I would like to start with a couplet from Iqbal which is very interesting. This is from a small poem he wrote entitled Lenin’s letter to God. It is Lenin’s explanation to God about why he did not believe in him in view of what he saw in the world. He says :”The buildings of banks are many times bigger than those of churches or cathedrals. The business of banks apparently is trade but in reality it is gambling. Their knowledge, their wisdom, their progress is all dedicated. They drink peoples’ blood and preach the equality of man”.
So Lenin says if that is the situation of your followers how can I believe in you. He goes on to other things which are interesting. Even a 100 years ago someone like Iqbal visiting these countries was able to see what is at the base of the problem.
The problem as we have seen the last few times has been compounded over the past thirty years, just before the present crisis of 2007 onwards by an increase in a kind of hubris which was inexplicable.
This mentality was best captured by the title of the book by Francis Foukama: The end of history. In the book he tries to explain that Western man has reached the pinnacle of discovering everything in terms of governance and finance. There is nothing more to learn. You just have to live the good life and therefore there is no more history to be made. We are on top of history. This is what he calls neo liberalism and its financial counterpart which we want to look at today.
Unfortunately for Foukama and his group when other people did not accept this they went on to become neo cons and said we should beat them up to accept it. This is where the last ten years has gone – into the use of force and brutality to force the rest of the world to accept this kind of dispensation.
But in the meantime the whole financial basis of that kind of an economy and political dispensation was collapsing beginning with the USA where there was a rise in what we call financial alchemy. Those of you who know the origin of the word alchemy (alkemia) will know that it was the basis of present-day chemistry. The historical role or motivation of chemists was to see if you could compound base metals into gold. If you can make base metals into gold you have got it made. That is the end of history and you can live happily ever after. As the Greeks discovered if you do some things they will take you on and on and you can live until the whole thing falls apart.
Unfortunately as we have seen in chemistry no alchemist has been able to make that ultimate and the quest goes on. In finance there is that equivalent. In the world of finance until recently if you have a triple A rated security that is equivalent to gold. You can trade it, you can change it, you can use it for anything at any time because it is recognisable as the top financial instrument.
In the USA over the past thirty years since the time of Reagan and Thatcher there were two parallel trends which emerged. The first one said that regulation itself is evil. Any regulation of anything, of markets especially was not required and was harmful. So there was a trend to try and remove any regulatory checks on finance including the check which separated the payments function of the banking system – which means exchange of payments (retail banking) from the investment functions, the more risk taking functions if the bank.
Before that you had to separate the two functions. So the retail functions which were more or less guaranteed by the state because you have a deposit provision which was more or less separate from the risk taking activities where you borrow or borrow more and if you fall you fall.
But those big institutions now became merged into one. They could therefore use the ordinary deposits of the people to gamble in the markets. This is what they did. It is not a pure gamble. A gambler knows that if he looses he looses everything. The bankers were half gamblers. They understood that if they win they take all the money home. If they lose the tax payer picks up the bill. So it is not even pure gambling or free market. It is a loaded gamble.
But they started on that path and the particular finance which they identified was home finance in the USA. They wanted to expand home finance in the USA even though they talk of the free market all over the USA. Home finance is heavily ring fenced by state institutions. Two state institutions Fredy Mac and Feny Mac who guarantee most of the home finance. And they take the insurance risk for defaults so it is really state guaranteed to anybody who is lending.
So if you can lend more you can make a lot of money. But finance under this de-regulated status discovers something every serious. I call it serious. They call it very intelligent. They discovered that if you create a book of mortgages you could easily securitize it and sell it out to somebody else.
You say okay I will give you a stream of revenue you pay me the capital back and I will create another book from that capital. This is called securitization or in this case mortgage back securities because those are backed by actual mortgages.
This is fine as far as it goes but when you find that the pool of mortgages which you can securitize is small your main function becomes to increase the pool of mortgages. How do you go about increasing the pool of mortgages? When you go to a bank or a building society and say I want to borrow for a home they will ask you how much you want to borrow and what is it as a proportion of the property – loan to value. How much loan to you want to value: 70 percent, 60 percent? That is fine. And what is your income. Normally they will say we will lend you a particular multiple of your income, maybe two and half times your income. But if you are prudent you lend so that you will be able to repay and they may lend you to 80% of loan to value.
The only way to increase this pool is to say we will start lending you 100% which means you do not need to save your 20% deposit before you buy your house and we will lend you five times, ten times your income. And we will not ask you where your income is from. You can self certify your come.
So I can go to a mortgage broker and say my income is x thousand and I sign here and I get somebody else to sign it and he says fine that is submitted as my income. So the riskiness of the lending venture becomes greater. That is how you can increase the pool. For example Northern Rock was not only lending five or six times income multiples it was also lending 140 of loan to value. And they said with the 40% more we have lent you you can go and buy a pleasure boat or a big car or whatever you want.
You had not put in something. You have got something on top. So you are not really worried about paying that back.
In the States they went further. The last stop of this cycle was what they call ninja mortgages: no income no job mortgages. They went to a person who was living in a backyard and asked him if he wanted to own a house. The person said I am living in a back yard what are you talking about. They said we will do everything for you. We will buy you the house, we will give you two years interest free or very low interest. After two years the price of the house will have gone up. We will refinance and we will pay you and you will slowly begin to own the house. He says ‘fine – better than living in a shack in somebody’s back yard’.
So they created up to this level and the trick was if got those tools and you were able to securitize you did not care as you would get your money back. They did some smart mathematics to show that if they mixed these really toxic mortgages with top rated mortgages with credible buyers they could still create AAA rated securities and that is why is why it was called toxic debt because you did not know what the mixture was or who it was functioning.
But the person who had originated it and distributed it had made his commission and he did not care what happened to it.
This was then sold globally to European banks and Chinese investors or whoever came to invest in triple A rated securities in the States. So when it came down you find that millions of homes in the USA are not serviceable. They are not servicing their debt and millions of people will go homeless. The whole financial system came crashing down.
This was the beginning of the crisis. If you want to see how careless they became you will see that when the bank comes to repossess the house they went to the court. And the court said do you have your papers when you have actually given the loan. And many banks said we do not, we had an agent, he moved his office and he threw away all the papers. You come to court to repossess somebody’s house without the paper which he is supposed to have signed to show he borrowed the money.
That became the least bother. The main bother was to originate, distribute and go away. So in this way they really polluted the financial system and everybody who was holding those securities throughout the world could not now be trusted. You did not know if they have anything genuine or just a mixture of worthless securities. That is why the whole financial system was about to collapse three or four years ago.
And then of course it was rescued by tax payers funds all over the world. It is estimated that the cost of this mess in terms of value destruction in the globe is in the order of four-and-a-half trillion dollars. This is not small money. When we were working on the debt of third world countries in the jubilee campaign and so on we were looking at eighty billion dollars to finish the debt of the whole developing countries.
Eighty billion dollars is only one-third of what was given to one insurance company, AIG, to rescue it. It was given about 250 billion dollars. So four and a half trillion is just telephone numbers – beyond telephone numbers even to imagine the amounts which tax payers and consumers have suffered.
It is reckoned that about ten years of growth of the global economy is gone in this value destruction. As a result of that what has happened is that growth globally has come down. Banks have been exposed of not being able to carry out their normal functions and when global growth goes down another problem comes and that is the second phase.
To understand that let us understand what happened in the past 30 years. During the past 30 years in a normal process if you have £1000 coming to you monthly you have two options. You can say I will save £500 a month and at the end of the year I will buy something if I want to. A car or whatever. I have saved five or six thousand pounds and I will buy it and I can borrow 20% on the car.
The other option is that some smart fellow comes and says you are stupid. You have one thousand pounds coming. I will give you ten thousand pounds now to buy anything you want. You just pay me back one thousand pounds a month as my repayment. Ten percent. So that is very smart. I do not need to wait. I get what I want now and debt is not a problem. Somebody like Mandelson would say that someone who does not understand debt is stupid. He needs to borrow as much as he can.
And so in the sense of your credit card thinking you are always maxed out. You are on the limit. Every month you pay a little bit and then you borrow. But the first time is a nice feeling because you get up to the max. Once you hit the max you are scarpered.
That is where Greece and many of the European countries were maxed. But now your projections are based on growth and that growth is gone. You can’t even pay the rates of the normal instalment. And if you follow credit card debt you see that if you don’t pay it just compounds at astronomical rates. Before you know it has just ballooned into something you can’t sustain anymore.
That is what Italy is facing now. The calculation is that if the Italian bond rates stay over 7% for a little while Italy will be facing a situation in which it can never pay back its debts so it is technically insolvent.
So very soon without growth you come to that problem But it is only a problem after 30 years when you have maxed out and spent whatever lee way you had in doing whatever you wanted to do – borrowing as much as possible.
So we are in this situation now. The question is was it a failure of policy or a failure of the system as a whole. Here it becomes very interesting. Most of you are young but some of you are as old as me and you will remember the famous Professor called John Kenneth Galbreight. He was very sharp economist and a very good hilarious writer. One of the last books he authored – even at the age of 95 the man was able to write lucidly. He has written a small book Innocent Fraud. It is a description of ten different mental frauds which have been performed by the market or by the system.
He talks about capitalism. He said capitalism became a dirty word because it was associated with colonialism. If you said you were a capitalist it was not only financially. People would say you are a colonialist, you are this, you are that. It became a very dirty word.
So he said slowly during the 80s we changed the terminology into markets and we said we are believers in the free market. It doesn’t ring any bells. It is not capitalist so everyone became market friendly. We want to be market friendly. We want to use markets to distribute the resources and so on.
This is one of the big frauds because the same thing is happening at the bottom. The main thing which he and other people subsequently identified was that if you cannot control finance and use it for productive activity finance will control you.
So just before this crisis if you looked at what returns you would get if you invested your money in productive activities, technology or manufacturing activities, the norm was eight to ten percent of your income. That is what serious manufacturing businesses were getting. What return in that time would you make on investment banking. Investment bankers were targeting 25% return on equity. When you are making two and a half times return on some activity other than actual production then obviously resources would go into that. Anybody who want to put resources would put them where there is the maximum gain.
Investment banking was able to generate that kind of return by using leverage ratios of anything between 20 to 40 times. Leeman Brothers when it went bust was leveraged 33 times. So leverage on the way out is very good but on the way down it is a big black hole. You just fall down. Leeman Brothers went bust in two days flat.
If you want to see the role of non regulation just look at one small incident from Leeman Brothers life. Leeman Brothers consulted their accountants who were Ernest and Young. They advised them that in the USA if you make this kind of transaction it would be classified as a loan and therefore debt. But if you do the same things in the UK it will be classified as an asset, this was called the ripo one zero five effect. The difference is that with a bank if you say it is a loan you cannot do anything with it. If you say it is an asset you can leverage it 20, 30, 40 times. So what they were doing was that every October they were doing these transactions to the value of 50 billion dollars and shifting them to London. And every February they were shifting them back to the states.
Fifty billion dollars leveraged 30 times is 1,5 trillion dollars of money they have to gamble. Even on very small margins you are talking basis points which is one hundredth of a percentage. Three to five basis points is enough to make you tons of money.
This way the way it was operating and you could see how regulation was being diluted all over the place and you were trying to find arbit right between different functions.
Essentially also what was happening because of the weight of profits in the financial sector they also started a very seriously squed distribution of wealth. If you want to understand this you look 20 years ago the difference in the United States between the average pay of the lowest ten percent in the organisation and the highest ten percent in the organisation was of the order of one to fifty times. Just before the crisis it had one from one to 280 times. So you can see the distribution of impact was that much more – worse.
And you can see that here it was the same also. Globally it went from one to thirty to one to 140 which again you can see on the streets all these protests which are about inequity. Everybody thinks I am the chief executive of this company and I am worth five million. From where? And then the whole thing inflates upwards.
So the equitable distribution is now contributing to the public feeling that things are not right. Something is wrong with finance.
Now let us see what is wrong with the theoretical argument of what we call capitalism. The theoretical argument is a very selective reading of Adam Smith because you must not forget that Adam Smith was a Scottish political economist and his first book is not the Wealth of Nations, his first book is the Theory of Moral Sentiments. He argues quite effectively that if you have a framework of morality in place then you can have markets functioning. Without the framework of morality these markets will not function. So if you forget his first book and so for the second one he argued that the invisible hand of the market will do everything. You just leave it free and it will do everything.
So the capitalist argument is that if the markets are left free it will attain the best outcome for society. You don’t really need to think about morality, the markets will do this job. Unfortunately the markets do not do their job.
The second argument of the capitalists is that if some people become very rich this wealth will trickle down to everybody. As we all know in popular wisdom nothing grows from the top down and wealth also does not come from the top down. If somebody has it they do not want to give it or make it more available. So it doesn’t work like that and we see the disparity increasing.
This is paralleled by another problem on the global level. This is bigger problem. Unless it is solved none of these problems will be solved. The second problem I am going to mention was the originator of the first problem and that is what we call global imbalances. At the moment if you look at global trade and if you think about it on a global level the total of exports and imports must come to zero. Those who import have a counterpart in exports so everything must cancel out.
So if you have a deficit or you are importing more than exporting somebody else is exporting more than they are importing. It can’t be that the total is more than zero. It has to balance out. So at the moment when there are two big areas of imbalance. One is some of the emerging market economies like China, Taiwan and Singapore – Japan to some extent – have persistent and continuous surpluses. China has a surplus of 700 to 800 billion dollars a year. And there other countries which must match that who have persistent deficits. And the biggest deficit country at the moment is the United States which has a deficit of anything between 700 to 900 billion dollars a year. So every year the United States has to borrow 900 billion dollars from somebody else to keep its imports at the level which they are.
The other big imbalance is between Germany, the Netherlands and other European countries. Germany has a surplus of the order of 300 billion dollars and the euro zone countries, mostly the southern European countries or as they are now called the pigs – Portugal, Italy Greece and Spain – have got a parallel deficit for that amount. So every year that amount has to be transferred.
You have about a trillion dollars a year being intermediated by these banks to convert the deficits into actual debts. And every year the stock of debt keeps on rising. So at the moment China has reserves of three trillion dollars. And the United States has debts of close to four trillion dollars.
Every year you increase the debts because you are borrowing more and so you have to pay more interest and repayment on those debts. Unfortunately this cannot continue. If your buyer cannot buy goods anymore you have only two options: either to shut down your supply, in which case your factories will shut down, or to fund it. In this case you say I will give you money to buy my goods. This is essentially what China and Germany are doing to most of their buyers.
But this is not an indefinite process because it cannot go on all the time. Sometimes it has to come to a stop unless you make find other ways to adjust it. But now the problem has been neglected for so long it has come to an unsolveable spot.
Can you imagine if the United States defaults on its obligations? Greece and Italy may default on their obligations. This will have an impact on the Eurozone but if the United States defaults you have a huge, huge issue on your hands. But if it doesn’t and it does not correct its imbalance than you have a continuing problem as to what to do and how to manage this process.
That is where we are. It is not a policy failure. There are some underlying issues with the whole system. Policy can correct. As economists when we were studying was the main policy instrument you have in your hands is interest rates. So the central bank is supposed to raise or lower interest rates to stimulate of control demand.
The question now is what do you do when interest rates are zero. Do you start charging people money for depositing in the banks? Effectively you are in real terms because if inflation is five percent you are actually loosing money which you have put in the bank because the value of this money is going down.
There are no policy instruments. These are now systematic problems. Unfortunately the situation has come and it was quite amusing on one part and distressing on the other part to look at the G20 summit ten days ago.
The Europeans were asking the Chinese and the Indians to see if they could help with funds to solve the problem. They also asked the Brazilians and they all said yes we would very much like to help you but we are very very inclined to help you through the IMF and let the IMF lend the money to you.
Somebody asked one of the Indian economists who is a member of the planning commission, Monteq Singh Al Walia. They asked Monteq why he was talking about the IMF. He said when we were in trouble and we went to the IMF the IMF said do this do that shut down this, schools, hospitals and we had to do it because there was no option. Now if the IMF says to the Europeans do this, do that we are okay but if the IMF says less than we have to say that is the standard you have to apply.
It is humiliating. Italy for example has agreed to have IMF inspectors to inspect its books but not IMF money because IMF money will come with conditionality and that will be an external check.
To give you an example of what the IMF can do in 1997 when the South East Asian countries were in a big crisis some countries called in the IMF particularly Indonesia which was suffering a lot and with the IMF prescriptions Indonesian GDP contracted by 14% from four. We are looking at zero growth not minus and we are looking in parts of Europe for this austerity. Can you imagine if we had a 14% contraction what would happen? So that is why the Europeans care not very keen to go to the IMF. The IMF does not have any scruples. They want their money back. They are not charitable uncles to say you can have the money.
So that is what is happening at the moment.
The last thing about the markets and capitalism is that in many senses the markets have always been rigged. For example here we estimated that the banking system itself, with the implicit guarantees of the tax payers because the taxpayers are now bailing out Lloyds, RBS and Northern Rock. What is the value of this implicit guarantee to the banks. It has been calculated at 40 billion pounds for the UK yearly. That is the implicit guarantee. Forty billion pounds is also the profit of all the banks combined. This means that the banks are making zero profit if you take account of the cost of the guarantee – if you remove that guarantee. That is what they will have to pay to the market.
Therefore the banking sector will change its composition. To give you an idea again of something which makes you think that I am not really exaggerating the facts. There are two particular speeches which you should be able to access. One is from the chairman of the Financial Services Authority, Lord Turner given in Cass Business School in March 2010 at the height of the crisis.
After analysing the crisis he said that in his view most of present day financial activity is socially useless. This is his statement and you can see it. The second one is from the governor of the Bank of England. At the end of a speech in the Midlands he said that out of every conceivable way to organise the banking system we have chosen the worst possible method. These are the two top financial regulators in this country making their pronouncements on what has gone on.
Lord Turner said just look at how much foreign exchange trading needs to be there. We know that for trade we need to convert currencies into each other. You want to buy dollars and dinars or whatever. So if your level of trade is ten trillion dollars how much of that is foreign trade. You might say that some people are taking positions maybe five times or ten times that level to cover all kinds of trade and speculation.
This was indeed the case until 1980. After the liberalization of the market he shows that by 2007 foreign exchange trading was of the order of over 1000 times the underlying foreign trade which means there is dealing for dealings sake for margins and profits. That is why he says it is socially useless. There is no point in this apart from making money for bankers and increasing the risk of the system.
So I think we are nearly there. We can see that this time it is not necessarily policy failure. Policy failures can be costly but can usually be corrected. System failures need larger measures need larger measures to correct. Unfortunately in the past when systems have shown failures the consequences for the world have been very bad.
In the aftermath of WW1 and that failure we had the rising spectre of communism and in the aftermath of the 1929 recession we had the rising spectre of fascism and Hitler’s Germany. So if we are not careful we can give rise to forces which can try to solve these problems by force and oppression which are not desirable even though some of us may think that this is good for the financial system to collapse but it is not necessarily good. You may jump from the frying pan into the fire itself so you have to be careful.
But these movements outside Wall Street outside St Paul’s are beginning to show that people are beginning to think about what to do. And one of the key factors which has emerged is the role of leverage, the role of borrowing on interest. Many many people are suggesting that we should have lenders participating in the risk rather than the lenders being insulated from the risk.
At the moment part of the discussion for Greek debt is that bond holders do not want to take a haircut or an impairment of their bonds. Fifty percent has been suggested. So that is the heart of the problem. Some people want to lend but not take the risk of lending. But that is not sustainable in the world. Participatory lending is the only way. Banking is now also being forced to borrow or to raise capital on what is being called in a debt sense – if it is not equity only debt – coco bonds, contingent bonds which means bonds which we convert to equity if the profitability goes down.
This means bond holders should be careful. If you are lending as a bond holder and you are guaranteed by the tax payer at the end you don’t care you just lend. But when you that you might loose some money you look at what you are lending for. And then you start to say I am lending for something which is not producing the return I was looking for and therefore I won’t lend.
So automatically it changes the whole system and structure. Before when it was concerning developing countries like Indonesia in the 1997 crisis the mixture of government borrowing and private borrowing was quite interesting. Indonesia has 86 billion dollars of debt. Twenty billion was government and 66 billion was private debt obviously raised by the big investment banks. So when the IMF came they said the main condition of the rescue is that private debt will be converted into sovereign debt. All those private borrowings will be guaranteed by the Indonesian tax payer.
We are now full circle round. They are saying that private banking debt in the eurozone countries will have to be guaranteed by the tax payer because the bond holders will not take any losses. At the point the tax payer is beggared and goes out onto the street because there is no way out to maintain the living standard to which they have been used to. At that point it is clear to the average tax payer that the system has failed. What comes in its place is the big question. Thank you very much.
* Mr M.Iqbal is a trained Economist and Accountant. He has worked as an Investment Analyst in the City of London for several years. He has been involved in consultancy on financial product structuring and niche marketing services to faith and ethnic communities in the UK . He has helped many banks in the UK on their launch of Islamic financial services. He is also consultant to a number of institutions on structuring and marketing Islamic financial products in the UK . Iqbal is a member of the Islamic Finance sub-committee of the City’s Financial Markets Law Committee (FMLC). He is also an associate of the Islamic Banking and Finance Institute of Malaysia (IBFIM). He was awarded the CBE in 2005 Queen’s Honours List for services to international development.
