Finances - A Paradigm Shift

Back in 2010, while attending a conference on Christian Economics, I met Gottfried Hetzer. He has been a missionary in Namibia and a business leader in Germany. He struck me as a man of integrity who has allowed God to do a deep work in his life.

A couple of years after I met him, he published a book called Finances - A Paradigm Shift. This is one of the best books on finance and money that I have ever read.

Part 6 of the book is called Kingdom Approach. Gottfried deals with topics like bribery, corruption, integrity, motivation, partnerships, reliability, retirement. Most books do not cover these issues.

I recommend this book to every follower of Jesus, who wants a better understanding of the challenges of finance.

Adair Turner on Finance

The Future of Finance and The Theory That Underpins It is a talk given by Adair Turner at the London School of Economics. It is available on a podcast here. It is a bit technical at time, but is worth a listen for those who want to understand the GFC.

Turner described the problems with the modern banking system very clearly, which is unusual for an insider. They usually pretend that the system is better than it is. Unfortunately, although he understands the problem well, Turner believes that the problems with the system can be managed. I think he is wrong. A more radical solution will be required.

Banks facilitate unmatched intermediation between lenders and borrowers. Lenders and borrower can obtain credit and debt contracts for different terms, risk and return. This mismatch is managed through the bank's balance sheet. On the liabilities side of the balance are short-term deposits. On the assets side are long-term loans, often twenty to thirty year mortgages. This creates a huge risk, as the bank ends up with many short-term debt contracts, which it could not honour, if all the depositors wanted to withdraw their funds at the same time. Banks depend on the central bank to act as a lender of last resort whenever this happens.

In addition to this liquidity risk, banks also carry the default risk. If a borrower default, the depositors still expect to get their money back. A bank needs sufficient capital to cover this default risk.

In the UK, business lending and borrowing net out. This means that most savings by households go in residential and commercial mortgages. This can create a self-reinforcing credit/asset price cycle. When real estate prices rise, banks are willing to lend more to mortgage holders. More mortgage money allows household to bid up prices. This self-reinforcing cycle creates frequent housing booms.

I describe a better solution to the liquidity problems of banks at Deposits and Loans and Money

Financial Fuss (8) - Perfect Storm

Almost no one expected what was coming. It’s not fair to blame us for not predicting the unthinkable.— Daniel H. Mudd, former chief executive, Fannie Mae

The clever people are now saying that they were caught our by abnormal market conditions. They are not to blame, but deserve to be rescued, because they have been hit by the perfect storm. This is just a crazy excuse for their foolishness.

The fall in house prices is not an abnormal market condition. It is what normally happens at the end of the boom. The collapse of a bank that is leveraged to the point where its liabilities are thirty to forty times greater than its capital is not abnormal. It was inevitable.

The credit crunch is not a perfect storm. It is the normal functioning financial markets after period of irrational exuberance. It is what normally happens when government agency stuff things up.

Financial Fuss (7) - Fostered Foolishness

Many people are blaming greed, but this is not really the issue. The world will always have greedy people and many of them will find their way into banking.

The financial system has come under pressure, because over the last decade greed has not been tempered by fear of failure. The actions of the government and the Federal Reserve over the last three decades have minimised the risk of failure for most of the financial sector.

This goes back a long way. It probably started with the 1987 share market crash when the Fed minimised the damage by pumping their money machine. The message was reinforced during the Savings and Loans crises of the 1990s. These institutions had moved into new areas of business and made unwise and foolish loans. When things went wrong, the government came to their rescue.

The rescue of Long Term Capital Management is another example. This company had used clever mathematical modelling to enter what proved to be foolish trades. The Fed rescued LTCM, so the clever people learned nothing their failures, except the need to be more clever.

When the dot-com bubble collapsed in 2000, the Fed boosted the money supply to prevent the markets from falling to far. Although this led to the housing boom, the government is riding to the rescue again.

Some parents rescue their children again and again, even if they keep on making the same mistakes. However, rescue without repentance reinforces rebellion.

The current rescue of the American financial system is creating the conditions for the next crisis, which will lead to calls for an even bigger rescue.

This full series is here.

Financial Fuss (6) - Bad Judgment

The current problems are the result of bad judgement or foolishness. This foolishness has been widespread through the economic and political system. I have described the full cast of fools in Credit Crunch Characters.

American households paid ridiculous prices for houses, because they assumed that house prices would keep going up forever. Some took on huge mortgages, assuming rising prices would eliminate the risk. Congress made banks lend to people who could not afford mortgages. Investment banks bought credit default swaps, assuming there was no risk of the counterparties defaulting. Banks relied on credit rating agencies, assuming that they would never get thing wrong. Hedge funds bought CDOs, assuming the clever mathematical models had eliminated all risk. Investment banks boosted their profits by being leveraged up to thirty to one, but never thought about the consequences of a decline in asset values.

Foolishness and stupidity were rampant and pervasive in the financial system. Good times make fools appear wise, so they gave no thought about what they would do if markets turned down.

Here are some examples of bad judgement, or should I say foolishness.

It is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing one dollar in any of those transactions. - Joseph J. Cassano, a former A.I.G. executive, August 2007

We have a good deal of comfort about the capital cushions at these firms at the moment. — Christopher Cox, chairman of the Securities and Exchange Commission, March 11, 2008.

Foolishness cannot be eliminated regulation. Regulations cannot stop foolish behaviour. The only cure for foolishness is experiencing its consequences.

Financial Fuss (5) - Regulation will Fail

Many commentators are claiming that the American financial system needs stronger regulation. They are totally unrealistic.

Government regulators will never be able to keep ahead of clever bankers. The current crop of regulators did not foresee the current problems. Only a few weeks ago, they were saying that the financial system was fine. If they were not clever enough to predict the credit crunch, how would they be able to come up with regulations that would have prevented it?

Most government regulations are designed to solve the last problem that occurred. They are usually incapable of dealing with the next problem, because they regulators do not know what it will be. You cannot regulate something that you cannot predict.

Financial Fuss (4) - Normal Banking Practice

The normal process by which a bank decides whether or not to make a loan is relatively straightforward. Two questions are asked.

1. Will the borrower be able to repay the loan and any interest when it comes due?
2. What assets is the borrower offering as collateral for the loan?

These questions have been forgotten over the past decade. Banks have lent to people who had no possibility of paying back the loan. They have lent to investment banks and hedge funds offering security of unknown value. Those days are over, and not too soon.

Banks will go back to asking the old questions. Businesses and households that demonstrate an ability to make the repayments will be able to get finance. Interest rates will be higher, but those who get over the higher hurdle will get funding. Borrowers with good security will be able to get finance. A ninety percent mortgage on a house will not be considered good security. In many areas, a twenty percent deposit will not be enough. A collateralised debt obligation that has had the risk sliced and diced a thousand ways according to a mathematical model will not be adequate security.

Applying these rules will dramatically change the finance sector.

Financial Fuss (3) - Less Debt

The volume of credit available has declined. This should not surprise anyone given that we have just experienced a decade of easy credit. That flush of credit produced the housing bubble, the commodity boom, and previously the dot-com bubble, so it is a good thing that it has come to an end. However, the end of easy credit will change many things for many people and businesses.

Banks will be more cautious about the way they issue credit. Home owners will no longer be able to obtain ninety or one hundred percent loan-to-value mortgages. They will not longer issue “no documentation” mortgages. Thirty or forty percent deposits will become the norm for home buyers. This is not a problem, but sensible banking practice. A return to sound banking practice will be good for households and businesses.

The American economy and American people have too much debt. A decline in the availability of credit is good for both. People will have to start saving for their future and saving to buy the things they need. Businesses will have to start investing their surpluses, rather than paying out big dividends and relying on credit to fund their expansion. Everyone will have to become more responsible.

Financial Fuss (2) - Credit Squeeze

There is now less credit available. Americans have been poor savers for a long time and have relied on people in other nations to make up the short fall. I suspect that foreigners are now not so keen on that role. Worse still, some of the money that used to be available for lending has been wiped out by “write downs” and losses by various banks. The collapse of leverage has also reduced the amount of credit available.

In a normal world, declining availability of credit would not be a problem. Interest rates would rise to ration the available credit to the most efficient users. However, the Fed is holding interest rates down at a level where demand exceeds supply. This makes it seem like there is a shortage.

When supply declines, some of those who would previously have received credit miss out. Marginal businesses will find credit more difficult to obtain. Homebuyers with only a small deposit will find a mortgage more difficult to obtain. This happens as banks become more careful about allocating credit. However, credit is still available for good businesses. Statistics show that commercial and industrial loans by commercial banks are still at very high levels.

Financial Fuss (1) - Market Queues

The latest financial fuss has brought out the usual range of confused economic thinking.

Commentators are suggesting that there is a shortage of credit. This is really an economic fallacy.

A shortage can only occur in a market, if the authorities get involved in price setting and keep the price too low. This happened frequently in Communist Russia. The government kept the price of bread low to assist the poor, but this produced frequent shortages and people would queue all day to get a loaf of bread, because the shops could be empty for days on end. If the price of any good is set too low, consumers demand more and producers produce less and shortages follow. When governments stay out of markets, prices rise and fall until the market clears and shortages and surpluses disappear.

This is what is happening in the financial markets. The Fed is keeping interest rates low, at a time when a new perception about financial risk has emerged.

Financial experts are saying that banks are unwilling to lend to each other. This is misleading. Banks are unwilling to lend to banks that might be bad credit risk. That is not a problem, but just good credit management.

The real problem is not a shortage of credit, but that investment banks with shonky assets on their books are unable to obtain credit at the cheap rates they paid in the past. They can still obtain credit, but they were unwilling to pay an interest rate that included sufficient risk premium to cover their likelihood of default. Some of the worst banks might have to pay “loan shark rates”, but that it what happens to those on the bottom of the heap. I presume that is why they are screaming about credit crunch. They really mean that they cannot obtain credit at the price they are willing to pay.

This full series is here.

The Economic Situation (3) - Credit Crunch

The credit blow out is finished. The world is moving into a decade of tight money.

The major effect will be higher interest rates. Money will be difficult to borrow. Many people and businesses will find their loan applications turned down, as banks tighten lending criteria.

The credit crunch will affect several sectors of the economy.

The financial sector is already under tremendous pressure. The sub-prime crisis is just the beginning. Losses will increase and more banks and finance companies will collapse.

When banks have to write off bad loans, their capital is reduced. This means that most of the pain will be felt by the shareholders of the banks. However, they have creamed it over the past decade, so their pain should not be too great.

Depositors are only affected by bad loans, if the bank has to close. This should be rare.

Somes jobs in the finance sector will disappear. Financial consultants have been on the pig’s back over the past decade, so it hard to feel sorry for them.

People who sell bankers their Louis Vuitton bags may face a town turn in business, but the pain will mostly be confined to the finance sector.

Nevertheless everyone will feel some pain, as many superannuation funds have invested in this sector.

The decline of the finance sector will only get really serious, if tight credit conditions begin to affect the rest of the economy. High interest may stifle business growth.