What, a global financial collapse?

Given that we do have a financial system that is global, and I doubt that anyone would dispute that, the concept of a “global financial collapse” should not seem to be very strange. We cannot trumpet the wonders of globalised financial markets and then say, oh no, it’s not possible for the entire system to fall down because national economies are well-isolated from the global system.

$USD

Most of the world’s debt is denominated in $USD and the $USD is still the major reserve currency. It’s a dollar-denominated global financial system. Therefore, a threat to the dollar is a threat to the system. If the dollar is routed, you could say, well then countries will just switch to a different reserve currency. Several factors bear:
1. Obviously, such sales of $USD reserves will collapse the dollar even further.
2. This will make it impossible for the USA to buy anywhere near the amount of foreign goods for import that they do now, meaning that the USA dries up as a market on which part of the so-called economic miracles of China, India and other parts of Asia depends.
3. Inflation in the USA will put basic goods out of the reach of more people which will help grind the economy down, distort investment decisions and raise interest rates. Think about the ruble devaluation in the early 1990s and the Asian currency devaluations in late 1990s.
4. Actions taken by the Federal Reserve would also bear on the situation, such as a large hike in interest rates to help stave off the fall in the dollar.
5. Other countries might then also be motivated to devalue their currencies in order to compete with cheap American ($USD-denominated) exports.

We would have an increasingly unstable environment of national economies in which countries are at each others’ throats trying to get some advantage in a no-win situation. National governments would find it harder to govern, setting up conditions for bellicose dictatorships.

Hedge funds and private equity funds are increasingly key players in the global financial system and 90+% of those are registered in UK territories such as the Cayman Islands. Yet their operations for the most part are in $USD. The Cayman Islands hedge funds alone, which comprise of 85% of all hedge funds, control an estimated $USD 30+ trillion in deployable funds.

What about gold? Aren’t currencies backed by gold so protecting their value and ensuring that gold is the final currency? There’s not a currency in the world that’s backed by gold. Even the Swiss, under pressure from various international financial interests, decoupled the Swiss franc from gold in the last 10 years. (See the book Gold Wars by Ferdinand Lips of the Swiss banking family.)

The hallmarks of the current financial system are low transparency and regulation. In effect, it’s relatively lawless, certainly when compared with the Bretton Woods system that was implemented in the post-WWII era.

Some history

In the Bretton Woods era, exchange rates and interest rates were closely regulated. There was no speculation in currencies or interest rate instruments (such as bonds) because exchanges rates and interest rates were fixed by agreement between sovereign nations working in concert to achieve mutually beneficial goals, which were essentially development of all nations at least according to the original principles of Bretton Woods. “Security at home is achieved by helping our neighbour to develop” to paraphrase FDR.

The International Bank for Reconstruction and Development (IBDR), which was later renamed the World Bank, was created as part of the Bretton Woods system to extend low-interest long-term credit to nations to rebuild and develop after WWII. This credit was often administered by private banks in recipient nations.

Fixed exchange rates and low-interest long-term credit created a stable economic environment for investments in long-term projects, especially large infrastructure projects, to develop nations.

The post-WWII period is characterised by an explosion of industrial and economic development, which mirrorred that under FDR of first rebuilding America out of the Depression and then preparing for war against the Nazis.

By the mid-to-late 1960s, the system started to break down after being in operation for a little over 20 years. This was caused by what can be summed up as consciously engineered cultural decay leading to retardation in scientific and technical progress. Nations competitively devalued their currencies to gain an upper hand. In the 1970s, Nixon, with his Secretary of State George Schultz, first cancelled the convertibility of the $USD to gold (“closed the gold window”) and then floated the $USD in 1973. Britain floated the pound in the late 1972 after a series of devaluations, and Australia floated the $AUD in the early 1980s.

There are a number of nations whose currencies are not freely traded, including Russia, China and India which notably have relatively anti-globalist governments who have more than a modicum of understanding of the physical infrastructure development and scientific mission orientation that is required for economic development. This leads us into the area of physical economics which is a topic for another day.

The conditions were set for currency, interest rate and all manner of financial speculation on a scale not possible in the Bretton Woods era and, then, only most recently seen in the “roaring 20s” which culminated in the stock market crash of 1929 to which inappropriate, or no, policy response by the Hoover Presidency encouraged the drawn-out economic woes of the 1930s which FDR inherited and addressed with decisive action.

FDR implemented large infrastructure programs, including the Rural Electrification Program and railway building projects. Hundreds of thousands of men were put to work in a matter of weeks on useful productive work at decent wages, financed by government-uttered credit.

Before the monetary system was able to function again under FDR, it had to be treated as though it was bankrupt and banks had to be able to remain open so that people would not lose their savings. This was done. Banks were effectively bankrupt and FDR’s administration knew this. Banks were offered loans in order to stay in business, which were, at first gingerly, accepted.

Back to the 1980s. In that period there was a shift towards policies that favoured speculation and usury and the floating of currencies dovetailed into that environment. Indeed, much of Western popular culture became geared towards amassing as much money for oneself in as short a time as possible through whatever means were necessary which, for the highest rollers then as it still is today, was typically in financial machinations and speculation, not in productive investment.

The 1980s was also the decade in which privatisation came in vogue – the acquisition of public assets which were built in an earlier era in which productive investment was understood to be important and necessary.

The government was endlessly attacked as being inefficient and wasteful, to the end of promoting privatisation; it is still fashionable to attack the government for being unable to run anything and, indeed, goverments still think that it’s a good thing to get a quick infusion of cash from the sale of a public asset which forms reliable basic economic infrastructure.

Typically, private owners of infrastructure raise prices, do not invest in maintenance, do not improve services and generally let the capital run down. We have seen this with privatised trains in the UK and the USA. We see how Macquarie Bank prefers to build and run roads around the world including in Australia: with minimum lanes and maximum toll.

In Australia we had the rise of forex trading by the major banks, the Accord under the ALP during the Hawke years and deregulation of the financial industry (fees and interest rates) under Keating (a.k.a. “the world’s greatest treasurer”).

Those who say that speculators benefit the world by “making the market more efficient” need to learn about Adam Smith and David Ricardo, and for whom they worked (viz. the British East India Company).

So we had a house of cards build up and fall over with the crash of 1987. It’s at that point that Alan Greenspan was appointed Chairman of the U.S. Federal Reserve. The conditions were set for the Y2K boom paving the way to the dot-com bubble which ran in conjunction with, and was briefly survived by, the telecom bubble.

These booms directly benefited the financial industry through IPOs of software-related then hardware-related companies (a la Dell, Compaq) then internet and telecom companies with new and supposedly innovative services. What’s more innovative? An undersea tunnel with maglev rail powered by nuclear energy, a desalination plant providing 100 GL of water per day, or an internet chat room with new colours and icons? This lopsided concept of economic value still exists – look at the stock market valuations of Microsoft and Google, against those of auto and aerospace manufacturers.

After the I.T., dot-com and telecom bubbles burst, forecast by Greenspan “irrational exuberance” comment, Greenspan played his next card: the housing bubble. U.S. Federal Reserve research papers from the 1990s show that Greenspan knew that a housing bubble would result from reducing interest rates and that is just what he did:

click here for a chart of interest rates

This chart shows that that action had the effect of creating a housing boom based on paper. We see first that the number of new mortgages suddenly rose:

and that cash-out refinancing of existing homes rose:

The increase in real estate prices led to an increase in the proportion of household wealth that was due to real estate:

Even GDP growth was increasingly due to rising real estate prices:

One of our focuses here is thie chart which shows the extent to which banks became invested in real estate:

Thus, the U.S. banking system – whence the world banking system through the $USD – is reliant on housing for its survival.

Fast forward to the present. While the Federal Reserve bosses downplay the housing market downturn that is well underway, there are more figures presenting the hissing of the bubble created by Greenspan’s policies. There may be an irrational collapsing of the housing market as Jack Lang described – in his book “The Great Bust” – as occurring in the 1930s: good properties as well as bad were dumped. Yet we have a banking system that is heavily invested in that housing market.

An aside on central banking:

Greenspan is not an elected official and that U.S. Federal Reserve Board meetings are conducted in secrecy, just as those of the Board of Governors of the Reserve Bank of Australia. The RBA Act requires Governors to take an oath of secrecy. Why? These unelected representatives are setting public policy. The ALP has had a tradition of nominating a union representative to the board, but Rudd has said that he’s not interested in doing that. So we have a coterie of private individuals, typically from private banking or wealthy businesspeople, setting financial policy behind closed doors.

Clinton tried to have the U.S. Federal Reserve Board meetings filmed or their transcripts published, but he was not allowed to get anywhere with that initiative.

Collapsing housing bubble

We shall now proceed through a range of items of evidence that the housing and mortgage market is falling apart. The mortgage market is important because it’s how property is linked to the banking system. You borrow money to buy a house and the bank takes a mortgage over the house. The mortgage represents the bank’s income stream from your loan repayments which include principle plus interest and its right to repossess and sell the house if you cease to be able to pay. The bank’s business model is built on most borrowers being able to pay for the term of the loan or paying out the loan before term in an orderly way. This system is breaking down due to an increasing number of defaults and repossessions.

Back to the housing bubble… Last year, Gilchrist Berg - founder of the $2 bn hedge fund Water Street Capital - said that he expected the mortgage bubble to burst and forecast that Fannie Mae could lose $22-29bn of its $40bn in capital by falls in property prices. (FNMA or “Fannie Mae” is the USA’s largest mortgage buyer and securitiser: Federal National Mortage Association.)

Stephen Roach, the analyst from Morgan Stanley, described the systemic risks with which the banking system is threatened in his paper “The end is never the same” of Nov 2006. Roach said that “the U.S. property market is now starting to to display all the classic symptoms of a mania” and that “‘asset flipping’ [where you buy a property, clean it up or not, and re-sell for a quick profit] is now reaching Ponzi-like proportions.” He said that “the aftershocks of the property bubble are likely to be far more worrisome than the equity bubble, this time the Fed may be ill-equipped to face what it shaping up to be an increasingly treacherous endgame.”

We’re no longer in the domain of forecasts but are seeing records broken as months pass in foreclosures, defaults, personal bankruptcies, time-to-sale, housing starts and house prices – particularly in Britain and the USA.

The rise in foreclosures was already well under way in the second half of last year:
USA Aug 2006
• up 27% from Jul 2006
• up 53% from Aug 2005 Homes in foreclosure
• MA foreclosures to Aug 06 up 72%
• CA up 173% to 43,000 or 31% of starts
• FL 23,000 or 12% of starts

South Korea has a large housing bubble and the economics and finance minister Kwan-o-kyo said on Wed 30 May this year (last month), “A sudden housing price plunge is one of the major risks that could arise within South Korea.”

A fall in South Korean property prices of ~25% would wipe the value of the GDP from the country’s housing stock, approximately $USD 870 bn. Household debt in South Korea is now triple what it was before the Asian currency crisis of 1997. On 1 Dec 2006, the Economist Intelligence Unit likened South Korea’s situation to the 1997 crisis.

Underreporting

On 21 May, John Burns Real Estate Consulting (JBREC) said that “it is going public with our concerns” that the national sales information for new and existing homes is misleading and is covering up a deep plunge of the housing sector. JBREC said, “The housing market has softened much more than is being reported” by the U.S. Fed Reserve and the National Association of Realtors (NAR).

JBREC has bought and compiled actual home-closing data for 55% of the USA and finds sales of existing homes is down 22% over the year May 2006-April 2007 versus May 2005-April 2006, compared with the 9% reported by the NAR. New home sales of the biggest homebuilders in the USA – D.R.Horton and Lennor – are down 37% and 27%. So the fall is consistently higher across new and existing homes – well over 20% for both.

Realogy Corp is the USA’s biggest realtor, which own Century 21, Coldwell Bank and ERA – their transactions fell 18% from 2005 to 2006. In addition, mortgage applications fell 18% even though the number of applications that must be completed in order to get a mortage is rising.

Looking at the states with the worst housing sales/foreclosure figures, JBREC found Florida home sales down 34% though NAR had reported 28%, Arizona sales were found to be down 38% and not 28%, and California 37% not 24%. This underreporting dates only from mid-2006 and JBREC does not accuse the NAR of intentional misrepresentation.

On Wednesday this week (6 June), the NAR revised its home sales forecast, saying that the decline in U.S. home sales would be steeper than earlier forecast. They said that the sales of previously owned homes would fall 4.6% to 6.18m – compared with their 2.9% forecast from a month ago – and the U.S. median home price will likely fall 1.3% to $219,100.

The Census Bureau continues to not subtract cancellations from sales which leads to overreporting of sales. The U.S. Federal Reserve uses these inflated Census Bureau figures to inform its formulation of monetary policy.

The U.S. Commerce Department reported that in Q1 2007, spending on new home-building fell by 15.4% from Q1 2006. Overall economic growth in the US was the weakest in four years (c.f. 0.2% Q4 2002) at 0.6% annualized.

S&P’s Case-Schiller index released Tuesday last week (29 May) says that home prices dropped 1.4% in Q1 2007, the first year-on-year decline in home prices since 1991. 13 of the cities in their 20-city index showed falling house prices in the last year, led by Detroit (8.4%) and San Diego (6%). Phoenix and Las Vegas, where home prices were rising faster than 50% p.a. a year ago, fell by 3% and 1.6%.

The NAR index for “pending” (i.e. exchanged but awaiting finance for settlement) home sales fell 10.2% from a year ago and -3.2% in April this year. An analyst is quoted in the report as saying, “There is absolutely nothing in these data to suggest that the end of the downturn of the housing market is yet in sight.”

On 18 May, a Wall Street firm reported that the foreclosure “shock cone” is widening. All foreclosures are up 60+% in 2007 over the same time last year, but foreclosure notices – which is the front-end of the process and usually triggered by a 90-day delinquency – are 127% higher than, more than double, in 2006. The same firm said that, on a national average basis, foreclosed homes go to market with a 30% price reduction from the buying price.

Exotic loans

Once upon a time, home loans required a 40% deposit and strong evidence of ability to comfortably repay. Now, a 5% deposit is considered respectable. A new class of loans evolved which have steadily been made easier to get, and we classify this generally as “exotic”. Examples are interest-only and minimal payment loans. These are typically extended to subprime borrowers.

Exotic loans accounted for 15% of all mortgages in 2000 and 37% in 2005 worth $420.6 bn.
• Florida (11% of USA housing starts) first half 2006, 47% of mortgage loans were exotic
• Virginia (2.5% of USA housing starts) first half 2006, 51% of mortgage loans were exotic.
Exotic is the new normal!

Subprime

The subprime sector is a subset of home loan borrowers who are a less-than-ideal credit risk for banks and other lenders. Nonetheless, in an effort to make more loans, subprime packages were crafted to sell to those who would otherwise be unable to “own” a house. These mortgages offer incentives such as:
• no interest payments for the first 12 months which then gets added to the loan,
• low payments for the first n months with the difference added to subsequent payments where the interest rate is then higher than usual to account for the greater credit risk these borrowers represent,
• interest-only loans so that the loan is never repaid,
• and so on.

These loans are extended to people who are a worse credit risk due to such factors as low-income, lack of a stable employment history, inability to provide documentation to support their purported income, etc. After the first 12, 18 or 24-month “honeymoon” period, borrowers are required to start payments which are often 50% or more of their income. They can’t pay and so the lender forecloses. In the USA, there is a higher incidence of these loans in African-American areas, even where average income is relatively high. Therefore, more investigation is warranted into the contention that such neighbourhoods have been targeted for predatory or usurious lending.

The mortgage market works by bundles of loans being packaged and re-sold into international debt/bond markets so that the party who ends up holding the bond – such as a “real estate fund” in Europe or an “Australian superannuation fund” – is a long way from the original loan and may not even have a great deal of knowledge of the details of what their bond comprises. If the borrower defaults, the bondholder may have little recourse but to take a loss on the bond coupon or the final principle that the bond represents. Suddenly, an American mortgage bond does not look so secure, especially the ones which promise higher than average interest payments on account of their being based on lending to subprime borrowers.

The distancing of debtor from creditor works to disadvantage both:
(i) The securitisation of mortgages is preventing renegotiation of contracts. This was reported in Reuters on 7 June. Lewis Ranieri and a Rice University Professor both confirmed this. Investment banks are under Congressional pressure to renegotiate mortgages to avert foreclosures. Even if the original mortgage broker or financier would have been willing to renegotiate, the loan is now out of their hands.
(ii) Bonds are not adequately priced for the risk represented; that is, the interest rates are too low when compared the risk of default and those buying the securities have little knowledge of the precise status of the mortgagors. Bondholders pay too much for dud loans.

While the “subprime meltdown” has received a lot of coverage, it has been underreported. Some estimates are that a quarter to half of all subprime loans will end in foreclosure. Aside from the human cost of hundreds of thousands of people losing their homes and possibly going through the process of personal bankruptcy, this will hit the overall property market with a downward spiralling of prices. Since foreclosure auctions are typically fire sales, they’re attended by bargain hunters (or vultures!) and it’s known that a few foreclosures in a neighbourhood drag down the perceived value, and hence the price, of all properties in that neighbourhood.

As the housing market falls, we need to be aware of the effect this will have on the banking system. More than 60 major mortgage houses, many owned by banks, have closed their doors in 2006 and 2007 due to large numbers of bad loans.

Looking at some of the “subprime casualties”, on 2 April 2007 – so it wasn’t an April Fools joke – New Century Financial Corp filed for bankruptcy, becoming the largest mortgage banker lender ever to fail.
(a) In its Delaware Ch. 11 filing – and most U.S. companies are registered in Delaware though New Century’s headquarters were in Irvine, Calif. – it said that it planned to sell most of its assets by mid-May and would fire 3200 staff, which is about half of its staff.
(b) The Bloomberg news feed says, “The company rode the U.S. banking housing boom to become the largest independent mortgage lender to subprime borrowers, only to collapse as interest rates rose and house prices fell… Like rival firms, the company lowered its lending standards to keep business flowing after demand slumped.” So New Century had to raise its rates so that its loans were profitable but its poor quality borrowers couldn’t pay.
(c) Between 1 June 2007 and 2 April 2007, its shares fell 97%.
(d) In 2006, it made $60 bn in loans. Of these, 86% or $51.6 bn were subprime.
(e) New Century ranked second only to London’s HSBC Holdings plc in total subprime mortgages granted in the USA.
(f) Over the two years to its collapse, New Century more than doubled the value of loans underwritten, as it underwrote approximately $120 bn in loans over those two years.

We already saw above that close to have of U.S. bank assets were in real estate in 2006. A collapsing housing market means that the (value of the) asset backing of loans is falling. For example, $80 bn lent out against what was previously $100 bn worth of real estate could become $80 bn in loans against $70 bn worth of property. Such a scenario would mean that banks could enter a situation of actual bankruptcy – for example, if borrowers are unable to pay banks and banks are forced to sell the property and cannot recoup the value of the loan, then the banks are unable to repay those from whom they borrowed, such as depositors and lenders in international financial markets. Banks, like any business, rely on cashflow from their income sources to meet current debt as they fall due and do not keep a large percentage of their assets in cash on hand to meet liabilities. If cashflow slows, then they need to take contingent action.

We could face a bankrupt U.S. banking system – assets being less than obligations and banks unable to service their existing debt. Perhaps it is already bankrupt and merely saved from declaring bankruptcy by over-inflated property values on paper. (Indeed, Lyndon LaRouche says that the global banking system is already bankrupt, when we take into account derivatives and all forms of debt many of which he calls “gambling debts”, and ought to be treated as any bankrupt organisation: by putting it into bankruptcy reorganisation, which is what FDR did in the 1930s. The situation now, globally, is far worse than in the 1930s in the USA alone.)

The chimeric value of banking system assets surrounding real estate is nothing compared with the mountain of paper piled up by hedge funds and financial organisations in general via leveraged byouts (LBOs) and in the form of derivatives which we’ll touch on later.

On 3rd April, a Reuters story appeared headlined “Mortgage crisis hits million-dollar homes” which covered the spread of the “mortgage meltdown” – meaning rising foreclosures and falling prices – into what is broadly known as the market for CDOs or “collateralized debt obligations” which are mortgage-backed securities.

Mark Keisel, manager of PIMCO the world’s largest bond investment fund, said, “Everyone’s looking at subprime.” Mark also said, “The rocks they aren’t looking under are the adjustable rate mortgages and teaser rates and low money-down loans. It’s going to affect prime as well.”

The foreclosure rate for homes valued at $750,000 and above has reached 2.5% America-wide. All ten of the cities with the highest rates of increase in delinquencies and foreclosures in the USA are in high-priced and most recently regarded as “superhot” markets of CA and MA. The prestigious eastern MI lakeshore towns and NV counties are not far behind. This causes one to think twice about the supposedly “bulletproof” areas such as Kirribilli, Mosman, Woollahra, Tamarrama, etc. How “bulletproof” are they? Prices in the western suburbs of Campbelltown, Liverpool, etc peaked in late 2003 while areas closer to the City have risen to levels causing Sydney to have what’s familiarly known as the least affordable housing in the world.

In the domain of Alt-A jumbo loans – which are not prime but not subprime either – of $400,000 or more, there are 1000 foreclosures per month in CA – according to RealtyTrac a real estate consulting and research firm. The Center for Responsible Lending (“CRL”) forecasts 2.2m foreclosures across the USA in 2007 and estimates that this will wipe out $164bn in homeowner equity, or an average of $80,000 per foreclosed home with many of these being second or third houses bought for real estate “investment” or speculation.

The research firm Housing Predictor surveyed 100 U.S. metropolitan areas in May and forecast two million more foreclosures nationally. This is close to the forecast by the CRL. This would take 2006-09 foreclosures to 3 million, larger than when the U.S. savings and loan bank sector collapsed in the mid-80s.

Ohio is the state with the highest foreclosure rat in the USA at 3.4% in 2006. A report by the Coalition of Homelessness and Housing in Ohio says that 73% of delinquent loans were made in 2005-6 and to middle and upper-income households with incomes up to $140k. Households with income over $65k had 21% of non-prime (i.e. subprime, Alt-A, etc) loans and low-income households (with income below $27k) had only 5% of the non-prime loans. So a slice of middle-class America that’s been trying to get ahead through essentially non-productive real estate speculation is being hit by this real estate collapse.

These mortgages underpin collateralized debt obligations(CDO) securities packages which have been bought and sold worlwide, and so the influence of changes in U.S. real estate will be felt through the world. On 30 Mar, Lehman Brothers – one of the more influential investment banks, in the class of Goldman, Close, Macquarie – estimated that mortgage CDOs had lost $20bn of value in March.

S&Ps, the rating agency, said in early April – approx. 2 months ago – that subprime mortgage backed securities may be the “worst performing in recent history”. S&P noted that delinquencies on the underlying have been “consistently higher” than in the prior five years. S&P said that ~13% of subprime loans made in 2006 are delinquent – already, in April 2007 ! Half of those 13% are “seriously delinquent” which, usually, means approaching 90 days late which means that the lender is on the verge of issuing a foreclosure notice.

S&P had previously estimated losses on subprime loans at 6.5%, a peak, and raised that still further to 7.75%. S&P said that this could significantly impact the value of CDOs.

The National Association of Homebuilders estimates that default and foreclosures on subprime loans may rise to $650 bn (approx 5% of US GDP in 2006) by 2009, or 1/3 of all subprime loans.

There is now a national (US-wide) inventory of 4.2m homes – 8.4 months’ supply – the highest level since 1999 when the NAHB started collecting figures.

On the seedier side, Beazer Homes USA Inc., a Fortune 500 company, was being investigated for potential fraud in Mar-Apr 2007 on matters relating to loans arranged by Beazer for low-income buyers, whose foreclosure rates have averaged 13% since 2000.

States to the rescue

Now what is the government saying or doing about this? Well, in Sept 2006, the Senate Banking Committee held a hearing on risks posed by the mortgage bubble in which they investigated and educated themselves on the problem.

In April 2007, more than five U.S. states were exploring floating bonds to “help distressed homeowners refinance” to head off foreclosure or were actually doing it. Lyndon LaRouche said that states attempting to bail out the collapsing $12 trn mortgage market will quickly lead to disaster, and that only the Federal government can issue sovereign credit and has the financial power and authority to overcome a crisis of this magnitude. OH, MA, RI, VI have begun moves to refinance using state bonds, while CA, CO, WA and WI are on the verge of doing so.

LaRouche and associates are working to catalyze a mobilisation inside the Federal government, particularly through the Democratic party, to do just that. In Australia, we’re working to alert the government of the probem in Australia and the shockwaves that will emanate worldwide, from which Australia won’t be immune especially given the lopsidedness of our economy – particularly in Sydney – towards “financial services” which is trumpeted by our government as somehow being a good thing, from the collapse of the American housing market and the effect of that collapse on the US banking system.

Secretary of State for MA, William Galvin, testified to the state legislature on 27 Mar demanding “emergency legislation” to halt foreclosures. Galvin said, “You are literally talking about thousands of people in MA, who I would call the ‘pre-homeless’,” because they are headed towards foreclosure and eviction. Lyndon LaRouche said that this – as opposed to bailouts – is necessary and is a state power.

The Center for Responsible Lending (CRL) forecasts that over 1998 to 2006, it will be found that every year saw a net loss in home ownership with more families losing their home to foreclosure than become new homeowners. In addition, only 9% of subprime loans go to first-home buyers - the other 91% refinance existing homeowners’ loans.

The CRL forecasts that 15% of subprime loans originated since 1998 have or will end in foreclosure.

Europe

We mentioned the property bubble in South Korea. There is also one in the UK and France. In the 28 March in the London Daily Telegraph, it was reported that French property construction fell 15% in Feb 2007 and prices have started to slip. French home prices had risen 210% since 1995, compared with 190% in the USA. It’s estimated that French property is, on a blanket average, 25% overvalued. In 2006, construction growth was 7.2% and in Jan 2007 became negative at -0.6% over Jan 2006. Jean-Paul Six, S&P chief economist, saud that this is a result of rising interest rates. In Spain, 93% of mortgages are adjustable or floating rate mortgages (ARMs) making Spain vulnerable to changing interest rates around the world. France, on the other hand, has no subprime market and most mortgages are fixed rate.

In Italy, home prices have risen 92% since 1997 and, in Feb 2007, the number of cities with declining house prices exceeded the number with rising house prices.

The distressed debt “opportunity”

From Saturday’s (2 June 2007) Sydney Morning Herald, we read that some private equity, hedge fund and investment banks are buying up subprime lenders and loans, betting that the market will “snap back quickly”. It seems that distressed debt is all the rage. An example is Cerberus Capital Management which has a reputation for buying distressed debt and is now by far the USA’s largest subprime lender. (The SMH picked up this story from the New York Times.)

Cerberus is involved in taking over and looting once-productive and now debt-laden companies, such as Chrysler.

Yen carry trade

The Yen carry trade and positions taken on the basis of Yen as a source of cheap credit is a major source of risk.

Japan’s central bank has a longstanding policy to stave off deflation – a possibility due to Japan’s high foreign reserves, high savings rate and high level of production – by making credit readily available. Interest rates have been zero or close to zero for several years.

Feeding off of this, the Yen carry trade is where money is borrowed in Japan at low rates and re-lent/re-invested outside of Japan at higher rates, so profiting from the difference. In a largely unregulated financial system, this presents opportunities. You can borrow $10 bn in Japan at 1%, buy U.S. Treasury notes at 6% interest, and earn the 5% difference for doing absolutely nothing productive. In this way, when you include the multiplier effect of credit creation – i.e. the seller of Treasury notes will then re-invest the money that you gave him, and so on – trillions of dollars of cheap credit has found its way into financial instruments, real estate, stocks and private equity funds worldwide. Senior fund managers and analysts typically say, “No-one really knows how big the yen carry trade is; but it’s in the $USD trillions.”

Investments made (better terms “positions taken”) in the Yen carry trade are at risk not only of a rise in Japanese interest rates but also of a rise in the Yen against the currency in which the positions are held. When interest rates start to rise in a country, then the value of its currency rises also.

We now have even real estate loans in Turkey – where interest rates have reached 18% - being made using credit ultimately from Japan. These “homeowners” will be hit with large increases in their repayments should the Turkish lira fall against the Yen and as the Bank of Japan (BoJ) raises rates, which it is doing.

Indeed, the BoJ announced in the first half of 2006 an end to its 0% interest rate policy and has been raising rates in 0.1% notches. (The BoJ benchmark rate is now 0.25%.) The announcement has been implicated in the Iceland stock market collapse of 22 Feb 2006 which shortly followed the announcement. That is, it is thought that traders quickly unwound positions made on the basis of low-interest borrowings in Yen.

The BoJ is doing this is order to dampen speculative activity in Japan itself. It is also concerned about possible implications on the economy of Japan when “carry trade Yen” eventually finds its way back to Japan, possibly more suddenly and unexpectedly than it would like. The BoJ has emphasised a controlled raising of rates with plenty of notice being given.

Despite the BoJ acting in the interest of Japan, on 22 May the OECD (the Organisation for Economic Cooperation and Development) warned Japan to “not raise short-term interest rates until their inflation rate is firmly positive”. The OECD is not concerned about inflation in Japan but, rather, about the threat to hedge funds should Japan end the era of cheap Yen.

The multiplier effect of cheap Yen will wind back the availability of credit, reduce asset prices and trigger loan covenants worldwide. Cheap Yen also underpins the $USD by allowing credit to flow from Japan to the USA. A precipitous fall in the $USD would also endanger the system as the financial system is dollar-based, as it has been since the end of WWII when the Bretton Woods system was set up using the $USD which was at the time the only currency unit that attracted universal confidence.

In 2006, the South Korean finance minister said that a sudden liquidation in Yen carry trade positions poses a risk for the South Korean economy because it would mean a rapid outflow of credit to pay out loans in Yen or other currencies.

Lyndon LaRouche has said that in a hair trigger sensitive financial system, ending the Yen carry trade will bring down the global system, as the forced default by an English king brought down the House of Bardi and unleashed the European Dark Age in which one-third of the population of Europe was wiped out. He goes on to say, “Let it blow. The system is doomed anyway,” and that a collapse, which is now inevitable, will pave the way for a reorganisation of the global financial system for a New Bretton Woods.

Moving on to the markets themselves and the major players, on Tuesday this week (5 June), Toshihiko Fukui, Governor of the BoJ, as well as saying that there would be another rate rise in Japan – in defiance of the OECD’s “suggestion” – said that the growth of the hedge fund industry is “too influential to ignore” to a monetary conference of international bankers in Cape Town South Africa. He said that, “In times of stress” these funds add volatility to markets.

At the same conference, European Central Bank (ECB) President Jean-Claude Trichet worried that a “triangle of vulnerability” exists that could trigger an upset to the financial markets:
1. Low risk premiums on debt instruments, meaning that the risk of default is not factored into interest rates,
2. The explosion of unregulated hedge funds, and
3. The growth of private equity firms together with their widespread use of complex derivative instruments.
He said that a shock at any corner of the triangle could have implications for the other two. For example, a significant turn in the credit cycle – e.g. Japanese interest rates versus U.S. interest rates – could mean that credit protection sellers – i.e. those who promise to make payments should there be an undesired movement in relative interest rates, forex rates, etc – such as hedge funds and investment banks might find themselves unable to make the payments. Similarly, if widespread problems at equity firms or hedge funds were to arise, this could spark a downturn in the credit cycle, such as an across-the-board ratcheting up of interest rates.

Well over 80% of hedge funds are registered in the British satrapy of the Cayman Islands, whose rules are set by the Cayman Islands Monetary Authority (CIMA). No securities market regulator has been able to pierce CIMA’s armour. We have $USD 30+ trn (an estimate only) of funds unregulated and able to deployed for purposes as diverse as the buying of Yen to the buying of Latvian real estate – and the Latvian real estate market has been booming – to buying infrastructure companies and toll-collecting rights.

Imagine a hedge fund owning your roads or your water supply. Alinta, the WA energy company, was ultimately bought by a private equity outfit based in Singapore. It’s ultimately private equity that is trying to get a hold of QANTAS. Hedge funds seek to maximise return on investment (ROI), end-of-story. As Chapman Capital LLC chairman, Mr Chapman himself, says, “We issue eviction notices to incompetent managers.” Their website presents as a military outfit. The way unregulated private capital deals with road and rail services – low maintenance and investment, high tolls/fares – is well known. These are crusaders dismantling civilisation using aggressive and unregulated financial “activism”, just as the Norman Chivalry and other mercenaries dismantled civilisation (not only of the Islamic world but Constantinople too) under the Venetian empire.

Joining the BoJ and the ECB, the Chief Executive of the Hong Kong Monetary Authority (HKMA) on 29 May cited these external risks to the currency stability of Hong Kong:
1. Sudden, sharp depreciation in the $USD
2. Disorderly unwinding of global imbalances
3. Spillover of the U.S. housing market weakness

He said that financial instability and volatile capital flows are induced by:
1. Increased risk aversion of market participants
2. Higher market volatiliy
3. The destabilizing activities of hedge funds.

In May, labour unions from 35 European countries decided to launch a mobilisation against private equity “leveraged takeovers” of companies saying they rob countries of taxes, workers of jobs and could collapse the market liquidity off of which they are feeding by causing an interest rate rise to dampen asset price rises and to price in risk. As defaults rise on LBO debt, you can be sure that rates will rise as the markets become cognisant of the actual risk of losing their capital.

The British Trade Union Council (BTUC) is a leading member of the group and said on 29 May that buyouts had taken $100 bn from Britain’s capital markets in 6 months.

On 29 May, the FT reported that private equity buyouts of corporations are growing at a record pace in 2007. In the USA, there were $82 bn of buyouts in May 2007, and most of this was funded by debt.

Derivatives

I want to give you an idea of the pile of paper that clever financial modellers are piling up. Maybe it’s bulletproof, but then so was Long-Term Capital Management (LTCM) headed up by a couple of Nobel Prizewinning economists which collapsed in an almighty financial explosion in the late 1990s.

Derivatives are instruments of the “risk management” industry. Investment banks charge fees to help manage the risk inherent in an unregulated financial system. While making money off of the volatility through market speculation, there is money to be had by offering protection to organisations that use credit for their business against that volatility in interest rates and exchange rates, as well as protecting against the risk of their debtors defaulting.

A derivative is a little like an insurance policy. The notional value of a derivative is the underlying value of the contract, instrument or security that is putatively protected by the derivative, such as a loan. The credit exposure is the amount that the seller of the derivative, such as investment bank, might have to pay the buyer should a certain credit event occur, such as a downgrading in the credit rating of the debtor in the underlying loan transaction.

Credit derivatives include credit default swaps where the risk of default of a debtor on a loan is shifted to a derivative dealer, such as a Citigroup, a J. P. Morgan or a Goldman Sachs. Credit derivatives are by far the largest class of derivatives, recently representing over $USD 250 trn in notional value as shown by this chart:

click here for a chart of growth in interest rate derivatives

Dealing in derivatives is similar to advanced speculation, because a dealer will earn steady fee or premium income in return for being able to predict the range of volatility in the market. If its risk assessments turn out to be wrong, then the effect is the same as of a bad trade. However, the effects can be much worse, such as in a credit default swap, where the notional value can become credit exposure if the debtor goes under.

Demand for fixed income derivatives, especially credit default swaps (CDS), has increased dramatically in the last few years, driven especially by the growth in hedge fund strategies which often make heavy use of debt.

In the five years that the International Swaps and Derivatives Association (ISDA) has been collecting data, the CDS market has grown from $631 billion in 2000 to over $17 trillion at the end of 2005.

Australia in 2004 had $AUD 17.6 bn per day in over-the-counter (OTC) derivatives – which excludes speculative buying and selling – activity, or $AUD 3.4 trn p.a. which was approximately five times our GDP.

Commercial banks generated $4.7 billion trading cash instruments and derivative products in the second quarter of 2006, compared to $5.7 billion in the first quarter of 2006 and $2.0 billion in the same quarter of 2005:
• Net Current Credit Exposure, the net amount owed to banks if all contracts were immediately liquidated, increased $10 billion from the first quarter to $199 billion.
• Credit Derivatives, the fastest growing component of the bank derivatives market, increased 20% from the first quarter and stood at $6.6 trillion in Q2 2006, approximately 50% of U.S. GDP. (U.S. GDP in Q3 2006 annualised was $USD 13.3 trn.) Credit default swaps represent 97% of the total notional amount of credit derivatives. (Note that this is “covered” by $199 billion owing to banks, or a 3.0% “net asset coverage” ratio.)
• Commercial banks held $119.2 trillion in derivatives contracts, up 8% from the first quarter of 2006, or approximately 9 times U.S. GDP in Q2 2006. Bank derivative contracts remain concentrated in interest rate products, which represent 83% of total notionals. (Note that this is “covered” by $199 billion owing to banks, or a 0.16% “net asset coverage” ratio.)

Warren Buffett has referred to derivatives as a “financial neutron bomb”. Derivatives have received a great deal of coverage as posing enormous danger to the system which they pretend to protect.

Take Citigroup as an example. Citigroup is the largest U.S. bank holding company by asset size and the third largest by derivatives use, and one of the largest derivatives dealers globally. According to the U.S. Office of the Comptroller of the Currency (OCC), Citigroup had $16.2 trn in derivatives on their books (in notional value) as of 30 June 2004, and 98.9% of this amount was for trading purposes as a derivatives dealer and only 1.1% were used for other purchases such as hedging its own banking activity.

Finally

I hope that I’ve given you some idea of the risks the global financial system faces. Indeed, the global financial system has no safe future in its current form, and will collapse in its own good time which may be sooner rather than later. This is the reality.

The solution put forward by the LaRouche movement, which is really the only solution on the table and the only solution available, is for a New Bretton Woods to create an environment for stable economic growth, which means physical growth not chimeric paper growth, large national and pan-national infrastructure projects financed by long-term low-interest credit under fixed exchange rates and a relatively protectionist regime.

There is no shortage of large projects on the table but there is room for many more, from the Bering Strait Tunnel to the Eurasian Land Bridge to the development of Sibera to the greening of Australia’s desert. Global development must occur against a background of a rennaissance in nuclear energy, fuelled by uranium and thorium, ultimately giving way to a fusion power based economy. Nuclear energy can crack water to generate clean and energy-dense hydrogen fuel, and can power the desalination of oceanwater on a large scale. The benefit of big projects is as much in their undertaking, the opportunity for human beings to develop and exercise creativity, as in the infrastructure which results from them.

The goal of the global financial architecture must be to enable such projects to further the welfare and development of sovereign nation states, with each nation promoting the general welfare for every individual human being who calls their country home.

The present, doomed system should be put into bankruptcy reorganisation, in which we’ll decide which debts are worth paying and which must be cancelled. All the outstanding debt could never be paid, and there is no physical wealth to back it up, yet it’s treated as real to loot what relatively few physical assets do still exist. The gambling debts, and a slice of outstanding derivatives are hardly worthy of a more honourable label, must be cancelled and forgotten.

We then must implement a New Bretton Woods system: a regulated global financial system with fixed exchange rates, low-interest long-term sovereign credit to finance large national and pan-national physical infrastructure projects.

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