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How solid is your investment? Part 3
Today we’re looking at financial bubbles. Why? Because you may already have been caught in not just one but two in recent years – the housing bubble in the US and the dotcom bubble just before that. Chances are more are coming, because they have become “business as usual”. Knowledge is power. So let’s find out more to protect ourselves!
The bubble is often born with a new invention or craze. The dotcom bubble is a classic example – a new technology with great promise, understood by almost no one. Publicists talked up the potential. Lobbyists tried to decrease regulations that might slow growth. The vision was of websites that would make millions, easy to set up, communicating with millions of people with ease and at almost no cost. The government gave tax incentives. Often such government moves will be seen when you have a bubble. They don’t cause the bubble but perhaps they legitimize and fuel them.
Once the momentum starts to build, huge sums of paper money seem to be created. Logic, knowledge, and memory all collapse. Rational thinking becomes a thing of the past. Gurus sprout up all over the place. Instant millionaires are suddenly kowtowed to. The media has a massive role to play as you can imagine. Government stands aside.
Emotion builds it, and emotion pops it, aided of course by the financial strain of an unsustainable event.
If it’s not built on real growth, then high prices are unrealistic, false, fictitious. If we live in an extractive world not a world based on genuine growth, then the appearance of growth has to come from other people’s losses.
Here’s an example of extraction versus real growth: if you take an acre of ground and you build up and improve the soil with mulch and compost, and you raise the water levels through careful watercourse and runoff management, you will grow more crops as the years go by. If you lose topsoil instead of building it, and lower the water table by incorrect water management, then although you can “force” high yields in the short term ultimately you will produce fewer crops as time goes by. In this second scenario, without genuine growth of your resources, you can only increase growth by forcing certain elements artificially, and it cannot be sustained indefinitely. This approach has been compared to mining, which extracts without refilling the stores; as opposed to what farming should be and was for many centuries: sustainable, building up and not depleting resources like soil and water.
Unrealistic levels of growth can’t be sustained because they are a kind of pyramid scheme – funded by later entrants on the bottom rungs. Which would be who? The masses, sucked in by the hype. And like a pyramid scheme, who makes the money? The people who got in first, the handful of people who are on the top of that pyramid and who jump off it before it collapses. Which means, the people with the knowledge.
By the time it hits the news and is the subject of chat around the braai, you can be sure it’s too late to be one of those people. By the time you hear it, it’s too late for you.
This is a simple rule, which will save you a lot of agonized soul-searching and crystal-ball gazing (also known as following the financial news in the media). And a lot of risk.
The dotcom crash did a lot of damage even though it was a new industry, quite small in extent. The subprime crash is doing more harm – it involves a lot more people, a much bigger segment of the economy. And it’s contaminating supposedly healthy areas of the economy.
What was behind it? Deregulation, and structures that allowed banks to lend more money; low interest rates; high demand (you may remember when we discussed credit cards that lower quality schooling concentrates housing demand around the remaining good schools, a major factor in increasing financial pressure for American households).
There was another factor that played a part. You may have heard of this term “securitized debt”. What this meant was that banks could pass the risk of their mortgages on to someone else – they could package debts like these and sell them on to someone who didn’t know better.
Even the International Monetary Fund (IMF) website, which is part of the system in a big way, and not surprisingly is positive about securitization, admits that there have been problems with securitization. It talks about “unexpected deterioration in the quality of the underlying assets” and how this has undermined investor confidence.
Why unexpected, I want to know. What is unexpected about people who can’t afford a house being unable to meet their monthly repayments? Banks know the rules. They assess the risks. Up till now it wasn’t too much of a problem. What changed? For the first time, they were able to pass the risk on to someone else. Which meant they kept the profits and exported the risks. So they tore up the rule book and lent to anyone and everyone. Made a killing. Didn’t worry about the potential losses. They were “someone else’s problem”.
The website also talks about lack of regulation and irresponsible lending (my term, not theirs) severely hurting financial stability. It says that as a bank, transferring your credit risk means less care with lending and risk management.
I say, that’s obvious. Anytime you separate risk from responsibility you can expect a serious deterioration in standards. It’s a recipe for disaster. And it’s going to hurt the person who’s taking the risk. Which is no longer the bank.
In theory, securitization spreads the risk over a larger pool of investors and is good for the economy. In practise, it makes everyone more vulnerable when a big bubble crashes. Even including the banks, as we’ve seen. Because they are not islands. Nobody is.
There are people who think the sub-prime market was just the canary in the mineshaft – the first inkling of danger that is actually systemic, not limited to a small area. The news article I started off discussing today mentioned a further $250 billion in losses spreading into healthier areas. It also mentioned that this was just one kind of financial structure amongst many, and mentioned also credit cards, and vehicle loans. And we know that credit card debt is also not in great shape, don’t we. So we have shaky assets that affect more and more people in terms of carrying the risk. Not a good situation.
Could more elements of this house of cards collapse? Everyone’s saying “we don’t know”. Everyone who calls themselves an expert, that is.
Meantime ignorance fuels more bubbles. Financial jargon continues to hide the truth. And the most vulnerable sectors keel over like canaries. We can ignore the message. Or we can look about us and take care.
Back to the next big thing. Carbon credits. The “fastest growing market in the world”. The one that is implied to be immune to all of this. Could it really be immune? Or is it going to be the next big bubble? How would we know? There are some signs.
Some candidates are: health care (which has mega-inflation already); energy (look at what the oil price did recently); biotech; and dotcom2.
So if you start hearing a lot about a certain area – it could be alternative energy, wind power, solar, hydrogen fuel, biofuels, etc. – start to be suspicious. If it’s on a magazine cover, be very suspicious. If everyone starts talking about it – then your guess is probably correct. If the US government puts money into it – perhaps you should make sure you don’t!
About the role of government – almost all governments
We’ve spoken about their loyalties to big business not the taxpayer. Did you know there’s a deal they have to bail out banks so they don’t go under? It’s much in use at the moment. Do you realize that this means banks can take less responsibility because the taxpayer will bail them out? Which means, taxpayers will fund private profits. Because who do you think gets the profits when they are there in abundance? Taxpayers? Or the bank’s shareholders?
The American government just rescued AIG to the tune of $85 billion. It hasn’t helped stabilize things so far. It’s upset the Asians who had to watch their banks and insurance companies collapse because it was supposed to be good for them. Some people say it’s a blow to the heart of capitalism, and therefore more damaging in terms of the credibility of untrammeled capitalism – which has been financial dogma since the 1980s, via the economist Milton Friedman.
What do I say? I say follow the Formula for Riches and you will not go wrong.
Educate yourself, understand that the media offers you the illusion of knowledge, and that any big thing you hear about is probably a pyramid scheme that’s peaking. If you hear about it, it’s too late.
Of course, I would never have invested in any of these things because I cannot keep control, I cannot be fully informed, and I cannot affect the outcome. But remember that any paper assets make you vulnerable to what we have just been discussing. Educate yourself and then find something better. But know what you are doing. And know that it will not be what everyone else is doing. And if it is – do the sums again. There’s probably an error somewhere.
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