Greed's the reason

2008-09-18 00:00

Several thousand years ago the Roman merchant economy was quite simple: the money used in daily transactions was a gold coin, worth exactly what its weight in gold would buy and everyone at that time agreed on the “gold standard”, which means that the government backed the currency.

Merchants sold cows, goats, pork bellies and wheat — the stuff that still makes the world go round — and they measured the value of those commodities on the commonly accepted value of the gold money.

One day, the Roman mint found that it didn’t have enough gold to strike enough coins for daily transactions in what was then a huge empire, so they debased the coins by adding lead or pewter, which devalued the coin.

This did not escape the merchants’ notice, even as far away as Britannia: “Excuse me, Centurion, but that coin’s got only half the amount of gold I charge for this bushel of wheat. You’ll now have to give me two coins for it instead of one.” Instant inflation.

Today, we just accept inflation as a built-in background to the way money behaves in our car, house, iPod and derivative-stocks buying environment.

Given that we are stuck with various inflationary market forces, here is a very simple explanation of the basic mechanics of what’s happening to Northern Rock, Lehman Brothers, Fannie Mae and Freddie Mac (U.S. federal mortgage giants), Merrill Lynch and a whole queue of investment firms waiting to slide down the slippery slope of what looks like a global insolvency in the making as this comment scrolls across the page.

Someone discovered that if “money” (which is always just what you choose to call it) is repackaged and represented in a different light, it could be sold as something other than money but that could yield large returns on an investment, which is what it’s all about: you put some money in and you get more money out than you put in.

Here’s what basically happened to the global money markets over the past eight or 10 years, not counting the normal bull and bear ups and downs, dotcom bubbles and other vicissitudes in the game of money manipulation.

This one is dead simple although you do have to have money to make money, however deviously.

Approach as many people as possible who are paying low rentals on the properties they live in after you have bought all those properties (speculatively, but cheaply because of the many rental defaults at that level). Then offer them an opportunity they can’t refuse: ownership of those properties at a rate lower than the rental they are paying (sub-prime) and then lean on them until they sign the mortgages.

The deal you offer includes a no-deposit clause as a sweetener but the fine print that outlines the Adjustable Rate Mortgage (Arm) conditions of the sale is not brought up for in-depth discussion during the deal making.

These were loans made to people with less than good credit, marginal ability to pay and who were using the purchased house as security.

Let’s keep the maths simple, too. Let’s say our home loan deal yields R20 billion profit during the 20 years over and above the original investment. But you want your money now. So you call this “money”, this 20-year profit something else, you call it a “leveraged commodity”. For leverage read risk. You are lending money over 20 years and taking the financial risk that the loans carry.

We all know and understand the risks in the property market and totally accept the strongest pillar of that understanding: house prices never go down.

Why? Because a home, to the average taxpayer, is the greatest single investment he or she will ever make and it’s the first thing paid off every month. The system is locked into a paradigm (a fixed system) called the home loan market, which has been the status quo for yonks (donkey’s years).

But donkey’s years are too long — the acceleration in the rate of change today is reflected on an asymptotic curve and you can’t wait 20 years anymore for your returns in the current home loan market system.

Getting your money now is a much better alternative.

So we change some rules.

Okay — over the next 20 years at the current rates I have an almost guaranteed profit of R20 billion.

Now I don’t want to hold on to that debt for 20 years. I want my money sooner, so I make up another name, a nice-sounding name for that debt. I call it a “leveraged return instrument on the future derivative yield of R20 billion on mortgaged properties” (a leveraged instrument for short) and sell it for R10 billion today.

It has now become a commodity and commodities are what drive sales on the exchanges of the world.

My R20 billion debt, an instrument that’s almost guaranteed to give your firm a return of R20 billion over 20 years for a R10 billion investment in today’s money will eventually double your investment.

But I get my money today and take a smaller profit. I take my R10 billion and run.

Then you do some sums off your own bat. You did not do the original work — buying the properties and selling the original bonds — but you are now sitting back waiting to collect R20 billion over 20 years.

We both double our money, but you now have to wait for your return.

“Hang on! Why?” you say. Why not rename the package and sell it off again? And that’s where it started: debts were renamed, repackaged and turned into commodities that were sold, over and over again throughout the investment world.

If you belong to a school board in Ixopo, you may have invested some of that board’s money in one of those derivatives. What your board does not know is that the original loans were sold at rates under the prime rate with an escalation clause called Adjustable Rates Mortgage (ARM) built in. Simply put, under this Arms deal the buyer paid five percent under prime for X amount of years, then three percent under, then two, then prime.

Then, because he had paid below the prime rate for a number of years, his mortgage is adjusted upwards (two, then three, four, five points above prime) to take up the years-long slack during which time he paid rates below prime.

It’s at this time, when the mortgage payback becomes more than the original rental that money runs out, defaults return and foreclosures begin.

Crunch time: “Where’s my return?” cries the Ixopo School Board.

“There is none,” reply Northern Rock, Lehman Brothers, Fannie Mae and Freddie Mac et al holding bags full of a future that can no longer be derived from nothing.


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