One thing the 2008 financial crisis showed us is that the big banks were very willing to take on massive risk in order to make exorbitant profits. Between 2002 and 2008 the US stock market nearly doubled in value before it all came crashing down.
How did it happen? The big investment banks were buying up mortgages from the retail banks, packaging them up as investments known as mortgage backed securities (MBS) and selling them to investors. This was all well and good, however, when the retail banks ran out of mortgages to sell to the investment banks the US government decided to loosen lending requirements and the sub-prime mortgage crisis began.
There are two major categories of mortgages, prime mortgages which are loans to high quality borrowers and subprime mortgages which are loans made to borrowers with lower credit ratings. Usually, due to the inherent risk, subprime borrowers are charged higher interest rates in order to offset the increased risk of default. This higher interest rate tends to reduce the number of subprime borrowers applying for loans as they cannot afford the higher rates.
However, retail banks began offering introductory or teaser interest rates, which are discounted interest rates to entice borrowers. These rates may last for several years before returning to the standard higher rates. From the retail banks perspective, they needed to sign up as many mortgages as possible to sell to the investment banks, besides there was no risk on their side, by selling the mortgages they were passing on the risk to the investment banks. From the investment banks point of view, they needed to buy as many mortgages as possible so they could package them up and sell to investors, besides there was no risk on their side, by selling the mortgage backed securities the investors took all the risk (as long as they sold them quickly enough).
In 2007, large numbers of subprime teaser interest rates began resetting to the higher rates resulting in massive numbers of payment defaults from lenders who could not afford these higher rates. The value of the mortgage backed securities dropped dramatically and the investment banks could no longer sell the investments they had purchased. This resulted in Lehman Brothers having to declare bankruptcy as the value of these mortgages dropped dramatically.
Between 2002 and 2008 the investment banks rode the wave of huge profits and fell into the gamblers trap, that their winning streak would never end, a concept known as the “hot hand fallacy”, coined by behavioural economist professor Richard Thaler. Falling prey to this delusion banks issued $1.4 trillion in these investments. However, the gamblers couldn’t stop there, instead of selling investors packages of mortgages, they invented synthetics which were essentially just bets on whether the value of the mortgage investments would go up or down. By 2008 synthetics were valued at $5 trillion, almost 4 times the value of the mortgage investments themselves. A synthetic is little different to a betting slip you might get at the horse racers. You are not purchasing any asset of value, you are just betting on who you think will win, in this case the bet was whether the mortgage backed securities would continue going up in value.
The big investment banks had become casinos and the investors had become gambling addicts. Except the investment banks were acting as both casino and gamblers as they purchased each other’s mortgage backed securities.
As we know 2008 brought about one of the biggest financial collapses in history resulting in 2.6 million jobs lost in the US alone. The bubble had burst and the everyday hard working individuals were left to pick up the pieces.
Of course the big banks, investors and governments all learnt their lesson and decided to be much more responsible moving forward, only investing in things that would actually improve production and jobs …
Since March 2009 the US share price has reached record levels, increasing by nearly 300% in 7 years.
This by itself is no real issue, so long as production raises commensurately and keeps pace. And while US Gross Domestic Product (a measure of the country’s total production) has increased year on year since 2008, it has only increased by 11% over the same period.
The obvious question that has to be asked is how can the value of US companies increase by 300% in 7 years yet total production only increased by 11%. This discrepancy is out by a factor of 27.
That alone should bring pause for concern about a stock market bubble and potential crash. But what is really concerning is the worldwide exposure to derivatives. Derivatives are similar to synthetics, essentially they are a bet on whether a stock or another asset’s value will go up or down in the future. While I am overly simplifying them and while than can be used to reduce the risk of investment, when you consider that the Bank of International Settlements stated the worldwide exposure to derivatives at the end of 2013 was $710 trillion dollars, you can bet the gamblers are out in force. Some news sites have suggested it could now be as high as $1.2 Quadrillion.
To put this figure in perspective the total worldwide GDP for 2015 was $75.59 trillion dollars and worldwide assets estimated at approximately $250 trillion.
Just preceding the global financial crisis, synthetics were 4 times the value of the actual mortgage backed securities. In 2015 derivatives might be as much as 4.8 times the value of all worldwide assets. I can only suspect that a large portion of these derivatives are bets of the future value of the stock market. And gamblers being gamblers they probably thought the stock price would never stop going up.
Right now there has been considerable volatility with global stock markets since the beginning of the year. If the market crashes again we are sure to be in for one hell of a ride.
Reserve Bank governor Glenn Stevens made the understatement of a lifetime, when in 2014 he stated that efforts to control financial derivatives trading following the 2008 credit crisis have fallen behind. Well actually, derivatives are an unregulated area of banking and very little has been done to curtail this reckless behaviour.
Our global banks put the most hardened gamblers to shame, I think it’s time we put them into rehab.
Oh, and by the way, in case you think an economic collapse is the end of the world, I would like to point out that our global financial system is 100% man-made. It is not a naturally occurring phenomena such as a tsunami or earthquake. We can change the system whenever we feel like. What is important is that people produce products and exchange them with each other. Modern money is just numbers on a computer screen. The government could at any time reset the system and wipe out all this ridiculous over inflated money. All it requires is someone with the guts to do it against all the protests coming from the gamblers themselves.
Kane Hooper is an entrepreneur and owner of Cloud Accounting Partners, specialising in providing real management information to SMEs. He has extensive experience in turning around failing companies, achieving profitable and sustained growth. Kane has run eight businesses and consulted many more across of wide range of industries.
Author of the Business CPR Series, books designed to assist owners of distressed business.
He graduated with an MBA from Deakin University in 2014, being awarded the prestigious Brookes Scholars Medal.
Kane is a member of several boards and has a strong interest in the Not-For-Profit sector.
Please visit: www.kanehooper.com