Date: Nov. 25, 2015
By: Frank Gue, B.Sc., MBA, P.Eng.,
2252 Joyce St., Burlington, ON L7R 2B5
905 634 9538
For: Editors, The Economist
Re: Bubble origins Nov. 14 p. 84 393 words
Filename: The Economist re global finance Nov. 15
I was surprised not to see leverage or risk as the main 2008 bubble-blowers (Adair Turner, “Money, credit, and fixing global finance”, Nov. 14). An explanation that is, a priori, much more credible involves reserves, leverage, and risk. In the run-up to 2008:
Banks loaned (more or less risky secured debt) more than they owned (more or less risky reserves). This shaky loaned-to-owned ratio became 100 and more, bringing with it the prospect of making huge profits based on a small “owned” component and on the foolish assumption that the value of the “loaned” component, both with unknown risk, would forever continue up.
In the example, a 1% rise in the value of loans into the inflating property market would give a profit (if he chose to sell) equal to the investor’s entire stake and proportionally higher as it continued to rise. The irresistible lure to gamblers (the stock market is a casino) of this leverage led, among other things, to the packaging of low-quality, high-risk (“sub prime“) mortgages into opaque, insecure “securities”.
With utter inevitably, such a rickety structure with so quicksand a foundation collapsed and we arrived at 2008, when the loaned/owned ratio predictably rose far above 1.0 and hundreds of US banks went bankrupt (having liabilities greater than assets) in a matter of hours . We then had spectacles like the Goldman Sachs can’t-lose double bet adding to the leveraged carnage; and banking rules cunningly created in Basel by bankers for bankers guaranteed to force taxpayers to bail-out banks that were (and still are) “too big to fail” but excused from the risk of doing so.
We had better hope for the success of the carnage canny Carney (Mark Carney of the Bank of England) may avoid with his proposal that banks be required to bail-in by buying bonds; and that senior executives be held personally, criminally liable for bad banking practices, because the next boom-bust is building up as we write. Again, the worst but not all the damage will be avoided in systems like Canada’s, where the 2007 loaned/owned ratio was never allowed to drop below about 14, safely far below the 100 (and worse) experienced elsewhere.
There is little room here for Lord Turner’s “cutting rates to stimulate the economy” as an explanation for 2008. Human greed will do just fine. Fasten your seat belts and put this as a memo into your bring-forward file for about 2016-2018.
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