings agencies to rate the investments less risky than they were, and also to conceal that the risk was based on sub-prime mortgage debt. Hedge funds demonstrated greed in the way they seek to provide astonishing returns to their customers, and greed is the motivation even for individual shareholders that want to capitalize on the falling share prices across the economy, even though it can lead to problems for thousands of people. The effect of this is devastating; since each element within the system puts their benefit before ethics, morals and the impact on the wider economy, this is why we have a situation where even though the effect of investment decisions can lead to a downturn in the economy, companies are prepared to make those decisions anyway. The biggest problem here is that this motivation is seen as a virtue. Greed is good; so we are told, and hence we can see that this is a systematic problem; i.e. it is enshrined in the financial system.

Muhammed (saw) defined this well when he said; "If the son of Adam had one valley of gold, he would want another"

The existence of the financial markets is a key factor that leads to wide disparities in wealth distribution in the West. Most wealth remains amongst a circle of people, while risks are suffered by the masses. The last two decades has seen an unprecedented level of wealth generated by the financial markets. Companies make billions of dollars each year, and this is deposited into the accounts of shareholders in the shape of dividends. The likes of Warren Buffet, Donald Trump, and Bill Gates earn more each year than the GDP of some of the poorest countries. Yet we find that this newly generated wealth is not distributed around the economy and very little of it reaches the average person, since progressive taxation is not reflective of the wealth generated, and in most cases the wealthy can avoid taxes through creative accounting, offshore accounts and other measures. The UK generated wealth (GDP) of £2.2 trillion in 2005, this was an increase from the previous year. However if we look at how much the 60 million population of the UK received of this generated wealth we see there are huge disparity, 2005 statistics from HM Revenue and Customs show that the richest 10% have more then 50% of the nation's wealth and that 40% of the British population shared in only 5% of this wealth. This has resulted in the majority of the population resorting to borrowing to fund their lifestyles hence UK consumer debt is more the £1.3 trillion, even more then Britain's GDP. The US situation is even worse, the US may generate $12 trillion a year in wealth but National debt is $8.5 trillion. This means US citizens are funding their lifestyles by borrowed money rather then the $12 trillion the economy generated. In a 2005 Harvard report it was calculated that 60% of earned income in the US was by the top two highest earning brackets (i.e. minority of the population). The report also highlighted the majority of people in the US only received 40% of income that was generated.

Because there is no motivation for direct investment around the economy newly generated wealth goes back into interest bearing investments; and hence out of circulation around the economy. The risks associated with bad investments are then borne by the masses in the shape of rising inflation, increased house prices, as well as recessionary effects. The average person deposits their money into banks that use his deposits to finance the banks investments via fractional reserve banking, and yet they don't see the gains from that, but stand to lose their deposits if the bank collapses.

The western system creates a mindset that only cares for making profits however they are made. Very little attention is paid to the suffering and misery that such actions can cause, and perversely we have a situation where companies prey on the suffering of the people. In the search for profits and increased profits we see the suffering of the masses whether from Nigeria to Indian to Uzbekistan. Even in western countries companies ruthlessly prey on the consumerism of the masses. The sub-prime housing sector is exactly that, it is an act of exploitation as companies offer big loans to people with bad credit histories as long as they offer their house as collateral! Since the targeted people are the most likely to have a spending problem, these loan companies will then repossess the house and sell it to obtain their money plus the extortionate rate of interest added on top.

From this exposition it should be clear that the current crisis proves once again that the financial markets for all its glitz and glamour constantly crash bringing misery for many, only a handful of rich capital owner's benefit from the markets due to the influence they yield. What needs to be discussed is how an alternative system will solve such problems and provide opportunities for investment. In part 2 an outline will be provided on the Islamic economic system and how it will solve the problems we have witnessed in the financial markets, how it will provide investment opportunities, a stable economy and wealth for the people.

In part 2 an outline will be provided on the Islamic economic system and how it will solve the problems we have witnessed in the financial markets, how it will provide investment opportunities, a stable economy and wealth for the people.

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