Monday, 3 November 2008

Where has all the money gone?

We used to be rolling in cash, houses were booming, credit was easy and money flowed like water. Then in September 2007, suddenly, it all stopped and since then we've been in a "credit crunch" and nobody has any cash.

However, enquiring minds will be saying to themselves: money is never really created or destroyed, it's only ever transferred from one owner to another, so where is all that cash today? Someone must have it. When the music stopped which lucky person ended up holding the cash?

This post aims to answer the question: who has the money? (And by implication, can we get it off them?)

The sad answer is, in the main, no-one has the money. It really has ceased to exist, basically because it never actually existed in the first place. We need to look at where it came from in the first place.

Let's start with something easy...

The Yen Carry Trade.
During the last couple of decades much profit was to be made in the yen carry trade, which worked as follows. The Japanese economy was in the doldrums from 1990 onwards after their massive property crash of the late 80s. (At one point the grounds of the Imperial Palace in Tokyo was calculated to have a real estate value equal to the entire state of California! So when I say "massive" property crash I mean it!)

To address this recession the Japanese government did the classic thing and reduced interest rates, arriving eventually so close to 0% that you'd struggle to get any return at all on your savings. The Japanese housewife (custodian of all money in Japan) was pre-disposed to intense saving due to the shame of being destitute in the omnipresent recession, but despairing of any return in Japan sent her money to the West where interest rates were higher. These yen were converted to US dollars and European currencies and lent to Western consumers for a low interest rate, but still considerably more than mama-san could get in Japan.

The banks operating this trade won in two distinct ways. First they could borrow at 0.5% and lend at 3.5% or more. Second, because the act of selling yen and buying pounds or dollars was pushing the value of yen down, when it came to repay, the capital sum had reduced; provided the borrowing kept increasing. Only when there started to be net repayment did the Western currencies fall and the yen increase.

At peak at much as two trillion US dollars worth of yen were transported to the West. Mama-san got her (relatively) high interest and greedy Westerners got to spend money they didn't own.

Unfortunately mama-san now wants her savings back. She doesn't trust the Western economies not to lose it. So the answer to the question of where the money is going is, in part, back to Japan.

Fractional Reserve Banking
Imagine this scenario. You want to buy a car but you don't have the cash. So you pitch up at HSBC and say, can I borrow £10,000? They say yes and a few keystrokes later your current account has ten thousand pounds in it. Where did this money come from? Answer, nowhere; it cost HSBC absolutely nothing to drop £10K into your account (which, of course, won't stop them charging you interest on it.)

You high-tail it along to your local dealer, pick out a car you like, haggle the price down to £10,000 and ask, how should I pay? The dealer invites you to transfer the cash to his account using your debit card. You notice he also banks at HSBC. So once you've driven away in your new car you're paying interest at, say, 8% on the £10,000 and the dealer is earning perhaps 1% on the £10,000. HSBC is meanwhile pocketing the difference on money that, so far, it created out of nothing!

But what are the chances that both you and the car dealer use the same bank? Well, quite good if the bank is as big as HSBC. Size is everything for banks. The bigger they are the more likely the money they lend will never actually leave the bank, just bounce around from account to account. Only the work you have to do to pay the interest is real.

Eventually the dealer will spend the money to pay its staff, to buy new stock, to rent its premises and the like. Some of your £10,000 must leave HSBC. Maybe a lump of it ends up at Barclays. What happens then? Well, it's quite simple, HSBC borrows it back from Barclays on the infamous inter-bank market at the LIBOR rate. So the money still does not really exist. The LIBOR rate is typically a few percent below the retail loan rate, the interest rate you are paying, so HSBC is still in profit after paying Barclays to borrow the money back. And of course, for every pound that HSBC has to borrow back off Barclays there will be another pound Barclays has to borrow off HSBC so in the main all these payments cancel out.

In September 2007 the system collapsed. Barclays refused to lend the £10,000 back! Or at least they would have done, but the LIBOR rate was soaring and Barclays wanted more interest than HSBC was charging on the original loan so borrowing the money back would have been pointless.

So the lending stopped. And as the existing loans were paid off no new loans were created and the money effectively ceased to exist.

Asset Deflation
Since about 1993 increasingly exotic financial instruments have been created to structure credit; a veritable alphabet soup: RMBS (Residential Mortgage Backed Securities) CMBS (Commercial Mortgage Backed Securities), CDO (Collateralized Debt Obligation), SIV (Structured Investment Vehicle). These are all tradable; they have a notional value. And as the value increased over the years the banks and other institutions such as pension funds which owned them have been booking the gains, ie, they have been producing annual accounts which showed these gains as real profit.

Unfortunately as it has become rather obvious that the debts on which these instruments are based will not be repaid in full so the value of the bonds has been falling.

And since the gains (although completely notional) were booked as real profit so the falls must be booked as real loss. Money, which in a sense never existed, drains from the system.

The future...
So what does the future hold for the credit crunch? Which dogs haven't yet barked? Well, there's the big one - CDS (Credit Default Swaps). A CDS is used to insure against the default on a loan. A dubious loan which needs to be sold on can be shored up using a CDS. This converts it from unsellable to sellable; or from only sellable at a hefty discount to a speculative investor, to sellable to a pension find which will only touch triple-A class bonds.

The market for CDSs is enormous, multi-trillion dollars, and there is massive cross-contamination between the insured and the insurer. This is very reminiscent of the Lloyds collapse of the 1980s where syndicates where unknowingly buying back their own risk.

If the CDS market fails it will be spectacular.

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