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Sub-Prime Driven Recession Coming to a Neighbourhood Near You Soon by Raphie de Santos

Sub-Prime Driven Recession Coming to a Neighbourhood Near You Soon by Raphie de Santos

As global stock markets go through a roller coaster ride, there is talk of a recession and the sub-prime crisis is leading to billions of dollars of losses for the world's major investment banks. Still there is no-one to bail out Northern Rock and the US Federal Reserve suddenly cuts interest rates by 0.75% while a rogue trader losses $8bn pounds. Raphie de Santos tries to make sense of it all, drawing the strands together to show that yet another of capitalism's "golden ages" is over and the fight for a socialist economy remains firmly on the agenda.

The major falls seen in all the world's stock markets mark the end of a long period of capitalist expansion which started in early 1980s. Stock markets discount the future and they are discounting major falls in the earnings of corporations around the world. In other words they are forecasting recession - two quarters of successive negative gross domestic product (GDP) growth - and periods of stagnation across all the major economies. The turbulence is far from over and stock markets hate uncertainty and there is so much of it around. In the weeks ahead we can expect more dramatic falls and partial recoveries. This is because nobody knows the full extent of the sub-prime crisis and its impact on the world financial system and economy.

While it is a widely held view that the US economy will go into recession in 2008, opinion is divided as to what will happen in the other major economies. The most optimistic view is that the UK will enter a shallow recession at the end of 2008 / start of 2009 and the rest of Europe’s economies will stagnate while there will be a slowing down of the emerging economies of China, India, Russia and Brasil.

At the roots of the crisis is the US Federal Reserve (akin to the UK Treasury) decision to cut interest rates aggressively in 2001 to avert a deep recession and help financial markets recover from the bursting of the dot boom bubble. This led to an inflated housing market and cheap credit, leading to a big increase in credit in partiular to those on lower incomes. From this policy flowed the sub-prime lending boom and repackaging of this debt and the seeds of inflation.

Capitalism is caught between a rock and hard place. On the one hand it needs to cut interest rates to increase the amount of money in circulation and ease credit repayments but on the other hand inflation is on the rise because of the demand that has been fuelled by years of cheap credit and growing demand from China and India in particular. Cutting interest rates has a very limited shelf life as if they run with the policy for too long then the major developed economies will start importing inflation because their currencies will be weaker against the currencies of the countries they are importing from.

Already the bond markets are implying that interest rates will have to go back up within six months to a year to curb inflation. All this is combined with end of the benefits of the technological boom that started in the 1980s - productivity gains are being offset with lower profit levels as more and more of the production process is carried out by technology and not humans meaning a reduction in new value or profits being produced.

In this article we will take a look at:

the US housing boom and the Fed

sub-prime lending

shift the debt off my books (engineered financial products)

the kings clothes

impact of China, Russia, India and Brasil on the world’s economy

the Soc Gen and market turbulence

what it all means for ordinary people

and how they are all interrelated and could lead to biggest financial and economic crisis since the 1970s.

The US Housing Boom and the FED

The boom in the US housing market has its roots in the US Federal Reserve (the FED) decision to reduce aggressively short-term interest rates during 2001/2002 to stem the crisis that arose through the bursting of dot.com bubble and the US economy sliding into recession. This created a boom in housing construction, a big increase in the paper value of US residential property which spilled over into the rest of the economy. With short-term interest rates at around 2% banks went out looking for new potential clients.

Interest rates normally increase gradually the longer the loan is for. The idea is that the longer the time of the loan the more chance that someone will not be able to repay it. The lender is paid a premium for the risk of not being fully repaid. The Fed cutting rates so aggressively for short-dated loans that this opened up many new transactions for banks and other financial institutions. They could borrow from each other at low rates for short periods of time and roll the loans over when they matured. At the same time they could lend at higher rates for longer dated loans. There was a fat spread between where they could borrow and where they could lend. As long as interest rates kept low for borrowing for short periods of time they could carry on making money.

All sorts of financial products - sub-prime loans, normal mortgages without offsetting customer deposits (Northern Rock) and Collateralised Debt Obligations (CDOs) – were designed around this strategy. It provided capitalism with new pools of credit to fuel its booms and soften its recessions. We were in a new “golden age” of capitalism where all the old problems of boom and slump had been eliminated. But this market has, as we will see, has blown up. It has brought the great credit boom, which stated after the Second World War. Capitalism will now find it difficult to find sources of credit to manage the fluctuations which are inherent in the system making more frequent and longer recessions likely.

Sub-prime Lending

In the US these fat spreads we have talked about meant banks and loan companies could even loan money out to the poorest sections of society - they could be compensated for even a significant minority of lenders not being able to repay their loans in full. A new sub-prime market was created of heavily indebted individuals, low or middle income households and even people on social security benefits. This type of lending spread to other parts of the world - particularly the UK but not to the same extent. With interest rates as low as 2% lenders could still charge 6-8% to sub-prime lenders to be compensated for extra risk and still make fat profits. The loans were typically mortgages or loans secured on homes.

Shift the Debt off My Books

Traditionally banks and other financial institutions have financed their loans and mortgages through the deposits they receive from their customers. This limited the amount of credit they would offer. At the start of this century they moved to a new model where they sell on mortgages and loans (personal, car and credit) onto the bond markets. This meant a growth in credit. But at the same time the initial lenders no longer have the incentive to check if the borrower is able to repay the loans as they are offloading their risk onto someone else. The business proved extremely profitable for the banks because of the fat spreads we talked about earlier and they used loan and mortgage brokers, who took a fee, to aggressively sell these products to the sub-prime market. In the US up to 20% of mortgages and loans are of the sub-prime type.

The Kings Clothes

The Investment Banks took these sub-prime loans and “engineered” them into complex financial products. Their value was not decided like traditionally shares by an open liquid market place with many buyers and sellers but by complex models. They were valued by the investment banks themselves based on an assumption about how many people would default on the loan and the relationship between the borrowers.

The rate of defaults could be observed but were massively underestimated. The relationship between borrowers (correlation) could not be observed and was estimated quite liberally. As the number of defaults in sub-prime market increased quite rapidly the value of these instruments fell dramatically. Defaults increased as the Fed pushed up short-term rates to curb inflation and the housing market. They did not fully understand the link between property prices, interest rates, the sub-prime market, these structured financial products and the financial system.

The market for these products dried up in the summer of 2007 and rumours swept the market that major banks were in trouble that is the losses on these products could cause bankruptcies. The inter-bank lending market - where Northern Rock borrowed its money - dried up as banks stopped lending to each other as no one knew who might go bankrupt. So far the investment banks have reported $100 billion of loses and this is a conservative number. As we mentioned earlier these instruments are based on an estimate of the relationship between borrowers. Some banks, only a minority, are using an independent estimate which has seen the value of these instruments fall by 80% over a year. If all banks were to move to this estimate the losses are likely to be in the region of $500bn to $1000bn with many likely bankruptcies causing a potential crisis in the world’s financial system. Many of the banks have off loaded these products onto pension funds and insurance companies which mean the person on the street could be facing heavy losses as well. Most of these write downs have occurred in the last quarter of 2007 and will be reported in the next couple of months.

The problem is that nobody knows who owns these products and where the next time-bomb will explode. For instance, the town of Cleveland in the US is virtually owned by a German bank. Of course all these properties are in the poor predominantly black areas.

China, Russia, India and Brasil

Many economic commentators believe that the existence of these markets and the restoration of capitalism in the former so called “socialist states” will lead to a softening of the recession and even the possibility that most countries outside the US and UK will escape it. There is a double edged sword with this argument.

One, these countries demand for raw materials and food have pushed inflation up globally which limits the scope for interest rate cuts in the US, the UK and Europe. Two, banks and financial institutions in these countries are exposed to sub-prime products – nobody knows by how much of course - and this will limit lending and credit and slow their economies. Three, a lot of the wealth in these countries is based on the paper profits of private individuals investing in the local stock markets. Much of this has been wiped out by recent market falls and this will reduce consumer confidence and dampen the economies. Four, recessions in the west will reduce demand for their products and slow their economies down further. Finally, the US, the UK and Europe will try and gain back some of the ground lost in competition with these countries forcing an inter-capitalist protectionist trade war.

All these factors could combine with what is happening in the west to create a truly global slump of 1930s proportions.

Soc Gen and the Market Turbulence

Some parts of the financial markets have tried to blame the market falls on the rogue trader at Soc Gen. This is just wishful thinking, trying to deflect attention away from the real fundamental problems we have discussed..

The Fed has stated they had no knowledge of the near $7bn trading loss at Soc Gen when they made the decision last week to cut rates by 0.75%. The losses meant that the trader had open positions (investments) worth about $80bn. It points to gross ineptitude by the bank's internal risk management. They must have had to post $1bn to $4bn a day to the financial markets (margin payments). They too would have been a large percentage of the positions on several European markets (open interest). How this was not picked up was not down to a trader hacking into internal accounting systems but gross ineptitude as the margin payments and open interest are derived from each local financial system and the trader would not have had the skill and the knowledge to hack into these systems.

Unwinding the investments may have accounted for some of the losses in Europe where Soc Gen had the positions but cannot account for the big falls in US and Far Eastern stock markets where they had no positions.

What it All Means for Ordinary People - Capitalism’s Reaction

Falling profit levels, recession and the credit crunch will see an all out assault by capitalism on ordinary people in 2008. We can expect to see attempted wage cuts, productivity increases, layoffs and workplace closures. Credit will be harder to come by and banks will be very tough in dealing with defaults. We are likely to see a much higher rate of house repossessions and personal bankruptcies in 2008. This together with inflation edging higher, which is lagging the decline in demand, will mean real cut in living standards and hardship for many working people in 2008 . We will also see cuts in public services and rises in council tax particularly from fiscal year 2008/2009 as government revenues come in way below government estimates with a declining GDP.

During 2003-2005 in the developing world the world’s major financial institutions have passed up the opportunity to ease the grip of their suffocating loans. As these institutions seek to put their own houses in order, they are likely tighten the grip on the poor south, leading to more poverty and death.

Unlike capitalism's last major offensive against the poor in the late 1970s, working people's organisations are much weaker and the demographics of capitalism have changed dramatically. But it does not mean there will not be a fight back. In 2008 Socialists will have plenty of opportunities to stand alongside working people and continue the fight for a rationale economy based on the democratic decided needs of the majority as they stand up against capitalism's onslaught.

Raphie de Santos is a former head of equity derivatives research and strategy at Goldman Sachs International and now works in the fund management industry.