Tuesday, June 23, 2015

The Inventions of Depressions

Finance had always been a bit risky. Funds invested in agriculture, trade, and mining were often lost due to bad weather, drought, physical hardship and ill-health, war and banditry.

But the invention of banking and the creation of State sanctioned central banks, with the ability to issue bank notes only vaguely related to actual gold reserves, created the conditions for booms and busts on whole community, whole region, and entire State based scale.

Mercantile based booms and busts started to appear in the 1600's as banking services made it possible to get credit and funds in exchange for debt, and notes against trade and goods. The first major boom was the Netherlands 1630's speculation in tulip bulbs. Money poured into Holland, and initial speculators made enormous profits, triggering ruinous investment by later speculators. The availability of bank notes made it possible for working class people, and minor merchants, to invest, so the crash affected whole communities and ruined land holders and nobles alike.

In 1717 a Scottish financier John Law, persuaded the French Government to establish the Banque Royale, which issued bank notes underpinned by his speculative Mississippi Company. He paid navvies to march through Paris supposedly on their way to dig up gold in South America, and managed to create a long run on the shares. It created such a bubble that he was able to take on the entire French national debt, and turn it into paper notes, which he issued to the french population.
In 1720 the bubble burst.

At the same time 1711, the South Sea Company was created as a public–private partnership to consolidate and reduce the cost of UK national debt. The company was granted a monopoly to trade with Spain controlled South America. There was no realistic prospect that trade would take place and the company never realised any significant profit from its monopoly. Company stock rose to ten times its orginal value as it expanded its operations dealing in government debt, peaking in 1720 before collapsing, ruining many who had taken on debt, via bank notes to buy share.

In the 1840's there was similar speculative booms and busts in railway shares in England, the US and Europe. In each case there is belief in some technological or economic breakthrough that will permanently change the market - but it is the ready expansion of bank notes to meet the speculative urge that created the boom.

In 1929 the new US Federal Reserve was widely believed to be the perfect financial safety net, controlling interest rates and money supply by buying and selling government bonds.

A new investment house opened every day of 1929 issuing $2.5 billion of securities, financing both businesses and the purchase of shares. Shares "bought" using the bank notes issued, were used as security for further loans. Until in October 1929 when a number of minor shocks triggered the collapse of confidence and the rush to sell triggered wholesale collapse.

The fragility of such a boom is highlighted by some of these minor shocks - the arrest of a London based stock broker over fraud; the tabling of a bill to introduce tariffs on imported goods; and the discovery by public investors that the ticker tape method of reporting on share trading and share values was running hours later than the actual trades.

Junk Bonds
Junk Bonds took speculative investment, supported by banks issuing notes and demand debt, to a new level.  The credit risk of a bond issued by a company ( an agreement to pay a specific sum on a specific date in return for a loan ), refers to the probability and probable loss upon a credit event (eg: default on scheduled payments, bankruptcy, or bond restructure) or a credit quality change issued by a rating agency.  A high risk bond offers high interest or returns to the holder making them attractive where a loss can be borne, and these were called junk bonds.

In the 1980's bank and finance deregulation allowed traders to create junk bonds in one company, based on the promise to buy another company and fund the bond from the cash reserves, or sale of assets of the second company. Again this novel "innovation" started speculation, but it was the banks compliance in issuing notes and debt that spurred the boom.

A second innovation in the 2000's was the creation of Collateralised Debt Obligations (CDO) where bonds, mortgages, and other debt agreements are bundled so that the nett risk rating meets the minimum levels of institutional, and conservative investors. In some cases the bundles are rebundled, so that accurate audit and risk assessment becomes difficult. Again a boom was created by banks being prepared to create debt and issue notes to support the speculation, and in fact further bank deregulation had made it possible to be both an investment advisor and the debt creator.

If you find the idea of CDO's and Junk Bonds a worry, you will love derivatives.
This is a contract that gets its value from the performance ( not the value ) of an underlying entity. This can be an asset, index, or interest rate. Derivatives can be used to insure against price movements (hedging), but more often pure speculation on price movements for speculation - eg: forwards & futures (the right to buy in the future at a set price), options, swaps, synthetic collateralized debt obligations and credit default swaps (the risk that someone won't be paid by someone else).

Again, the preparedness of banks to support investment in derivatives, and the banks ability to create the debt out of thin air - fractional reserve banking - drove speculation in this new innovation. In 2001 it was estimated that $44,000 billion was invested in derivatives in Wall Street, and to put this into perspective, the world wide losses on stock market adjusts over 2000-2003 was $7,000 billion

The size of the derivatives market is obscured because much of the activity take place within hedge funds. In 2010-12 the majority of countries cooperated to create and legislate bodies to make derivative trading more transparent and subject to regulation. This was driven in part by the reported $39.5 billion in derivative trade losses due to fraud and market collapse in the decade 2000-2010.

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