Peter Willans
As a result of the sub prime meltdown precipitated by the collapse of two hedge fund offshoots of the US giant banking corporation Bear Stearns in July 2007 financial markets have gone from phase to phase of instability. Recent reports indicate that 2.2 million households in the United States are in some stage of mortgage distress or default2. Foreclosure warnings rose 75% from the previous year. Increasing household stress is concomitant in Australian housing markets. A recent survey of homeowners in Sydney’s outer suburbs indicates that homeowners having been losing as much as $450 a week in individual property values3. The typical credit cycle of displacement, boom, euphoria, profit taking and panic before the bust is now being played out to script.
CONTINUING instabilities in global financial markets are the result of the evolution of global financial markets without global economic policies. Cheap credit combined with lax lending standards has fuelled the expansion of housing markets in the United States and Australia.
The current crisis had its nemesis in the policy decisions taken in the United States in the aftermath of the World Trade Centre disaster in 2001. Then Head of the Federal Reserve, Alan Greenspan endeavoured to stimulate the economy further in 2003 by lowering short term interest rates to one percent. An unprecedented influx of capital from Asia including high levels from China swamped credit markets. Similar unprecedented flows of unregulated speculative capital have entered Australia. High volumes of cheap capital have created an Australian housing bubble which is now starting to burst.
Along with high level capital flows and low interest rates came a new unbridled version of capitalism in the form of sophisticated and secretive financial instruments such as securitised debt to be marketed in tranches known as Collateralised Debt Obligations (CDO,s) and Structured Investment Vehicles (SIV’s), which supported real estate booms bigger in valuation than the technology stock bubble.
Real estate purchases used to require a considerable down payment in order to leverage the balance of the purchase from a lending institution. The proliferation of unregulated lenders has been associated with the rapid decrease in the amount required for a lending transaction to occur. In 1976 in the US the average first time buyer contributed 18% to the purchase matrix. Between mid-2005 and mid-2006 half of all first time buyers contributed nothing at all. The median contribution was only 2%. All of this was not so serious in a rising market but by the final quarter of 2007 US housing values fell across the board. Fifteen million homeowners in the US now owe more on mortgages than their homes are worth1.
As a result of the sub prime meltdown precipitated by the collapse of two hedge fund offshoots of the US giant banking corporation Bear Stearns in July 2007 financial markets have gone from phase to phase of instability. Recent reports indicate that 2.2 million households in the United States are in some stage of mortgage distress or default2. Foreclosure warnings rose 75% from the previous year. Increasing household stress is concomitant in Australian housing markets. A recent survey of homeowners in Sydney’s outer suburbs indicates that homeowners having been losing as much as $450 a week in individual property values3. The typical credit cycle of displacement, boom, euphoria, profit taking and panic before the bust is now being played out to script.
Dean Baker the co-director of US based Centre for Economic and Policy Research says that average housing prices have fallen by ten percent in the United States during 2007 which is something that has not occurred since World War 2. At this rate American households are getting poorer at a rate of US$2 trillion a year4.
When German Chancellor Angela Merkel and French President Nicolas Sarkozy met in Meseberg, Germany on September 10 2007 they discussed a critical global economic issue that was missing from the recent APEC Summit meeting in Sydney. This issue was the increasing nature of volatility associated with hedge funds and derivative markets around the world. Sarkozy took a tough line on “financial speculators” saying that they should not be allowed “to destroy an entire international system”5 Whilst this sentiment has been shared by UK Prime Minister Gordon Brown there seems to be a growing disconnect between policymakers and financial market lobbyists who forcefully resist any suggestion to regulate their industry.
When Dr Ben Bernanke, chairman of the US Federal Reserve, the most important financial supervisor of all, was quizzed by the US Senate banking committee about whether derivatives – complex financial instruments liberally used by hedge funds – should be regulated, he commented: “Derivatives, for the most part, are traded among very sophisticated financial institutions and individuals who have considerable incentive to understand them and use them properly.”6 This statement came very close to admitting that regulators don’t have a clue what is going on and are therefore powerless to regulate the funds. Given their sheer size and increasing influence of hedge funds, this is stunning – and should scare policy makers who are scrambling to provide responses to a deepening global economic meltdown.
Chancellor Merkel criticised hedge funds and ratings agencies which had been closely associated with the recent financial turmoil in the United States.
Substantial evidence is building that cheap credit facilitated through hedge funds and off-shore based businesses has played a major role in the demand and consequential price increases of properties in most western countries and excessively in the US and Australia. Sophisticated and cunning unregulated capital market players continue to manipulate markets even though policy makers are cognisant that this circumstance only exacerbates the already precarious nature of housing affordability and housing credit crises.
Ratings agencies had played a significant role in the collapse of sub-prime housing market lenders and hedge funds were caught with negative positions on Collateralised Debt Obligations in the form of sub-prime portfolios.
Ratings agencies have made huge profits out of retailing their opinions on the rating the credit-worthiness of an array of sub-prime mortgage related securities. As sub-prime markets boomed over the last five years so did the ratings agency profits, with Moody’s net income rising from US $289m in 2002 to US $754m last year7. Not only have ratings agencies made an enormous return through housing market securitisation it is significant to examine the role that agencies played in market influence. The Securities and Exchange Commission in the US are currently investigating the role of agencies in the targeting of low income areas to release sub-prime funds and the way that funds have been highly rated when there was little capacity for lenders to repay loans.
At a recent presentation to Russian companies Moody’s detailed an “iterative process, giving feedback” to underwriters before bonds are issued8. (iterative meaning a rework scheduling strategy in which time is set aside to revise and improve parts of the system by collusion between the agency and the lender). It is the alternative to incremental development to develop the entire system with “big-bang” integration9.
Calls from both European leaders come at a time when hedge funds are expanding there interests to cover the demand for Islamic investments in the United States, Europe, Asia and Australia. Barclays Bank plans to launch hedge funds that comply with Muslim Sharia Law through the banks venture partner the US based Shariah Capital Inc10. Further capitalisation of the hedge fund structure builds upon its 1000 organisations and US$2 trillion capital base.
Investors will be offered access to a group of hedge funds that will be managed in the host country according to Islamic Law. These funds will conceivably compete with other dynamic off-shore funds that feed into the US, and increasingly, into Australian housing and credit markets.
Recently the political spotlight has fallen on domestic consumers in Australia who are bankrupting in higher numbers than ever before.
One reason for this has been the influx and availability of an array of financial credit instruments covering home loans, consumer finance options, pay-day finance, and low-doc loans supplied through the vehicle of hedge funds and the “carry trade”.
Australians have borrowed heavily and are now exposed as never before. People are walking away from homes and loans they can never repay, in increasing numbers across Australia. And whilst the severity in social circumstances is taking affect on borrowers and consumers the exact opposite applies to the corporate lenders and loans companies.
Hedge Fund managers and chief executives of these funds are creaming massive remuneration from their hedge fund businesses. Top private equity and hedge fund managers in the US make more in 10 minutes than the average US worker make all year. Hedge funds have single-handedly made a mockery of the employment system globally according to a new study in the United States.
The 20 highest-paid fund managers in the United States made an average of US$655.5 million a year or 22,255 times the average salary of US$29,500 . Chief executives in other large US corporations are averaging US$10.8 million last year (their weekly pay of US$210,700 is 7 times the average workers salary) pale in comparison to the hedge fund chief’s average of US$12.6 million a week or US$210,700 an hour based on a 60 hour week. The American Institute for Policy Studies rightly criticises these “stratospheric” returns in its examination of concentrated wealth and power and the way it undermines and corrupts democracy.
These “stratospheric” returns are in large part siphoned through the base end borrowings of millions of ordinary salary earners whose main goal in life to provide a secure place to live, earn, and raise families. The exceedingly disproportionate circumstances between hedge fund managers and family home loan borrowers is the demonstration, if ever one was needed, of the crisis of capitalism and the extreme disconnect between capitalism and the orderly function of civil society. It is the political sleeper of this generation.
Rising inequality between workers and corporation executives is one of the highlights in the growth and domination of the economic stage of unregulated and regulated global finance. Rising inequality goes beyond efficiency rationalisations and becomes a major social issue when citizens of both the United States and Australia observe pay ratios between executives and other workers was 39 to 1 in the 1960s, 254 to 1 in 1997, and now the 20 highest paid hedge fund managers made 3,315 times the average pay for the top officials in the US Governments executive branch, including the President , let alone the average worker.
And the legacy at the bottom layer of hedge fund activity is borne largely by the naive borrowers in the domestic markets it is the political sleeper in the next election as the continuing high levels of default amongst Australian homeowners and consumers. Through the sub-prime and hedge fund turmoil in the United States and Australia over the past month it seems that intervention to educate borrowers against the perils of unregulated finance is the last thing on politician’s minds.
Advertisements on radio and television by new non-bank money lenders is increasing and the influx of money into Australia funds via hedge funds is growing apace.
In Australia some 180,000 homeowners are defaulting or have defaulted on their loans in recent times. This figure could indicate at least double or triple that number are in risk of loosing their assets, although many borrowers may now not have equity in properties. Many borrowers are turning to superannuation savings to pay outstanding arrears. Figures from the Australian Prudential Regulation Authority (APRA) indicates that the amount of money withdrawn by people in debt-stress has increased from $31 million in 2001 to $135 million in 2006 with the number of applicants doubling in this period. These are superannuants borrowing life savings to stay in their house.
Whilst it is difficult to gauge the exact amount of money borrowed in home equity loans taken out by Australians against the rising value of their home asset in recent years it would be reasonable to expect that borrowing could mirror those of the US. The US Federal Reserve estimated that between 2004 and 2005 more than six hundred billion US dollars (more than ten times that of the corresponding period a decade earlier had been borrowed with most spent on personal consumption. Devaluation of home prices obviously causes the double effect of loss of home equity, and the increasing cost of servicing loans in negative equity situations. This is a major problem in the US and Australia.
With calls for greater transparency (but surprisingly not enforced regulatory arrangements) from heads of state such as Merkel, Sarkozy, and Brown, it may be a prudent time for Australian policymakers to take stock of the existing social and economic issues and the potential for further disruption.
Whilst the main policy response has provided strategies to build more home units to meet demand the issue of massive amounts of unregulated finance flowing in and out of Australia should be flagged as one of the biggest socio-economic questions of our time.
Ref
1US National Association of Realtors 2008
2Alex Veiga. , Associated Press Business Writer in Yahoo Press “Nevada had top foreclosure rate in 2007” 29 Jan 2008.
3“Sydney house prices in landslide” Kelvin Bissett and Justin Vallejo. Daily Telegraph 2/3/2008.
4John Cassidy “”The Minsky Moment” The New Yorker February 4 2008.
5Hedge Fund News. “Merkel and Sarkosky Discuss EU Hedge Funds”. September 11 2007.
6Janet Bush ; “Why Hedge Funds will destroy the world” New Statesmen 31/7/2006.
7San Diego Legal Studies paper No.07-46 “How and Why Credit Rating Agencies Are not like Other Gatekeepers. As reported in The Economist September 8 2007. Buttonwood. “Credit and Blame”.
8Portfolio magazine “Scandal develops around rating agencies:Time to short? August 15 2007.
9Iterative and Incremental Development Wikipedia.
10“Barclays plans to launch Islamic hedge funds” Reuters Monday September 10 2007.
Peter Willans is a PhD student with the University of Tasmania’s School of Sociology
