Whereas just a few months ago there seemed no end to the upward drive of stock market prices and availability of loans to buy companies, build skyscrapers or invest in ever-mushrooming condominiums from San Diego to Shoreditch and Shanghai; now all has changed. An abyss has opened up before the financial sector of capitalism.
Every day another huge global bank announces that it has had to ‘write-off' the value of assets that it has bought (mortgage loans for houses in the US or bonds that are ‘backed' by the value of mortgages in America). It's $10bn for Citibank, $5bn for HSBC, $8bn for Merrill Lynch and so on. So far, the banks have fessed up to $60bn of losses.
And heads have rolled. The head of Citibank, the biggest bank in the world (until a Chinese bank surpassed it last month when it launched on the stock exchange), has been sacked and forced into taking a redundancy package worth $150m. He was followed by the head of the biggest investment bank in the world, Merrill Lynch.
And around the world, smaller banks and financial institutions have not just lost money, but have gone bust. In the UK, it was Northern Rock, a lender of mortgages in the north of England. Big mortgage lenders have gone bust in the US. The biggest American lender, Countrywide, is on the brink with huge losses recorded. Desperately, the big banks are trying to drum up a special fund worth $75bn to help fund lots of small ‘Special Purpose Vehicles' that they originally set up to make extra profit.
Even supposedly ‘safe and prudent' financial institutions like company or local government pension funds have been burnt. Few people in the remote Norwegian town of Narvik, 200km north of the Arctic Circle where the sun has disappeared until January, were likely to have given a lot of thought to the credit squeeze sweeping the global money markets - that is, until it threatens their wages over Christmas.
Narvik, along with three other similarly isolated towns of Hemnes, Rana and Hattfjelldal, has become the latest community to discover just how directly even the most remote places can be affected by the financial turmoil after it made multi-million dollar bets on complicated US-linked financial products.
The towns invested about $96m (€65m) in complex products linked to unspecified municipal bonds in the US, designed by Citigroup, and sold to them by Terra Securities, the investment banking arm of one of Norway's leading banking groups. Now representatives of the towns have admitted that recent market movements linked to the credit crisis had destroyed most of the value of their investments.
The great credit crunch is not located just in the US, but is everywhere. And it's only just begun. The OECD estimates that the final losses from this credit contraction will be $300bn. Other bank estimates put the hit at $400-500bn, or about 1% of global annual output.
It's going to be that big because the start of the problem was in the US housing market. Way back in the early 2000s, a huge boom began in the US residential property market, not dissimilar to the boom in the commercial (factories and offices) property market that started in the mid-1980s in the US. As money flowed into the property market, mortgage rates plummeted and banks began to offer easier and easier loan arrangements.
Whereas before the usual US mortgage for 75% of the value of the house was at a fixed rate for 30 years, while house prices rose at a moderate 3-5% a year, now you could get a 100% (or even more) mortgage at a special discount rate of near zero for the first few years, with even the cost of paying that ‘back ended' to the cost of the loan, which could be just ten years.
Moreover, if you could not prove that you had a good steady job with income to pay the loan, it did not matter. Because house prices were now rising at 15% a year, you could easily cover the cost by selling on or borrowing more later. Banks would lend what they called ‘sub-prime' mortgages (so-called because they were made to riskier borrowers) without compunction.
The housing boom took off as the Federal Reserve Bank cut interest rates down to 1% and the head of the bank then, Alan Greenspan, declared publicly that it was a great idea to borrow more and spend to keep the US economy motoring. However, in June 2005, things began to turn for the worse. First, rising inflation forced the Fed to reverse its policy and begin to hike interest rates. It did so for the next 18 months from 1% to 5.25%. Mortgage rates rose sharply and borrowers began to feel the pinch.
Most important, house prices had got so far ahead of incomes, which for the average American family had hardly moved, that lots of new homes coming onto the market were no longer affordable. Builders found that they could not shift their new condos without massive discounts and incentives. Eventually, even that was not enough and those sub-prime borrowers who had bought without adequate incomes or had done ‘buy to lets', with the hope of ‘flipping' their purchases quickly into sales, could no longer afford their homes.
Defaults on sub-prime mortgages rose from 3% to 15% in a year. Lenders suddenly found that their highly lucrative mortgage incomes were dropping fast. And here is where the problem got so much worse.
In the great new world of the global finance capital, the mortgage lenders had not kept these mortgages on their books. They went to other banks and particularly to smaller financial organisations like hedge funds (funded by blocks of capital set up by some financiers using the money of very rich people and promising them huge returns) and said: look why don't you buy a block of mortgages from us? Some mortgages will be prime (good credit) mortgages and some will be sub-prime. But a batch of this mortgage debt (a mortgage-backed asset) will pay a lot more than interest at the bank or even interest from a government bond. And don't worry, it's really safe because house prices are going up and up and anyway your batch of mortgages includes lots of good safe ones.
And then the banks went to insurance brokers and said: why don't you offer insurance on these mortgages defaulting? It's not going to happen so you can make money selling premiums to the buyers of our mortgage-backed securities. And they did.
Soon everybody and his dog was buying and selling mortgage securities around the world. Sub-prime mortgage securities reached $3trn globally and prime mortgages reached another $25trn.
This was similar to what the savings and loans banks in the US did in the 1980s. They were very small savings banks that collected the savings of all the people in the small towns of mid-America. Then they lent their money to local businesses to build offices, factories and develop.
But a boom in commercial property broke out as interest rates fell and the owners of these small banks thought they were onto a winner. They began to lend to businesses in a big way and got involved in lots of big commercial projects offering very good low and fixed rates of interest. But then interest rates began to rise as inflation exploded in the late 1980s. These banks found they had to pay higher rates to depositors, but could not raise rates to their business borrowers. The banks went bust, or their owners did a runner with the local people's deposits.
Both the savings and loans disaster in 1980s and the sub-prime crisis now are examples of how a corrupt and greedy capitalism tries to maintain economic momentum by turning to unproductive sectors because the productive sectors have weakened.
In the US, the rate of profit earned by all sectors of capitalist investment peaked in 1997 (see our previous articles in this column). As explained by Marx, capitalists are continually trying to increase the profit they make out of their workers. If they don't, then their competitors will undercut them in price or invest more to lower costs.
This competition drives capitalists to find new ways of raising profits. Once they have exhausted the exploitation of the workforce, they can only raise profit by using new labour-saving forms of technology. That requires extra capital invested in machinery and plant over labour. This rising proportion (that Marx called the organic composition of capital) begins to drive the rate of profit down just as the mass or overall total of profit rises. Eventually, the falling rate of profit will exert enough influence to stop the mass of profit rising.
That process began in earnest in 1997. Eventually the hi-tech boom of the 1990s burst in a stock market collapse of 2000 and the mass of profit stopped rising in 2001 and there was mild recession. But the recession was only mild because capitalism tried to keep the system going by the expansion of credit into unproductive areas like finance and property. The boom in property provided a cushion against the collapse of productive forces. This even reversed the fall in profitability for a while, from 2002 to 2006. Employment and economic growth also picked up.
But to achieve this, there had to be a huge expansion of money credit, indeed the largest in capitalist history. Marx called this fictitious capital. Credit is money supply (printing banknotes and increasing bank reserves), debt (issuance of bonds and loans) and stock market values (increased prices for buying and selling shares in companies). When this expanded way beyond the accumulation of real capital, it was fictitious. The prices of shares, bond and houses did not match the value appropriated by capitalists from the sale of things and services produced by workers in factories, offices and transport facilities, namely profits.
In the first seven years of the decade of 2000, fictitious capital grew at over 25% a year compared to the growth of real production in the capitalist world (up a maximum of 5-7% a year). Money supply printed by the central banks rose about 7% a year, while banks increased loans by over 10% a year. And then there was the issuance of bonds by big companies and governments. That form of credit rose by over 15% a year to reach $73trn by 2006, or around 140% of world annual production.
But the most staggering part of the explosion of fictitious capital was in the value of what are called derivative contracts. Of the $70bn in debt, about $11bn was ‘sold on' over and over again in various contracts derived from that debt. These derivatives, in essence bets on the future value of a bond, a mortgage or a share, rose in value to a staggering $550trn, or 11 times world annual output.
This made for easy money, allowing borrowers to buy property, shares and other assets by the bucketful. But most of this expansion of credit was into unproductive sectors of the capitalist economy - sure, it delivered jobs and income, but as Marx explained, under capitalism, it was unproductive because it did not create value that could be used to reinvest in new production and drive the economy forward. Indeed, as more and more money went into the stock or property markets, less and less was available for investment in industry, new technology or better skills for the workforce.
As we have shown in this column before, it has been a feature of modern capitalism in its declining phase for capital to be invested more in unproductive rather than productive sectors. For example, the financial sector now contributes 30% of the profits of capitalist businesses in the US. Strip that away and the productive sectors of the economy are not doing well. Indeed, the underlying rate of profit has fallen over a period of decades, even though there are long periods when it rises.
The credit crisis is the other side of the coin. Once the US property market began to collapse from summer 2005 onwards, so the massive credit boom was revealed for what it was - a fantasy, not based on real values.
Now the credit bubble has burst just like the hi-tech dot com bubble burst in 2000; and just like the savings and loans bubble in commercial mortgages did in the mid 1980s in the US; and just like the credit bubble in Japan did at the end of the 1980s.
Banks are now losing money hand over fist. So are the clever hedge funds and insurance brokers. Credit is contracting fast, as fictitious capital goes up in smoke and the real level of values is revealed. This real value will be found at a much lower level of production, employment and income - and of course, at a much lower level of profit.
The collapse in credit will be just as severe over the next few years as the expansion of fictitious capital was in the last five. And this time, the profit cycle is also in a long-term downward cycle that still has some way to go to reach the bottom. At the same time, we remain in a long-term downward cycle for share prices, which express the confidence that capitalists have in their own system. Finally, the global property market is dropping too, not just in the US, but also in the UK, Europe and later in parts of Asia.
Everywhere the arrows are pointing down for capitalism. This synchronised downturn in profitability, credit, stock and property prices heralds a major economic slump by 2009-10, or even earlier. The credit crunch will lead to the worst global failure of capitalist production since 1980-2 and perhaps even as bad as 1929-33.
- “A financial September 11” - Lessons of the banking crisis – Part One and Part Twoby Alan Woods
- Britain: The rocky road to ruin by Michael Roberts (September 19, 2007)