As I write, financial markets in Wall Street, New York, the City of London and all over are in turmoil. In just 24 hours, two out of the four largest investment banks in the US have disappeared. Lehman Brothers, around for 158 years, has declared bankruptcy and 25,000 employees around the globe have lost their jobs.
Merrill Lynch, the world’s largest investment bank, has been taken over by the largest high street bank in America, the Bank of America. Bank America was virtually ordered by the US financial authorities to take over Merrill Lynch, paying $50bn. Otherwise, that bank too would have gone bust, putting thousands more out of work. Even worse for capitalism, it would have meant that both Lehman and Merrill Lynch would have defaulted on their contracts and obligations and thus brought down many other banks (15 were rumoured to be in trouble).
Along with Bear Stearns (wiped last March), three out of the top five investment banks in the US have vanished in a puff of financial smoke.
And finally, America’s largest insurance company, AIG, announced that it needed to raise $40bn within hours if it was not to default on its obligations and appealed to the Federal Reserve for a loan before it was too late!
All this took place only one week after the world’s largest semi-government mortgage lenders Fannie Mae and Freddie Mac had to be nationalised to protect American homeowners and the mortgage industry from going bust. These two lenders had over 40% of all mortgages in the US and 85% of recent new mortgages. It would have meant the total collapse of the housing market if they could not do business. So the Bush administration was forced to nationalise them!
How did this terrible mess for capitalism come about?
The capitalist economists have no real idea. Some say it is the fault of greedy chief executives of the banks who gone into reckless investments and lent too much money to people who could not pay it back. Some say it is the fault of the Federal Reserve and other central banks for keeping interest rates too low and thus encouraging too many people to borrow too much or too many banks to lend too much. Others say it was the failure of the central banks to ‘regulate’ the banks and investment houses to make sure they had enough funds to do their business instead of borrowing to lend etc.
But perhaps the story of the British travel agent XL, which also collapsed this week, leaving hundreds without jobs and tens of thousands unable to get home from their holidays, has the most interesting clues to why this global financial tsunami is sweeping away so many big financial institutions.
XL chief executive explained tearfully to the press that his company had gone under without warning for two reasons: the sharp rise in the price of oil had dramatically increased the company’s costs for air fuel; but when he tried to raise more finance to cover this, he was unable to get any banks to provide funding at rates or terms that made it viable to continue. And there we have it. Such is the stranglehold and fear in the global credit crunch that banks are no longer willing to lend money at reasonable rates or on reasonable conditions to businesses. And those that are hard pressed are forced into bankruptcy – expect much more of this over the next year.
Why are the banks unable to lend? It’s because they have lost so much money on the writing down of the assets they have bought over the last five or six years. Now they must retrench and stop lending. Now they must find new capital and investors before they can start relending. In the meantime, they are too scared or unwilling to lend, even to other banks (that’s why Bear Stearns, Lehman, Northern Rock and others went bust – nobody would lend to them).
What are these assets that have lost so much value? In the main, they are called mortgage-backed securities. In the old days of the housing market, banks or building societies would attract cash deposits from savers like you and me (we should be so lucky!) and then use these deposits to lend to people who wanted to buy a home. From deposit to mortgage – simple.
However, some bankers started to be more ‘innovative’ in order to make more profits. They started to borrow funds from other banks and then lend that on mortgages. This ‘wholesale funding’ became particularly popular with US and UK banks, like Northern Rock, which had been a rather sleepy building society until the mid-1990s when it converted into a ‘bank’ with shareholders and an aggressive management out to make money for its investors (not savers).
But that was not the end of it. Many banks came up with another wheeze. They would take their mortgages and batch them up into a basket of different quality mortgages which they would sell off as a bond or security to other banks or financial investors. By creating these securities and selling them off, they ‘diversified’ their risk to others. Also they set up separate companies that took all these liabilities completely off their books. That meant they could go out and borrow more and do more mortgage business. Soon many banks that used to have enough cash and stocks to match at least 10% of the loans, now had reduced that to just 5%, or in the case of the big American banks and mortgage lenders to just 2%. Leverage was now 50 times, the money the banks actually had to meet any losses.
But no problem – the US housing market was racing upwards. So as fast as banks lent money, they made it back in the rising house prices. Home owners could afford to pay them back and take out even bigger loans. Banks could lend to people who hardly had any income because they could count on the value of the home rising to cover their loan.
But then it all went horribly wrong. From about 2006, house price rises began to slow and then began to fall. Once house prices headed downwards, so did the ability of mortgage borrowers to pay back their loans and their willingness to take out bigger and better mortgages. The mortgage market slumped. Soon the mortgage lenders were losing money and behind them, the owners of all these mortgage-backed securities found that their ‘assets’ were no worth what they paid for them. And just everybody and his dog in the financial world had these securities. The risk had been diversified so that everybody got hit when things went wrong.
Why did the housing market go down? Why did it not carry on in a straight line upwards and it had done for nearly 18 years? I venture an answer. First, there are cycles of motion that operate under modern capitalism. The most important law of motion under capitalism is profitability. As Marx showed, the rate of profit is key to investment and growth in a capitalist system: no profit, no investment and no income and jobs. But profitability moves in cycles: for a period, profitability will rise, but then it will start to fall. In previous articles, I have tried to explain how that pans out.
But the profit cycle is not the only cycle of motion under capitalism. There is also a cycle in real estate prices and construction. The real estate cycle seems to last about 18 years from trough to trough.
There appears to be a cycle of about 18 years based on the movement of real estate prices. The American economist Simon Kuznets discovered the existence of this cycle back in the 1930s. We can measure the cycle in the US by looking at house prices. The first peak after 1945 was in 1951. The prices fell back to a trough in 1958. Prices then rose to a new peak in 1969 before slumping back to another trough in 1971. The next peak was in 1979-80 and the next trough was in 1991. The spacing between peak to peak to trough to trough varies considerably. It can be as little as 11 years or as much as 26 years. But if you go far enough back (into the19th century), the average seems to be about 18 years.
The last peak in US real estate prices was in 1988. Assuming an average cycle of 18 years, then house prices should have peaked in 2006. The last trough was in 1991. Assuming an 18-year cycle, then the next trough in US house prices should be around 2009-10.
The real estate cycle does not operate not in line with the Marxist profit cycle. The latter is a product of the laws of motion of capitalist accumulation. It operates in the productive sector of the economy (and by that, I mean ‘productive’ in the Marxist sense, namely contributing to the production of value).
In contrast, the real estate cycle operates in the unproductive sector of the capitalist economy. New value created and surplus-value appropriated in the productive sectors of the capitalist economy are siphoned off by the unproductive sectors as the owners of capital spend their profits and workers spend their wages. Housing is a big user of consumer income. So the cycle in house prices reflects the spending behaviour of capitalists and workers, not the profitability of capital.
For these reasons, the real estate cycle has different timings in its turns than the profit cycle. As I have explained before, the profit cycle reached a trough in 1982 before rising for 15-16 years to peak in 1997. In contrast, the US real estate cycle troughed some nine years later in 1991 and only reached its peak in 2006-7. The next trough is due no earlier than 2009-10.
This huge rise in house prices, exhibited around many parts of the world as well as the US, represented a massive diversion of resources by capitalism into unproductive sectors that produced no new profit through investment in technology and productive labour. As a result, it actually reduced the ability of capitalism to invest in new technology to boost economic growth. It was entirely a process of creating fictitious capital. That is shown buy one stark fact. You can measure the movement of house prices from 1991 to 2006. In 1991, the US house price index stood at 100; by 2006, it had reached 200, a doubling in price. But the costs of building a house including land purchase had not risen at all. So house prices were way out of line with the real production value of a home. The housing market had become a huge financial speculation. When home prices got so far out of line with the incomes of those who were buying them, the market finally toppled over.
Capitalism does not operate in a smooth and steadily increasing way to progress. It operates violently, lopsidedly, in cycles of boom and slump. The path of chaos and anarchy applies to the cycle of profit and also to the cycle of housing construction.
So what now? Well, more banks are set to fail. There will be more misery in the financial markets. More to the point for working people not worried about whether rich investors lose money, jobs throughout the financial services industry are going to go. And we are not talking about the fat cats at the top who caused this mess – they will leave with the payoff and pensions intact. We are talking about the tens of thousands on moderate pay packets who put all their savings into the shares of the banks they worked in, and which are now worthless.
And more, the collapse of the financial sector will lead to a serious economic downturn. It is already underway with the US, the UK, Europe and Japan going into economic slump, where output will stop increasing, companies will fail and unemployment and inflation will rise sharply.
The politicians are lost in all this. Whether it is a right-wing Republican administration or New Labour, they know not what to do. Indeed, in many ways New Labour has been so tied to the model of American capitalism with its ‘free choice’ and ‘open deregulated markets’ that it is even more in denial than the Republicans. In America, they have nationalised the mortgage lenders. In Britain, they just look shocked and babble about the ‘worst crisis in 60 years’.
Eventually, capitalism will recover, unless governments come to power mandated to end the rule of capital. But it will recover only by restoring profitability. To do that, many jobs must go and many companies must be swallowed up by richer ones. That process has started in the financial sector. It will continue across the whole economy.
This article first appeared on Socialist Appeal.
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This post was written by Michael Roberts