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Just
how bad is the world's derivative habit?
'Credit' has an almost religious quality for consumers, which parallels its genuinely religious relatives 'credo' and ‘creed’ – both from the same linguistic root. Yet like cocaine it comes in lines and is a powerfully habit-forming stimulant; a much less attractive imagery. "Prosperity was assisted, too, by ... stimulants to purchasing, each of which mortgaged the future but kept the factories roaring while it was being injected ... People were getting to consider it old-fashioned to limit their purchases to the amount of their cash balance; the thing to do was to 'exercise their credit' ... 15% of all retail sales were on an installment basis ...It was fun while it lasted." - Only Yesterday, an informal history of the 1920s, F.L. Allen (published 1931). The 'stimulants to purchasing' of the 1920s were the initiatives of private businesses, and although reflecting our own times were benign by comparison. Credit was extended, at least a little cautiously, to people who had some prospect of paying the money back. Nowadays access to credit is a human right. It is available to consumers through personal loans at the bank, credit cards by direct mail, and store-cards at the till. Its mail-based advertising single-handedly sustains the postal service. So important is it that the British government even intends creating a publicly owned state bank to grant it to those unfortunates unfairly excluded by the prejudice of a private banking sector which reckons these prospective customers most unlikely ever to have the means to pay anything back. (Wise of the banks; unusually dim even for a government.) But although current consumer indebtedness is bigger than it has ever previously been it is still only the tip of the iceberg. Corporate consumption of credit is worse. Through the international bond and derivatives markets it is driven by a repeating cycle of government intervention.
Eventually the credit rating agencies notice the level of borrowing, drawing attention to the top-heavy debt structure of these businesses and the risk of economic shocks. Some managements quiet down, jealous of their investment grade credit rating. Others – most now – anxious not to be the victims of the next takeover, extend themselves 'off balance-sheet' into the derivatives markets. Here - under the disguise of clever financial management - they underwrite financial contracts for fantastic amounts of money and generate small profits on large but improbable risks. These derivatives are just like insurance, only the risk that is being insured is not a fire, or a flood, but the equally low risk financial equivalent - something like "the yield on 10 year US Treasury bonds, less the yield on 5 year Japanese government bonds, divided by the yen/dollar exchange rate will not exceed 5% before the end of 2004." They are always confusing and in the end rather unlikely to go wrong. But they can. Procter and Gamble famously found out what can happen when their £200m borrowings were 'insured' by derivatives to save $7.5m over 5 years. When the impossible happened their small saving turned into a loss - effectively an insurance claim against them - of $157m. Unfortunately the reason derivatives remain popular is that for every Proctor and Gamble there are 50 smaller winners, for whom the risk pays off, resulting in what amounts to financial insurance profits being generated apparently out of nowhere – from 'off' the balance sheet. And what happens to these lucky companies? Their profits rise, their shares follow, and the brilliance of their management leads them to take over those companies more circumspect than themselves. So the derivative habit is perpetuated and companies start to rely for their profits on being lucky in financial insurance markets - rather than being good at doing something commercial. And all this wonderful magic happens ‘off’ balance sheet, so anyone who assesses risk in the old fashioned way – by looking at a company’s liabilities – have not the slightest idea what is actually going on. The hard evidence can be found in financial figures straight from the publications of the IMF and the Bank for International Settlements. The world bond market - debt which has been issued in the form of traded bonds - grew from $800bn in 1970 to over $35,000bn in 2001. This is 43 times. It is still growing. Yet even this newly colossal bond market is a runt next to derivatives. They have caught the prevailing wind of off-balance-sheet accounting and exploded out of control - allowing financial products to be constructed which are way beyond the regulatory abilities of the banking authorities to police. The BIS estimated the main financial derivatives markets at $1,100bn in 1986. The figure for 2001 for the exchange traded contracts monitored by the BIS was $150,000bn. A further $98,800bn in Over The Counter (OTC) derivatives have to be added as well. So in 15 years the notional sum of derivatives outstanding has grown by nearly 250 times. This combined $250,000bn in derivative exposure is about $50,000 for every person on the planet, or $250,000 for every person in the developed world. It's $1m per head of financial insurance risk for each of the 250 million richest people on earth, even though there are only about 15 million dollar millionaires out there - worldwide. Yet in the minds of the investment bankers every cent of these derivative exposures is secure credit. They believe. J.K.Galbraith - who wrote the definitive account of the events surrounding the Great Depression of the 1930s - had this to say about the financial instruments which helped cause it:- "One of the paradoxes of speculation in securities is that the loans that underwrite it are among the safest of all investments. They are protected by stocks which under all ordinary circumstances are instantly saleable, and by a cash margin as well....A few firms made this decision: instead of trying to produce goods with its manifold headaches and inconveniences, they confined themselves to financing speculation...This was, possibly, the most profitable arbitrage operation of all time." The Great Crash - published in 1954 In only one detail does this comment seem dated. Now surely Professor Galbraith would concede that the 1920s offered only the second most profitable arbitrage operation of all time. Articles in the series include:
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2004 Paul Tustain Contact Info
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Paul
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