October 30, 2007

Lets hide the debt problem!

Filed under: Economics, Musings, Observations, Worries — Tags: , , , , , , , , , — conceptualizer @ 5:16 pm

The Master Liquidity Enhancement Conduit (MLEC) fund has been created by several big US banks with between $75bn and $100bn (depending upon who you believe) to buy up debt from Structured Investment Vehicles (SIV) which in simple terms are mortgage providers. The debt is largely in the form of Residential Mortgage-Backed Securities (RMBS) and Collateralised Debt Obligations (CDOs) – i.e. mortgages. SIVs, which own about $400bn of assets, are investment pools used by banks, but most enthusiastically by Citigroup who originated them in the 1980’s. It is now clear SIVs have been too keen to offer debt to financially dubious property buyers. The MLEC is an attempt by the private sector to mitigate some of the risks associated with bad debt incurred during the US property price bubble. That bubble was inflated by the poor lending strategies of the SIVs and ultimately those that initiated them. The MLEC fund will be accepting only the best risks, leaving the worst in the SIVs, so they will flounder rather than the banks. It is interesting to speculate as to why this cause was not taken up by the IMF, whose role it is to promote international financial stability. Perhaps they do not see it as a big enough problem.

So can this fund help? Well as an attempt to reintroduce confidence to the market and hence stability, to some extent that is going to happen, especially as it has the tacit approval of the US treasury. However, ultimately the problem is rooted in lending money on the basis of economic growth that was not there. Now that position has to unwind and the costs of the overestimate will have to be dissipated. This fund can only act as a buffer, trying to spread and slow the normalisation cost, it still has to happen. So in that sense it is more like an attempt to convert a painful punch into a protracted uncomfortable pressure. The problem has to be handled and it seems that somewhere someone has made the decision that the drawn out normalisation approach is the better option. So as we get used to the inevitable slowdown, the remaining market confidence will be subdued rather than demolished. In that sense it is a better strategy as stability and confidence are perhaps the most essential assets of a reliable economy. Ultimately the costs of this failing will be carried by everyone, the banks will ensure that, rather than just their shareholders.

September 11, 2007

Debt to save the world!

Are you wondering how the problems in the US sub-prime market can be so pervasive? I am. Surely that market can’t be that big and not all of those borrowers are going to default. I suspect the problem is more to do with a lack of confidence afflicting the markets. They have had such a good run for so long people are suspicious and looking for that next crash. This probably says as much about human nature as it does about debt. However, in general the amount of debt is increasing while savings decrease (lowest household savings ratio since 1960), so should we be concerned? If we extrapolate carefully from this situation we can uncover some interesting trends that will impact on us all.
The US sub-prime problem is a personal debt problem rooted in the combination of: widespread lending to people at the limits of their ability to cover repayments, at low interest rates, with high loan to value conditions, in a confidence lead rising property price market with big property development programs. Later, increased interest rates were the trigger that pushed those closest to the edge over it and once enough had succumbed the price bubble burst. With increasing repossessions, declining property values and high loan to value conditions lenders suffered big loses. They then tried to increase their margins to recover their positions by increasing interest rates on their most risky situations and pushed more borrowers into the red exacerbating the situation.
Significant personal debt was once a facility only available to a small fraction of people, but recently it has become available to almost all people. This broadening of the debtor base to include less wealthy and financially sophisticated customers tends to encourage debt commoditisation. Commoditisation reduces profit margins, consequently money is chasing larger customer volumes and larger fractions of the market. This change militates against the small lender, increasing pressure to consolidate into fewer global money managers (GMM) providing credit and debt services. When they become large enough their financial power will eventually succeed even that of central banks to influence interest rates and so governments will gradually relinquish some economic control to them.
In addition to growing personal debt, governments are not shy about creating a public debt on our behalf. This has been the case for a long time, such as when financing the second world war effort, for which we could not reasonably have been expected to save as we did not plan it. Outside of unplanned costs like war, how can it be that a whole country can’t live within its means? Like any individual, government should save for expenditure rather than use the more expensive option of borrowing. Unfortunately, saving is a long-term strategy that is not encouraged by our current system of government. It is much easier to ride a wave of popularity fuelled by spend from debt than to tell everyone we have to save. The end effect of this is again to imbue the GMM with greater control as they increasingly own the money lent to the individual and the state.
The rise of the GMM will have some interesting consequences. Firstly, interest rates are facing long-term downward pressure as the GMM seek to encourage every person and country to become a customer, essentially owning some of their generated wealth. So the GMM will seek to make debt easier to afford with lower rates and savings are going to be less remunerative due to tighter margins between their credit and debt services. This will be a problem for savers (who fund the GMM) if inflation is not restrained. One corollary to this situation is increasing pressure on governments to keep down inflation. This will lead to tightening on expenditure, for example leading to more frequent disputes with public sector workers over pay. Another corollary to this is that those seeking higher rewards will increasingly become financial instrument market speculators, so we should see an explosion in speculation management services specialising in certain sectors of the markets and on specific classes of investor. For similar reasons as in the creditor consolidation, international financial market consolidation is inevitable and already ongoing. Protectionists economies lack vision and will find their markets increasingly sidelined until they capitulate, but then their influence will be much smaller. Secondly, economic power will increasingly rest with the GMM, with governments forced to recognise their influence. This should eventually resolve in GMM taking a moderating role in international disputes, becoming the ultimate non-partisan authorities that no government ever can be.
So, in the short term those debtors existing at the margins will have a tough time in several countries, but the problem is too small to cause lasting or widespread damage. In the medium term this is a lesson about hubris being tolerated. In the long run the GMM will ultimately convert our own desire to get things without saving first into a stabilising international force. The emergence of the GMM and their concomitant economic power is a defining characteristic of our age.

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