CHAOS CHRONICLED
Alf Field
"Men haven’t changed much in
the last 2,000 years and, in consequence, we must still learn from history." – Kenneth Clark, "Civilisation"
"You
shouldn’t be worried. You should be angry. We’ve just come off a multiyear orgy
of irresponsibility and recklessness that’s unprecedented in the history of
finance. Where was the government? Where were the regulators? How did this
happen?" - Barry Ritholtz, CEO at
Fusion IQ.
THE WORLD FINANCIAL CRISIS
Indeed, how did it happen?
The onset of the world’s worst financial crisis in many decades is one of the
most important factors (if not the most
important factor) currently influencing investment decisions.
The crisis has created
chaos and confusion. Not many people understand how the world has arrived at this
unfortunate situation. This report endeavours to identify the underlying causes
of the crisis and explains why the USA current account deficit has
been the main destabilising force in world finance.
To fully comprehend what
has happened requires at least a rudimentary knowledge of a number of subjects,
viz:
- Money - its origins and the various forms into which it has evolved;
- The Fractional Reserve Banking system;
- The International Monetary System;
- The development of derivatives, especially the Over The Counter (OTC) derivatives market;
- How the various inputs melded into the difficult crisis that the world is now facing.
Some of what follows is
very basic, but it is important to work through all the background in order to
eventually reach the point where the reader will hopefully experience a moment
when understanding dawns.
1. MONEY – ITS ORIGINS & DEVELOPMENT INTO DIFFERENT FORMS
Money evolved to
facilitate the exchange of goods and services. In a barter economy in ancient
societies one or two items became commonly used to facilitate exchanges. These
items were useful and attractive to everyone. They were traded, not for
themselves, but because they represented items that retained their value and
could be traded later for other goods and services. These items represented the
original forms of money.
These items that emerged
as money had a number of basic characteristics. They facilitated the exchange
of goods and services and could be divided into small units so that even the smallest
items could be traded. This function is called the "medium of exchange".
Secondly, they provided a means of measurement of the relative values of
different items, this is the "unit of measurement" function. Finally, the items
used as money should not deteriorate so that they could be stored as savings
for future purchases. This is the "store of value" function. All forms of
successful money perform these three important and basic functions.
When the Bronze Age
allowed men to produce metals, the metals soon became used as money, called
"commodity" or "metallic" money. The metals were not perishable whereas early
forms of money tended to be livestock and agricultural commodities which had
limited life spans.
Many centuries of trial
and error saw gold and silver selected as the primary forms of money, followed
by copper and base metals. The use of precious metals as money really took off
when coins were minted containing a guaranteed amount of metal, the guarantee
being evidenced by the image of the King or Emperor stamped on the coin. In
Roman times the Aureus and Denarius were the gold and silver coins in general
use.
(See www.unrv.com/economy/romans-coins.php
for a more detailed account of Roman coinage.)
These coins were widely
accepted until the Romans started reducing the precious metal content of the
coins, making up the weight with cheaper metals. This trend towards debasing
the coinage eventually resulted in the demise of the Roman currency and also of
the Roman Empire. The gold Bezant, produced in
Constantinople, became a coin used
successfully for over 800 years in international as well as national trade. It
was the forerunner of other coins that were minted in European countries
through the middle ages.
Gold and silver coins are
heavy to carry around in quantity. Goldsmiths, who manufactured gold and silver
jewellery, had secure vaults to protect their stocks. They extended their
businesses to provide a safe-keeping service for wealthy individuals who owned
large quantities of coins. The Goldsmiths issued receipts for the gold
deposited with them. These paper receipts contained the following wording: "I
promise to pay Bearer on demand at the above address xxx gold coins".
These receipts were
accepted by merchants and traders as being "as good as gold" and were the forerunners
of modern bank notes. They were more convenient to transport and use than the
heavy metallic coins. Thus the second form of money was "receipt" money, following
after "commodity" or "metallic" money.
Goldsmiths spotted another
opportunity to expand their businesses by making loans of gold coins. Initially
the loans related to their own capital. The Goldsmiths simply issued a receipt
against their own gold holdings to the borrower. Later, when the Goldsmiths
noticed that only a small proportion of the gold coins held in storage were
ever claimed by their owners, they started increasing their loan business by
issuing receipts in excess of the gold that they had in storage. As long as
they always had sufficient gold coins on hand to meet the quantity of receipts
tendered for return of gold coins, everything was fine and the holders of the
receipts were not aware of the shortfall in available gold coins.
In this way "receipt"
money morphed into "fractional receipt" money, so called because the stock of
gold coins in the Goldsmiths’ vaults was only a fraction of the gold receipts
issued by the Goldsmith. If greed caused a Goldsmith to issue a vastly
excessive number of receipts, it would cause concern amongst the receipt
holders. This could lead to a sudden unexpectedly large surge of redemptions,
absorbing the entire supply of gold coins in the Goldsmith’s vaults. In those circumstances
the Goldsmith was bankrupt and would leave town in a hurry, just ahead of the lynching
mob consisting of the remaining holders of unredeemed receipts which were now
valueless pieces of paper. The threat of bankruptcy had the effect of imposing
a discipline on the lending activities of the Goldsmiths.
Goldsmiths were the early
bankers and the "fractional receipt" form of money eventually developed into
the modern "fractional reserve banking system" which is in common use around
the world. This system is discussed in more detail in the next section.
The final form of money
that we need to discuss is the money in general use around the world today. It
is money issued by Government edict and defined as "legal tender". This simply
means that all citizens are required to accept "legal tender" bank notes in
trade and settlement of debts. It is commonly called "fiat money". This is what
we all work for and use for living expenses.
There were times when fiat
money could be exchanged for gold at a country’s national reserve bank. When
convertibility into gold was available, fiat money was "as good as gold" and
generally accepted. The cost of the two World Wars necessitated a change
because both the UK and the USA had to
create far more of their local currencies to pay for the wars than the
available gold stocks allowed.
The Bretton Woods
agreement signed in June 1944 fixed gold convertibility of the US Dollar at $35
per ounce, but convertibility was only available countries holding gold in
their national foreign exchange reserves. Convertibility for individuals was
cancelled. All other currencies were given a fixed relationship to the US
Dollar. This system worked well until the late 1960’s when it came under
pressure with many countries, led by France, exchanging their US Dollar foreign
exchange holdings for gold.
In August 1971 President
Nixon bowed to the pressure and abandoned the convertibility of the US Dollar
into gold at $35. This launched the world into a new and untried system of
completely floating fiat currencies. All countries were put in a position where
they could create unlimited amounts of their own local currencies without
restriction. This is one of the important sources of trouble leading to the
present crisis.
2. THE FRACTIONAL RESERVE BANKING SYSTEM
Modern economies use fiat
money systems where the local currency is designated by Government edict to be
"legal tender" that must be accepted in all commercial transactions within the
economy. Modern fiat money is not convertible into anything and is based simply
on the "full faith and credit" of the Government concerned. This fiat money may
only be created by the Government concerned, although most governments delegate
this function to the country’s Central Bank (CB).
Modern banking systems
allow Governments to "stimulate" their local economies by creating money and
injecting it into the banking system. Assume that $10m is injected in this way
and it is received by Bank A which then uses this deposit to make $10m of
loans. These loans are used by borrowers and eventually deposited in other
banks. This results in other banks receiving deposits totalling $10m. This
sequence could go on indefinitely until an infinite number of loans are created
on the back of the original $10m deposit.
To limit this multiplier
effect of new money entering the system, banks are required to place a fraction
of their new deposits with the country’s CB and it is only the remainder that
may be loaned out. Typically the fraction of new deposits required to be placed
with the CB is of the order of 10%. Thus in the example above, Bank A receiving
a new deposit of $10m would have to place $1m on deposit with the CB and would
be free to loan $9m. The bank receiving deposits from the $9m loaned by Bank A
would have to place $900,000 with the CB and would be free to lend $8.1m. Banks
receiving the $8.1m would have to put $810,000 with the CB and could lend
$7.29m, and so on. Eventually the original injection of $10m is multiplied to
$100m in loans, a ten-fold increase of the original $10m deposit.
The fraction of deposits that
must be placed with the CB, which is called the "reserve ratio", can be varied
from time to time. It is one of the tools available to the CB to control the
economy and banking system. A few years ago the reserve ratio in China was 7% which
allowed Chinese banks to multiply new deposits into loans 14 times greater than
the original deposit. With inflation increasing in China, the reserve ratio has been steadily
increased to around 14%, allowing new loans to be "only" a 7 times multiple of
new deposits.
In Australia the
reserve ratio is 8% allowing a 12.5 times multiple of new deposits. Most
Australian banks operate on a more conservative ratio. For most countries, the
ratio is about 10% allowing a 10-fold multiplier of new deposits. This is the
ratio that we will use in the following discussion.
A typical bank is a highly
geared operation with reserves only 10% of assets. The majority of bank assets
are loans. Major losses (generally bad debts) can cause pressure on the bank
from several sources, pressure that has the capacity to bring the bank to its
knees.
Each day a bank must
regulate its reserve balance with the CB. After all trades are cleared at the
end of a day, some banks will have surplus liquidity while others will have
shortfalls. This gives rise to the overnight borrowing market where banks with
surplus cash will lend to those with a shortfall so that they can top up their
reserve deposits at the CB. If a bank with a shortfall cannot borrow sufficient
funds in the overnight market, or if the other banks refuse to lend to that
bank, the bank with the shortfall can borrow from the CB at penalty rates.
If a bank has to borrow
excessively from the CB for a lengthy period of time, other banks and
depositors will become suspicious of that bank’s ability to carry on in
business and will withdraw their deposits from that bank. This can happen via a
line of individuals trying to withdraw their deposits (as in Northern Rock in
the UK)
or by electronic withdrawals (as in the Bear Stearns case). We will return to
Bear Stearns in section 5.
This is a brief sketch of the Fractional
Reserve Banking System, sufficient for the purposes of this discussion. A
detailed review of this subject by Murray Rothbard can be found at:
www.lewrockwell.com/rothbard/frb.html
3. INTERNATIONAL MONETARY SYSTEM
As previously mentioned,
in August 1971 President Nixon decreed that the USA would cease exchanging gold at
$35 per ounce for dollars tendered by foreign central banks. This act
completely changed the International Monetary system and removed the discipline
that gold provided under the Gold Exchange Standard which was introduced at the
Bretton Woods Conference in 1944.
Once gold was removed as
the disciplining factor in the monetary system, a new reserve asset had to
emerge. The US Dollar, presumably because of the size of the US economy,
became the de facto
international reserve asset. What evolved became known as the
US Dollar Standard.
The principal flaw in the US Dollar Standard is that it has no
mechanism to prevent or correct large and persistent trade imbalances between
countries. Under the Gold Standard and its successor, the Gold Exchange
Standard, countries that ran current account deficits had to curb their
activities when they ran out of gold to settle their deficits. They had to
devalue their currencies to stimulate exports and curb imports.
Under the US Dollar Standard, the USA can settle large trade deficits
by exporting newly created US Dollars. Consequently, the deterioration in the US current
account deficit has gone unchecked for decades. It recently reached the level
of $2 Billion per day. This is one
of the major factors that has destabilised world economies, and is a major
contributing factor to the current crisis.
When foreign
companies sell goods in the USA
they take their dollar earnings home and convert them into their own
currencies. This puts upward pressure on those local currencies. The CB’s of
those countries intervene to prevent their currencies from appreciating in
order to preserve their trade advantage. They intervene by creating local money
and using this to buy US dollars. In this way, the exporters are able to keep
their export earnings in their domestic currency, the local currency does not
appreciate against the US dollar and the local CB’s foreign exchange reserves
reflect a large increase in their US Dollar component.
The US current
account deficit of $2 billion per day finds its way into banking systems around
the world as new deposits. Enter the Fractional Reserve banking system
multiplier of 10 times new deposits. This means that banks somewhere in the
world have been given the capacity to increase their loans by $20 billion per
day, and that is per day, provided
that they can find suitably qualified borrowers
That is not
the end of the story. The foreign CB’s need to invest the US Dollar component
of their foreign exchange reserves somewhere. They have tended to buy US
Treasury Bonds, thus returning the $2 billion per day US current account deficit back to the USA. These
purchases result in new deposits into the US banking system of $2 billion per
day. Yes, that does mean that the US banks can also increase their
lending by 10 times that amount, or $20 billion per day, provided that they can
find suitably qualified borrowers.
The magic of
the Fractional Reserve banking system combined with the current unsound
International Monetary system has, incredibly, provided banks around the world
with the potential to increase their loans by $40 billion per day! This is how
massively the US
current account deficit has destabilised the world financial system.
4. DEVELOPMENT OF THE OTC DERIVATIVES MARKET
The US trade
deficit has been growing steadily for nearly 2 decades, providing vast new loan
potential to banking systems around the world. This vast increase in world wide
lending capacity is directly responsible for the various bubbles that have
emerged in different places. Examples are Japan
in the late 1980’s (stock market and real estate), in other Asian countries in
the 1990’s and more recently in China.
In the USA, the technology
bubble and the recent real estate bubble were supported by this huge increase
in liquidity flowing from the new lending capacity injected into the world’s
banking systems by the US
current account deficit.
Not
surprisingly, banks have had increasing difficulty finding suitable investments
and credit-worthy borrowers for the vast amount of potential new lending
capacity that they had available. Huge demand for new products or new
investments emerged. Fertile minds on Wall Street and in other financial
centres went to work to develop an array of new investment products with an
alphabet soup of acronyms to satisfy this demand.
The search for
new loans reached increasingly less credit-worthy borrowers. Ultimately
standards degenerated to such an extent that people who should never have been
allowed to borrow, called Ninjas, (no income, no job, no assets), were able to
obtain 100% mortgage loans to purchase homes. The bottom of the borrowing
barrel had been scraped bare. Thereafter it was only a matter of time before
trouble in the form of losses emerged.
Bankers must
have been aware of the risks being run in this highly charged situation of
easily available excess liquidity. Over The Counter (OTC) derivatives were
developed to provide insurance against specific risks and to distribute the
general risks over a wider market. These OTC contracts are individually
tailored instruments. A whole new lexicon or vocabulary has evolved around
them. Words such as caps, collars, floors and swaptions emerged out of the Bear
Stearns fiasco. What these words mean can only be ascertained by lawyers
looking at the small print of each derivative contract.
There is no
clearing house or market authority standing behind these contracts to ensure
that they are fully discharged. In the event of some parties going bankrupt or
simply refusing to meet their obligations, the counter parties to those
contracts would have no alternative but to sue the defaulting party or stand in
the line of creditors in the bankruptcy proceedings. .
The Bank for
International Settlements (BIS) makes an attempt to quantify the growth in OTC
derivative products. Growth has been phenomenal, recently reaching something of
the order of more than $500 trillion (with a T) in "notional" value. Notional
value simply means the gross amount covered by the contract. For example an
option or swap contract covering $100m of bonds might cost say $2m in premium.
The $100m is the notional value while $2m is the initial underlying market
value. Subsequently the market value of a particular contract could vary from
zero to $100m depending on the terms of the contract and how the underlying
securities perform.
There is an
element of double counting as many contracts have been arbitraged or sold to a
range of different parties. The BIS only picks up OTC derivatives from banks
and similar sources and makes no attempt to quantify OTC derivatives entered into
by non-banking participants such as hedge funds, investment funds, stock
brokers and others. The BIS believes that their figures cover about 85% of
outstanding OTC derivative contracts but the truth is that they really don’t
know how much non-banking participants have generated in OTC derivative
contracts.
The growth in
OTC derivatives has been dramatic, particularly over the past decade. Credit Default
Swaps (CDS) have been the fastest growing derivative category recently. They
are a form of stop loss insurance on credit or financial instruments. CDS
derivatives have grown from $10 Trillion to $46 Trillion (notional value) in
the 2 years to June 2007. This included a massive gain of $24 Trillion in just
the 6 months to June 2007, a breathtaking 109% gain in half a year. A lot of
people must have suspected what was coming and bought insurance against
possible loss. It remains to be seen whether they will be able to collect on
these contracts.
The numbers involved in
OTC derivatives are so massive, even if calculated at supposed "gross market
value" (assuming that it was possible to calculate that number), that they
dwarf the rest of the numbers in the world economy and financial system. The risk inherent in OTC derivatives is that
the entire edifice can only function provided all parties involved meet their
obligations when they fall due. A collapse of a major counter-party could
trigger a domino like collapse of banks around the world.
5. HOW IT HAPPENED
The crisis has reached the
point where the US
banking system has effectively exhausted its reserves that it should have with
the Fed. The US
banks are functioning only because the Federal Reserve is lending the banks
what they need to meet their reserve requirements by taking on questionable
assets at cost. It makes nonsense of the fractional reserve system of banking
when the banks have virtually no reserves and are operating only courtesy of
the Fed.
The desperate measures to
save Bear Stearns (BS) were implemented because of the "inter-connectivity" of
banks and investment houses involved in the OTC derivatives market. BS had an
exposure to OTC derivatives of more than $13 trillion notional value. If BS
went bankrupt and could not meet its OTC derivatives obligations, it could
possibly have triggered a domino like banking collapse.
JP Morgan Chase had the
largest exposure to OTC derivatives of all the American banks at $78 trillion
prior to taking over the OTC derivative obligations of BS. When combined with
BS, Morgan will have an exposure of over $91 trillion to OTC derivatives at
notional value. This is nearly 18% of the world’s exposure to these
instruments.
How did it all
happen? Alan Greenspan is the top culprit being blamed by the media. There is
an element of truth in this allegation but his part was a small one. The fact
is that the world went along with the major problem, being the US trade
deficit, and accepted US dollars in exchange for real goods and services. World
wide fiat money and fractional reserve banking systems caused a much bigger
flood of liquidity than Greenspan was ever responsible for.
Greenspan possibly
did take interest rates too low for too long and allowed the Fed to be more
accommodative than was strictly warranted during the early years of this
decade. The cake had already been baked by then. Greenspan’s free and easy
attitude simply accelerated the eating of the cake. If Greenspan had taken a
strongly decisive attitude, as Paul Volker took in the 1980’s, Greenspan would
have triggered a deflationary collapse. Nobody wanted that.
Call it benign
neglect. Call it national introspection with individual countries only being
concerned about their own interests. Nobody wanted to disturb the status quo.
Call it lack of concern about what would eventually happen. It is summed up in
the attitude: "it’s our currency but it is your problem".
Sure the
rating agencies and the regulators have questions to answer but the real reason
it happened is that the world had to get to a point where totally irrational
lending finally reached the last unworthy recipient of a loan. Then things
could change. It required serious losses to refocus attention on conservatism
and probity. It required losses large enough to get people to really examine
what happened, to correctly identify the causes and to take action to ensure a
better system in the future.
6. WHAT HAPPENS NOW?
It does not
take a genius to work out that the US Dollar Standard (with the US dollar as
the reserve currency) has to go, but it will take a genius to work out what the
new system should be. The new system will require sound money that cannot be
manufactured at will by Governments, money that performs the 3 basic functions
of medium of exchange, unit of measurement and store of value. A new international
monetary system needs to be developed.
It seems that
the eternal money, gold, will have to be returned to the monetary systems, both
national and international, to provide the necessary discipline.
That is all
for the future. Meanwhile there is a mess to clear up and how that occurs will
have investment consequences and implications.
There was a
crisis in the US
banking system during the 1970’s with major loans to South American Governments
going sour. South American countries actually defaulted on their sovereign
loans, leaving the American banks with large losses. If these losses were
brought to account, the banking system would have wiped out its reserves.
Special permission was granted to allow the loans to be carried at book value
until the banks raised new capital and/or accumulated sufficient profits to
write off their South American loan losses. The banks were allowed time to
trade out of their losses.
The current
situation is different. In the 1970’s crisis it was possible to identify where
the losses would fall and the individual banks could quantify their losses. In
2008 it is impossible to identify the quantum of losses or determine where they
will fall. The US
banking system has already recognised losses that have wiped out bank reserves
to the extent that the banks can only continue operating with aid from the Fed.
The losses written off to date are likely to be augmented by additional
sub-prime and CDS losses of presently unknown magnitude. Moreover, it is
unclear where those losses will finally appear. Every bank is suspect.
The mountain
of OTC derivatives is one of the major problems facing the world’s banking and
financial systems. Unfortunately there is no easy way of getting rid of these
derivatives. George Soros recently suggested that a clearing house system
should be established for the OTC derivatives. This is an impractical
suggestion as a brief example will quickly illustrate.
Assume that
investor A buys $100m of 5 year bonds in XYZ Company. He is unsure of the
strength of XYZ Co. and buys a 5 year CDS from B to cover any loss in the event
of XYZ Co defaulting on its bonds. The investor pays a premium of say $2m per
annum. Two years later it is desired to close down this transaction. If A and B
were still the only parties to the transaction, they could sit around a table
and discuss how to determine the current market value of the CDS. IF they could agree a market
value for the CDS and IF both
parties were willing to cancel the CDS, it could be cancelled by one party
paying to the other the mutually agreed amount.
In reality B
will probably have arbitraged its position to a number of other parties and the
investor A may have sold his bonds to a number of other investors with the CDS
protection attached. It is a practical impossibility to get all parties to this
simple transaction together to discuss a possible settlement and cancellation
of the deal. This is just one simple transaction without the complication of
additional features such as collars, caps, swaptions, etc. It is also just one
of zillions of OTC transactions that are in existence. To expect a clearing
house to be able to settle these derivative contracts is just wishful thinking.
This mountain of OTC derivatives has the capacity to
bring down the banking system in the event of the bankruptcy of one or more of
the larger counter parties. Some way has to be found to eliminate this OTC
derivative cancer which would otherwise be fatal to the present system.
History has
shown that when debt becomes excessive, the lenders almost always lose. They
lose either because their debtors go bankrupt or they lose because they are
repaid in currency which has been debased by wholesale printing, making the
currency worth very little in real terms. There is no doubt that the world has
reached an extreme level of debt creation. The only question is whether the
debt will be settled by bankruptcies or whether the debt will be repaid in
largely worthless currency.
Fed chief Ben
Bernanke has made it quite plain that his plan is NOT to allow debt to be
repaid by bankruptcy and deflation. All his actions to date are in line with
his proclaimed policy. There is no reason to think that he will change his
thinking or modus operandi. Thus we
have to believe that USA
has embarked on a voyage that will allow debts to be repaid in debased, largely
worthless currency.
Jim Sinclair
has drawn an analogy comparing the Weimar
Republic in 1919 with the present mountain of OTC derivatives. After World War I the
Allies imposed excessively large reparation claims on the German Republic.
The Germans objected to the magnitude of the claims and only agreed to the
quantum when the Allies allowed the Germans to settle the reparation payments
in Reichsmarks. The Germans then adopted the attitude that "if they want
Reichsmarks, we will give them Reichsmarks". They then proceeded to print new
Reichsmarks at an accelerating rate to settle the reparation debts, eventually
causing hyperinflation that destroyed the German currency.
Jim Sinclair
suggests that if one crosses out the words "reparation payments" and replaces
them with the words "OTC derivative contracts" one would have a clearer picture
of the current circumstances. The suggestion is that the OTC derivative problem
can only be settled by creating sufficient new currency so as to inflate the
currency to the point where it is largely worthless. That would allow all these
derivative contracts to be settled in debased currency.
All the
evidence to date suggests that a liquidation of debt via the deflationary
bankruptcy route could only happen by accident. It is possible to have a
temporary situation where debt is extinguished by bankruptcy in part of the
economy whilst the currency is being aggressively debased.
Eventually,
however, the odds strongly favouring the elimination of currently excessive
debt via debasing the currency route should prevail.
This report
commenced with two quotations and it finishes with 3 quotations. These come
from above the massive arches of the triple doorways into the Milan Cathedral:
Above the
first arch: "All that pleases is but for a
moment."
Above the
second arch: "All that troubles is but for a
moment."
Above the
third arch: "That only is important which is
eternal."
Gold has been
the eternal money.
Alf Field
10 April 2008
Comments to: ajfield@attglobal.net
Disclosure and Disclaimer Statement: The author is not a disinterested party in that he has
personal investments gold and silver bullion, gold and silver mining shares as
well as in base metal and uranium mining companies. The author’s objective in
writing this article is to interest potential investors in this subject to the
point where they are encouraged to conduct their own further diligent research.
Neither the information nor the opinions expressed should be construed as a
solicitation to buy or sell any stock, currency or commodity. Investors are
recommended to obtain the advice of a qualified investment advisor before
entering into any transactions. The author has neither been paid nor received
any other inducement to write this article.
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