1 – THIS TIME IT WILL BE DIFFERENT – Yes, far worse!


The last crash 2007/2008

Before the last financial crisis in 2007/2008 sub-prime mortgages were all the rage. The idea was that if mortgage lenders put a pot-pourri of mortgages in a parcel, the risks attaching to mortgages at the lower end of the security spectrum would, statistically, be offset by those at the higher end, and the package itself would then be euphemistically labelled a “collateralized debt obligation” (CDO) and classified as a self-standing tradable security carrying its own rating, somewhere between AAA to BBB. (Anything less than BB is classified as “junk”.)

These mortgage packages themselves were “sliced and diced” and flexibly packaged by lenders to be traded between investment banks and mortgage companies. Even the government-backed home loan agencies “Fannie Mae” and “Freddie Mac”, originally established to encourage home ownership among the poorer classes, got in on the act, unwittingly sealing their own demise in the process.

The subliminal theme underlying the perception of low risk at the heart of the entire process was: “Who would be crazy enough to risk their home by not keeping up with mortgage payments? Cutting down on holidays and entertaining bills, maybe even clothes – but missing out on mortgage payments? Never!”

Irresistible terms

Had any objective observer been so mistrusting as to open one of these parcels they would have found that a significant number of its mortgage contracts had been written on terms that betrayed a complete absence of basic commercial sense.

Anything, to mask the charade!

A factory worker earning, say, $25,000 a year, might have been granted a mortgage of $700,000 – on “teaser” terms that sought a trifling initial deposit and delayed commencement; or “flexible” terms that permitted suspension of instalments for a 6-month period; or a lower interest charge and hence reduced repayments if the borrower happened to be in any sort of financial difficulty. Unvarnished defaults led, quite simply, to “renegotiated” terms. Anything, to mask the charade!

Lenders made mortgage terms so generous as to be irresistible. Indeed, when the domestic debt bubble eventually exploded it was estimated that a quarter of all homes in America were in negative equity!

Had any representative of an investment bank, a rating agency, an auditor, or the Securities and Exchange Commission (SEC) as top financial regulator, bothered to sample a parcel’s contents, it would have been obvious to them that the mortgage broker’s sole motivation was to “sell” the loan!

Conflicted rating agencies

The marking system operated by credit rating agencies (Standard & Poor’s, Moody’s and Fitch) was inherently suspect since the agencies themselves were conflicted, being paid by the very banks that submitted the poisonous parcels for grading. Even the SEC turned a blind eye on professional relations between senior staff members and banks whose business they were invigilating. Bernie Madoff, erstwhile Chairman of the NASDAQ exchange, was adviser to the SEC on market regulation while operating his own investment house as a giant Ponzi scheme.

instalments would have been nine months in arrear.

Fees and margins on mortgage packages were so lucrative that no one wanted to prick the money bubble. Consequently, everyone – banks, brokers, rating agencies, auditors – claimed to be relying on each other for the purpose of authenticating the solvency of the rump of mortgage parcels. But none of them actually looked at a single mortgage contract – even though, in some cases instalments would have been nine months in arrear.


The wilful blindness that gripped financial markets was nothing short of criminal – on a scale not witnessed since the escapades of Horatio Bottomly, or even the South Sea Company (which, Parliament believed, had taken over Britain’s national debt). As with those legendary episodes, the ensuing mayhem took a commensurate toll. The demise of Bear Stearns and Lehman Brothers, and several smaller entities like Northern Rock in this country, led to the loss of thousands of jobs, homes, savings and pensions – but very few prison sentences.

A familiar refrain

Hank Paulson, head of the US Treasury, and Alan Greenspan of the Fed, among many high ranking officers, issued proclamations claiming that the lessons highlighted by this catastrophe had now been learned. Sadly, however, these lessons were confined to the domestic real estate market that collapsed in 2008 in the maelstrom of sub-prime mania – but they left unheeded the phenomenon that continues to plague monetary activity to this day: mounting debt that can never be repaid.

What’s happening NOW?

The very syndrome outlined above, in a different guise but an equally precarious framework, applies today with apocalyptic force. Instead of domestic mortgages we have corporate and sovereign debt. Instead of the flexibility of “teaser” terms we have “covenant-lite” terms that involve minimal collateral and offer little protection for the lender in the event of default.

This applies to 80 per cent of the financing provided by private equity in current deals. There has been an explosion in “alternative” funds now offering credit to support a level of borrowing that is more risky and more voluminous than in 2007. Borrowers are taking full advantage of the favourable terms on offer from lenders who are so obsessed with the lure of deals that they impose no potentially restrictive terms, no threats of repossession or foreclosure – despite the backdrop of a precarious economic outlook, mounting sovereign debt, and near-certain defaults.

These cycles must – MUST – lead to a bust

Notwithstanding all the vapid reassurances of Greenspan and Paulson, the reason why the lesson of ten years ago cannot possibly have been “learnt” is obvious: our economies are still operating on “funny money”, which is the cause of credit cycles. These cycles must – MUST – lead to a bust. This law has been proved every time central banks have tried to stimulate an ailing economy – not by addressing the real causes of its ailment, but by conjuring up swathes of yet more fiat money, representing nothing more substantial than the paper it’s written on.

The scale is mind-blowing

The scale this time is unprecedented – even the language tells the story. Remember when the biggest financial number we conceived of was a “million” (pounds or dollars)? Now, owners of modest and unexceptional suburban dwellings with a suitable postcode find that they have become “millionaires”. Then we got used to seeing “billion” (1,000 million) whenever large financial numbers were being reported. Now, government finances are reported in so many “trillion” (1,000 billion). Next? Any guesses when we shall see “quadrillion” in the headlines? After all, it’s only monopoly money!

This ceaseless credit expansion always lays bare damage caused by earlier rounds of central bank intervention: the previously created malinvestment, capital destruction and misallocation – distortions that are now having to be unwound. As I have explained many times in earlier posts, when the newly created confetti money is pumped into the system, its distribution follows a path that may be rationally explained – but is not exactly equitable.


In next week’s post I shall describe the way in which the scourge of credit expansion takes place in the monetary system, and highlight some indicators that the system’s demise could be triggered sooner than you think.