How the 1% drove 99% to debt and destruction – US experience

This entry is part 6 of 8 in the series Deriving Capital's Future

Read on for the 6th part of analysis of derivatives market by Dick Bryan and Michael Refferty. This was originally published in Socialist Register. We are publishing the tamil translation of the same along with the English text (for reference) for our readers.

6

Figure 3 shows evidence from the United States between 1996 and 2010 on the issuance of the major securities listed by Moody’s. The figure shows starkly the rapid growth of home equity security issuance from 2000 to 2007, by which time they comprised 65 percent of all security issuance. In the financial crisis, home equity security issuance fell from a 2006 peak of $483 trillion to just $2 trillion in 2009.33 Figure 3 shows also the dominance of securities based on income streams generated directly from households : home equity, auto loans, credit card loans and, especially from 2001, student loans. Indeed, the category of ‘other’ in Figure 3, representing forms of security issuance not backed directly by household incomes, has been remarkably minor throughout the period.

Figure 3 US Asset Backed Securitization Activity, New Issuance by Asset Type, 1996-2010, (US $ millions)

Source: Thomson Reuters, SIFMA

The growth of household borrowing, as the foundation for the rapid growth of securities until 2007, is now well understood as a combination of two factors. First was the existence of stagnant or falling real wages which led to the growth of working-class demand for borrowing in order to sustain living standards.35 Second was predatory marketing practices by money lenders, especially towards economically vulnerable groups.36 Together, these two factors were complementary, at least for a brief era in securities markets. The ‘originate-to-distribute’ model of the securities industry meant that a key risk of loans to households, the risk of non-payment, could be passed on from the loan originator to the security buyer: there was no need for due diligence on the part of the loan originator so long as there remained market demand for the associated securities.37 The issue of who was buying the securities, and why, will be considered shortly.

The Moody’s list above nominates not just households as objects of securitization, but a range of other assets too which generate reliable income streams. In particular, utilities such as airports (and aircraft), roads, electricity, water, telecommunications, and health industry became the objects of new financial calculation. These ‘infrastructure’ and ‘quasi-monopoly’ assets, so called because they have relatively stable cash flows and low correlation with economic cycles,38 were reconfigured so that their (presumed) reliable revenue streams could be sold into financial markets in return for lump-sum (plus interest) payments: they were securitized. The owner of a toll road, for example, could sell into financial markets a product which provided an income stream based on the rate of toll payments.

The derivative aspect of securities, to reiterate, is that they involve selling off an income stream (or a claim contingent on future events), but without selling off the (underlying) asset that generates the income stream. In the case of toll roads, the owner of the security owns the income stream from the toll roads but without owning the roads themselves. In the case of mortage backed securities, the owner of the security owns the stream of interest payment on mortages, but does not own the mortages themselves, and hence has no claims on the houses that sit under the mortages.

For the issuer of the security, the benefits of securitization comes from transforming future – and therefore to some degree uncertain – income (tolls, electricity bill payments, student loan repayments) into guaranteed and up-front revenue (the sale price of the security), and selling off the risks of the revenue stream. It permits them to build more toll roads, more electricity supply and give more loans than if they had to await full repayment. For the purchaser of the security, they gain exposure to a tradable asset that is likely to give a better rate of return than bank deposits or Treasury bonds, and it gives them a diversification of risks without having to own underlying assets. Such securities became alternatives to buying treasury bonds: many of them rated AAA, and so presumed to be just as (or almost as) secure, but with higher rates of return.

The critical technical question is how much risk is attached to these securities, and the risk-return calculation required to price them. We know from the well-documented history of mortage-backed securities and explanations of the global financial crisis that the issuers of securities often either did not realize, or sought to hide, the ‘real’ risks.39 It is also clear that credit rating agencies and other market gatekeepers such as audit firms and investment banks, whose specialist role was to make such calculations got it disastrously wrong.40

Framed in terms of accuracy of pricing of risk, and who knew and did not know about product quality and inappropriate credit ratings, the analysis gives focus to moral and market failure. This, in turn, opens up policy agendas about strategies to make these markets more transparent, with agendas of product disclosure and consumer protection.41 But those agendas avoid engagement with the reasons that these markets grew the way they did. A politics based on understanding how financial markets are evolving, and the potential that might lie therein for labour, must explore these reasons rather than privileging an (essentially conservative) agenda of simply containing the operation of financial markets.

PORTFOLIO DIVERSIFICATION AND THE SEARCH FOR YIELD

What explains the rapid growth, especially from the 1990s, of forms of derivatives based on product innovation pertaining to new asset types and income streams? We have already considered the growth of household debt combined with new acts of imagination and technological innovation, facilitated by a lax regulatory environment. We might frame these as supply side factors. There were demand side factors, too: the surpluses being accumulated in the sovereign wealth funds of Asia and the Middle East and the the hedge funds employed by the super-rich and also increasingly by pension funds. They were all looking for products in which to hold their wealth. Specifically, this demand side focus points to capital’s search for yield and the associated strategy of risk diversification.42

The precipitating factor was low interest rates and hence low rates of return on sovereign debt. The Reserve Bank of Australis (RBA) noted in 2004:

With interest rates on low-risk investments falling to low levels in many countries, investors have sought to maintain yields by moving into higher-risk assets such as corporate debt and emerging market debt. As they have done so, credit spreads on these assets have declined, which means that investors are receiving less compensation for the risk they are taking on. 43

In a similar vein, the Governor of the Bank of England observed in 2007:

This desire for higher yields could not be met by traditional investment opportunities. So it led to a demand for innovative, and inevitably riskier, financial instruments and for greater leverage. And the financial sector responded to the challenge by providing ever more sophisticated ways of increasing yields by taking more risk.44

In explaining this shift, the role of hedge funds and sovereign wealth finds has been prominent.45 The RBA had identified in 2004 that ‘the low interest rate environment may also have encouraged a shift in investments towards hedge funds as, in the past, hedge funds have achieved higher average returns than traditionally managed investments, albeit in exchange for greater risk’. The search for yield generated diversification. ‘Hedge funds appear to be having trouble maintaining their rate of return as their typical investment plays have become “crowded”. This in turn has caused some hedge funds to seek a wider range of investment opportunities and to take on more risk.’46 Evidence also points to sovereign wealth funds, in the search for yield, increasingly placing reserves with hedge funds, along with growing investments in derivatives and asset-backed securities.47

The search for yield provides a critical explanation of the pursuit of higher risk. But, of itself, it is limited in explaining financial innovation. After all, the appetite for profits and preparedness of capital to take risks is not new. Two further elements in this explanation are needed.

(continued in part 7)

From analysis of derivatives markets  by Dick Bryan and Michael Refferty. originally published in Socialist Register vol 47 in 2011

Series Navigation<< They own your loans, your income and your life – how to take it back?Capitalism – Titanic without life boats for the masses! >>

Permanent link to this article: http://new-democrats.com/deriving-capitals-future-part-6/

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