I returned from a couple of week’s holiday in the sun yesterday. So for two weeks I saw no news and received no emails. Very refreshing. What was not so fresh was the news that greeted my return. Once again the bankers have been caught up to their tricks of looting their investors and the general public. To anyone outside the world of banking and regulation what they have done, namely fixing LIBOR, the interbank lending interest rate, would be criminal but it seems Barclays may well be let off with an insignificant fine.
You might expect from the national press some interesting new perspective on the banks and their chums in the regulatory authorities and government but all we get is the same old indignation and calls for enquiries and a few stiffer measures to control the banks. The most generalized comments refer to the culture within the banks and this is held by some to be rotten to the core. Well, we can all say ‘aye-aye’ to that.
But what will happen to truly curb the banks in their activities? We all know the answer to that. Nothing. Business secretary, Vince Cable, described the problems in UK banking as “a moral quagmire of almost biblical proportions”, although he did not specify in which book of the bible such a quagmire is mentioned. In reality this moral quagmire is unprecedented in the Old Testament or anywhere else. Bob Diamond, et al, are taking us into brand new territories of greed, power and moral decadence.
Cable says the government is taking urgent action, including creating a clearer separation between “casino-style investment banking” and retail banking on the high street. Well, OK, this separation should never have been abandoned as it was by Bill Clinton and New Labour and fully supported by the Conservatives and the LibDems at the time, but it is hardly enough. In fact nothing that is being proposed to fix the rot by any political party or any commentator or economists will work. This is because the prevailing orthodoxy has no idea of why we have the crisis.
I have argued many times in these newsletters that we will never get anywhere near solving the problems and banking and finance in our economy unless we change completely the way we allow money creation. This is currently almost exclusively in the hands of the private banks. It must be given to the government and managed under a constitutionally protected, democratically controlled, independent authority. Today I want to look at another issue concerning banking that needs to be radically changed if we are not to see constant repetitions of the kind we are seeing today in the Barclays scam. This topic may not sound too exciting but it is fundamental to current banking practice and fundamental to why banks exert so much power over us.
In addition to taking away the banks’ ability to create money we need to abolish the following practice: securitisation. This is not the only one. There are no overall economic justifications for ,CDOs, CDSs, SIVs and many others. I could go on. But securitization is the oldest and is the base on which the others were built.
But let me make one thing clear. We need private banks. We cannot rely on state-run banks, for this creates the overriding danger that proper management will not be maintained, as no one will be responsible for the losses – except the tax payer. At present we have the worst of all worlds where we have private banks underwritten by the tax payer. No major UK political party has any intention of changing this.
So what is securitisation?
Suppose you ask your bank manager for a loan, say, in order to buy a house – a mortgage. He grants you the loan and you then have a contract with the bank. The bank’s obligation to you is fulfilled by making the cash, let’s say, £100,000, available to you and your obligation is to pay interest and repay capital in regular monthly payments over a defined period of, say, 20 years. In addition the contract involves you giving the house as collateral so that in the event of your defaulting on your side of the contract the bank will be able to claim the house as its property to cover your debts.
So far so good. This sounds like good old-fashioned cozy banking as you always understood it. The contract depends not just on the strong terms it contains but also on the personal understanding you have with the bank manager and the sense of continuing agreement and obligation. You may assume you are repaying the bank and the bank holds your debt to it on its books. But this assumption would be quite wrong.
In today’s banking world, what you may not have appreciated is that within a nanosecond of the contract being enacted, the loan has been “sold” to another party. The bank has made a tidy profit as “originator” of the deal from its fees, but if it keeps the loan on its books it will be restricted from making further loans and earning further fees and bonuses. This is where what is known as the “shadow banking system” comes into play. This consists mainly of what are called Special Purpose Entities or SPEs (usually sited in tax havens such as the Caymen Islands) and it is the SPEs that take the loan off the bank’s books. But the SPEs don’t keep it either. They then sell the loan to “investors”. Thus the “investors” supply a capital sum which is passed through the SPE to the bank who originated the loan to you. In return the “investors” receive, via the SPE again, the income stream represented by your regular payments minus the fees of all those along the way.
The process I have just described is “securitisation”. It is effectively just selling on a loan to another party. It first started to become widespread in the 1960s but ballooned in the 1990s and reach mammoth proportion in the noughties. Meanwhile all sorts of complications (or “innovative financial instruments”) which we need not go into have been introduced that ride on the back of securitisation. However all of them are designed to increase credit in the economy and as we know for every piece of credit there is also a debt. It is plainly obvious, even to orthodox economists, that the amount of debt we now have in the world economy is unsustainable.
So what is wrong with securitisation? It is wrong in the first place because it destroys the integrity of the original contract that you had with the bank. You do not now know who you ultimately owe the money to. Your bank does not have to tell you and due to all the complications that follow on from securitisation, frankly it does not know itself. Why does this matter? It matters because the process of divorcing the lender from the debtor generates a whole new economy of debt and risk management where the real economy that you live in and work in means less and less. The banks should be there to serve the real productive economy, but as it is now, the real productive economy serves the interests of the banks.
The idea of banking as most people understand it is as follows. Some people have money surplus to their requirement to live – i.e. savers. Others need money to start businesses or invest in property. (Today we are used to borrowing just to live but this is a malign result of current economic management and by no means inevitable.) The banks mediate between savers and borrowers to allow credit to go where it is needed. Debt is kept to a minimum with prudent banking and prudent regulators.
We are now a very long way from that situation. There is more than one reason for this but securitization is an essential element that creates the new economic world we live in. I mentioned the problem of the divorce between lender and borrower but this in turn results in a further major problem.
Without securitisation, the amount of debt in the economy would be driven mostly by real economic factors. A business wants to invest in new plant. A loan is created to enable it to do that. With securitisation this is reversed. Now the driver is the desire of the banks and their investors to find new debt to “securitise”. The full obscenity of this was shown up clearly in the American sub-prime crisis where loans were made not because they were a good thing for the borrowers but because of the rapacious desire for more debt for the bank originators to sell on. The sorry tale whereby the rating agencies faked high ratings for the loans is too familiar to repeat here. But none of this could happen without securitisation. It is only because the banks know they can sell the loans on that they create them in the first place. If they had to keep the loans on their books the subprime crisis would never have happened.
A great deal of the current economic crisis is due to securitisation. It allows the tail to wag the dog whereby there is an overriding desire for debt by banks and “investors” regardless of whether the real economy can support that debt. Securitisation and the malign instruments of risk management (what many would call betting) that it generates all serve to balloon the money supply. That money supply is held by banks and “investors” who then want to place that money at a profit. If they run out of debtors they cannot place it.
Today their need for debt is being satisfied by sovereign debt and the politicians are falling over backwards trying to structure the debt of sovereign nations so that those who hold the vast mountains of cash can find a home for their money. That is, for instance, essentially what the euro crisis is about.
But let us step back a little. This mess is based on banks being able to shift loans off their books. Surely they need to have this facility. Otherwise they might be deprived of flexibility and that could hobble their operations unreasonably. In fact, for this to happen, there is an alternative to securitisation which does not usher in all its bad aspects – assignment.
If you have ever held a commercial lease you know how this works. Suppose you have taken out a lease a period of say 14 years on an office. If you wish to move you can assign the lease to someone else, that is to say, the person taking it over then becomes responsible for all the obligations of the lease, paying the rent, maintaining the property and so on. However, your obligations are not finished, for if the assignee defaults on the contract, you as originator of the lease will still be responsible. Exactly the same thing would happen if a bank assigned a debt. If would retain ultimate responsibility for it and so the integrity of the contract would be preserved. Prudent lending would be necessary.
Defenders of the practice of securitization argue that without it then most types of hedging would not be possible. There is not space here to go into this, but essentially hedging is a way of protecting your investment against unforeseen risk. Suppose you invest in a company in order to collect your yearly dividend payment. As with anything in economics there is a chance that the company will not perform as well as you thought. You can “hedge” this risk by for example taking out a derivative contract on the Footsie index. This means that if the value of your shares become subject to violent swings you will be covered by the relative stability of a large group of major companies. The beauty of the deal is that the “hedge” will not tie up any capital. You will only have to pay the regular premium, just as you would pay a regular insurance premium, Such derivative contracts can only exist through securitisation and so, without securitisation, you cannot hedge.
But the most successful investor of modern times would never hedge in this way. He famously called derivatives ‘weapons of mass financial destruction’. His method of “hedging” consists mainly in good old diversification which requires no derivatives and so no securitisation. But mostly he doesn’t hedge because he skillfully values companies. If you need to hedge with derivatives then you should not be in the investment business.
Quite simply securitisation should be banned. The integrity of loan contracts must be preserved in an economy that is based on real productive activity as opposed to the money economy and the near-corrupt, or actually corrupt, activities of the banking community that goes with it.
Securitisation leads to the demand for more debt by those who control finance. It leads to the increasing “financialisation” of our lives which means every aspect of our lives from paying for an education, paying for our next holiday, ownership of a property, buying almost anything, all become the subject of loans. Companies and nations all become mired in debt and the banks love it. We trade our future to survive in the present. We give up our economic freedom for debt slavery to our financial masters with no way out. As things stand, our children have little chance of ever knowing a life free of debt.
So should Bob Diamond be investigated? Well. Yes, of course. But frankly until we understand what is fundamentally wrong with the way we run the economy, the future of this despicable man is no little importance except symbolically.
The present noise about him in the press and from politicians will soon die away – until the next banking horror story comes along.