Implosion of US ’sub-prime’ housing bubble goes global
How serious is the turbulence on global stock markets and can central bank intervention, such as last Friday’s discount rate cut by the US Federal Reserve, restore calm? Commenting after the Fed’s intervention, the Telegraph (London, 19 August), warned the world is still facing "the most serious financial crisis since global share prices collapsed back in 1987."
Behind the mayhem on stock markets is what the Washington Post called "a full-blown credit and liquidity crisis" brought on by the implosion of the US mortgage bubble and in particular the high-risk sub-prime sector. The huge growth of the sub-prime market – loans to house buyers with bad credit histories or with excessive levels of debt – sums up both the lunacy and the unchecked parasitism of modern capitalism.
Socialists stand for a strong publicly owned and controlled housing sector to provide decent living space at affordable rents, instead of today’s cutthroat housing market that preys on ordinary working class families with few options other than a lifetime of debt.
As the housing bubble grew over the last six years, the sub-prime sector exploded into a gigantic pyramid scheme totalling more than $1,300 billion or about one-eighth of total home loans in the US.
The bursting of the housing bubble last year has left banks and hedge funds, which made huge profits from the sub-prime craze, facing huge losses. Hedge funds are highly secretive investment companies that exert a decisive influence on the global financial system – accounting for around a third of all share transactions on Wall Street. Due to financial engineering on an unprecedented scale, sub-prime debt and other related forms of financial ‘junk’ have been re-packaged and sold as ‘assets’ to banks and hedge funds around the world, operating under the delusion that because the loans are based in the US they are a safe bet. The result is the financial equivalent of mad cow disease – with contaminated sub-prime carcasses spread throughout the global food chain. No one knows where or when the next outbreak will occur.
A wave of hedge fund collapses – roughly one a day – have shaken the global financial system, starting with the collapse of two funds at New York based Bear Stearns in mid-June. This was then followed by blow-ups in Australia, Britain, Canada, France, Germany, Japan, the Netherlands and Switzerland.
"It’s like popcorn in a kettle," said the head of one New York hedge fund. "First you have one or two pops, then it turns into a cacophony."
Each new fund collapse or write-down triggers a fresh bout of panic on the stock markets, where hedge funds themselves account for a big share of daily trading. Whereas hedge funds were still largely peripheral a decade ago, today they are at the core of the global finance system, with most major banks having set up their own hedge funds in order to get a slice of the action. The full force of this was brought home on 8 August by jitters at BNP Paribas, the largest publicly traded bank in France, as a result of billions of euros in sub-prime losses at three of its hedge funds. In Germany in late July, the Merkel government was forced to organise a $4.8 billion bailout for IKB Deutsche Industriebank, a medium sized bank. Just ten days before the bailout, IKB had announced it would be almost entirely unaffected by its sub-prime exposure.
A credit crunch or liquidity crisis means that banks and other lenders recoiling from ‘high-risk’ debt, refuse to extend new loans. In recent weeks major banks have been refusing even to lend to each other through the so-called inter-bank market that oils the wheels of the finance sector. This explains the massive injection of liquidity by central banks, led by the ECB in Europe, which has pumped an additional 204 billion euros into the market in the last fortnight. The Fed in the US, and central banks in Japan, Australia and other regional markets, have followed suit with smaller but still sizeable injections of liquidity. So far, however, these measures have singularly failed to restore stability to financial markets.
"People are losing faith in credit, so the economy is seizing up," remarked US hedge fund boss, Barton Biggs.
The cumulative falls on major stock markets since the crisis erupted in July are more then ten percent, the official definition of a ‘correction’. This has erased a staggering 4.5 trillion US dollars from global stock markets in four weeks. Last week (13-17 August) alone, the drop on New York’s Dow Jones Index was almost ten percent, while Tokyo’s Topix share index fell 9.4 percent. London’s FTSE index has tumbled 12.5 percent and Germany’s DAX by 9.9 percent in a month. Some smaller ‘emerging’ markets have suffered bigger falls – 21 percent in Indonesia and 17 percent in Brazil. China’s stock market, still closed off from the outside world and driven by its own bubble logic, continues to buck the trend rising 25 percent in the same period.
Some commentators on Wall Street are drawing parallels with ‘Black Monday’ in 1987, although the sell-off then was far more abrupt – the Dow Jones fell 22 percent in one trading session.
Even so, the market mayhem has shattered the irrational confidence of the capitalist class and their belief the world was entering a new ‘super-cycle’ of prolonged global expansion.
"They say a light bulb burns brightest just before it burns out," noted the San Jose Mercury (19 August). "On July 19, the Dow Jones industrial average closed at 14,000.41, an all-time record high. But beneath this triumphant march, the foundation had eroded."
Bernanke to the rescue?
On Friday 17 August the Fed (US central bank) cut its discount rate, the cost of loans to banks and other financial companies. While global stock markets immediately rallied, recouping some of their losses from the preceding days, a debate raged over why the Fed was throwing a lifeline to banks and hedge funds – the architects of the sub-prime crisis – while lending rates for millions of struggling homeowners remain unchanged.
The Fed move underlines the depth of the current crisis. Only two days before a Fed official had argued that only a "calamity" would cause the Fed to implement an emergency rate cut. There is a growing fear that the sub-prime meltdown can lead to bank collapses, with many asking "what does Bernanke know that we don’t?"
Another risk, equally serious, is that the rapid fall in inflated asset prices (stocks and other financial instruments but also property) and surging levels of debt will impact on consumer spending and push the economy into recession.
This was spelt out by the Federal Reserve’s Open Markets Committee in justify Friday’s rate cut: "Financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth."
It’s possible the Fed acted because a major US finance company was close to collapse. One suspect is Countrywide Financial, the biggest US mortgage lender, which accounts for one in six home loans. Underlining the fact that the sub-prime contagion is spreading, Countrywide has relatively little exposure to sub-prime loans and until a few weeks ago was considered one of the "strongest players" in the US mortgage sector. The company’s shares slumped 25 percent last week.
So, has the Fed’s action succeeded in pulling global markets out of their tailspin? On this point there is no shortage of pessimists among financial actors.
"My advice is not to panic. But it is going to be a difficult few weeks for the market," a leading City of London fund manager told the Independent on Sunday (19 August).
The growth of the sub-prime sector was a key ingredient in the housing bubble caused by the Fed’s policies in the aftermath of the dotcom crash of 2000-01, whereby interest rates were cut to 40 year lows. A flood of cheap credit led to manic lending policies by US financial companies, looking for profitable investment outlets. In some ways this was reminiscent of how Western banks descended on poor countries in the 1970s pushing huge loans on easy terms, which then massively backfired in the shape of the ‘Third World debt crisis’. As the US housing bubble grew, financial companies came up with crazy schemes to dupe ever-larger sections of the US population to take on more debt. One such ploy was ‘Ninja loans’ to borrowers with ‘No job, No income and No assets!’
When the housing bubble burst at the end of 2006, house prices began to fall and loan delinquency shot to record levels. Last year, more than a million Americans lost their homes to foreclosures. At least 70 US mortgage companies have gone bankrupt or put themselves up for sale, with the ripple effect still working its way through the finance sector.
While the sub-prime sector itself is significant, there is growing evidence the crisis is spreading to ‘prime’ US mortgages. In recent weeks there have been distress signals from several companies dealing in "jumbo" loans, so-called because they exceed the $417,000 level that government-sponsored companies like Freddie Mac will buy.
"Made in America"
In the age of capitalist globalisation with an unprecedented interconnection of financial markets, today’s crisis cannot be ring-fenced to the US. The practise of ‘securitisation’ especially, whereby small stakes of sub-prime and other high-risk debt have been re-packaged and sold to banks and insurance companies around the world in the form of complex financial products such as collateralised debt obligations (CDOs), has enormously aggravated the situation. Such financial witch-doctory was all the rage among capitalist economists who claimed until just a few weeks ago that it would disperse – and therefore lessen – financial risk.
In truth, rather than lessening risk, global dispersion has had the opposite effect as we are now seeing. Hedge funds have become the carriers of the sub-prime virus into every reach of the global finance system.
As The International Herald Tribune (6 August) explained, "This repair cycle is going to take a lot longer because it is not concentrated in the banking system like it was in the 1990s."
The lack of transparency and regulation as far as hedge funds and derivative markets are concerned means policy makers, but also banks and fund managers, are now operating in the dark – unable to gauge the full extent of the financial ‘contagion’ from the sub-prime meltdown. This in turn has heightened the aversion within the banking system towards all risk – even towards financial products not directly connected to sub-prime loans.
These events undoubtedly mark an important turning point for the global capitalist economy, signalling – at least in the US and most western capitalist countries – the end of the era of cheap credit, which has powered global economic growth since 2001. Counting foreign-exchange reserves and the US monetary base together, the global supply of dollars has risen at an unprecedented average rate of around 18 percent in the past four years, according to The Economist (8 February 2007).
As marxists and some of the more sober capitalist commentators have repeatedly warned, this tide of liquidity has created unsustainable imbalances in the global economy – the huge misalignment of currencies, trade balances and investment levels especially between the older capitalist economies of the West and Asia’s rising economic powers. Also within each national economy there are extreme misalignments as the share of wages in national output in most countries has fallen significantly as a result of neo-liberal policies – outsourcing, casualisation and deregulation. This has produced record profits but also an ever-greater reliance on debt to prevent a collapse in consumer spending.
Ten years after the Asian Crisis that saw hypocritical US and Western leaders lecturing Asia’s rulers and masses about how wasteful, unprofitable and opaque their brand of capitalism was, cash-strapped Western banks and governments may be forced into even greater dependence on the ‘deep pockets’ of Asia’s mostly state-controlled banking sector to keep them afloat. This in turn will provoke sharp conflicts as foreign government-backed investment funds move into Western economies not just as creditors but increasingly also as buyers looking for bargains among the stock market debris.
Although the speed and depth of the crisis remain an open question, the tightening of global liquidity that is underway will have major consequences across the economic spectrum from (still inflated) asset prices, to consumer spending and investment. A contraction of consumer spending in the US will ricochet around the world, cutting demand for Chinese and other Asian exports and leading to a rise in trade protectionism.
Global forecasters like the IMF are thus far clinging to upbeat predictions of strong global economic growth of 5.4 percent for this year and 2008. In particular, they expect red-hot growth in China, India and other Asian states to continue. But at a certain point the bursting 0f property and asset bubbles worldwide, and a tightening of credit, will impact even on those regions of the global economy currently experiencing rapid growth. As a spokesman for Singapore’s Trade Ministry put it, "The chief downside risk is the potential for current problems in the US credit markets spreading to other financial markets."
Even if central banks now begin cutting interest rates again, this is no guarantee that credit conditions will ease if the financial system is weighed down with – as yet undeclared – bad debts. After the bursting of its property and asset bubble in 1990, Japanese capitalism experienced more than a decade of economic stagnation, despite the Bank of Japan (BoJ) slashing interest rates to zero.
As one market analyst predicted: "All the government can do is delay the real estate doomsday, they cannot stop it. The US real estate market is in for a major crash, as are other housing markets around the world."
In his classic study Imperialism, the Highest Stage of Capitalism, Lenin wrote that:
"Translated into ordinary human language this means that the development of capitalism has arrived at a stage when, although commodity production still ‘reigns’ and continues to be regarded as the basis of economic life, it has in reality been undermined and the bulk of the profits go to the ‘geniuses’ of financial manipulation."
Since these words were written the dominant role of finance capital has been taken to absurd levels. Hedge funds, for example, which are a relatively new phenomenon, use a variety of strategies, from betting on or against stocks, currencies or commodities to more complex strategies involving investments in ‘derivatives’ or funding for corporate takeovers.
Despite their decisive impact on the global economy, hedge funds operate outside of even minimal government controls. Three quarters of the world’s hedge funds are headquartered in the Cayman Islands, a tax haven. The capitalist politicians bear full responsibility for this situation – a working group on behalf of the Bush Administration decided as recently as in February this year that hedge funds "needed no regulation," reported the Washington Post (4 July 2007).
Since the hedge fund Long-Term Capital Management collapsed in 1998, posing a major threat to the financial system, the volume of money managed by US hedge funds has risen from about $300 billion to well over $1 trillion. Globally, they are thought to manage almost $2 trillion, although no one is really sure. The role of hedge funds goes a long way to explain the stock market volatility of recent weeks.
During the credit boom, banks and brokerage firms lent large sums to hedge funds and other speculators who drove down the premium on risky assets like those based on sub-prime debt. Now as that market has collapsed, banks and brokerages want hedge funds either to come up with more collateral to back up margin loans or to sell assets. The wealthy investors behind most hedge funds are also clamouring to withdraw their investments.
This explains why, rather than the ‘flight to quality’ that normally occurs when investors flee riskier assets, shares of many of the world’s largest and presumably strongest companies have been hammered in the stock market panic of recent weeks. Shares in companies like General Electric, Wal-Mart, Toyota, Samsung and mining giants like BHP Billiton and Rio Tinto have suffered huge drops. This is partly because hedge funds have been forced to sell their most liquid names in order to cover against losses from sub-prime and other high-risk assets. Continuing falls in share prices can cause big problems even for companies with healthy balance sheets in securing new loans, thereby spilling over to investment and other areas of the ’real world’ economy.