Money Lending: Rotten to the Core

Reddit

I am sure glad to see the first quarter of 2008 behind us. It seemed as if every couple of days there was more bad economic news. Each announcement was worse than the last. The banks, investment houses, hedge funds, etc. just pumped out the bilges with their financial gray, brown and black water. It didn’t matter if the tide was coming in or going out. The whole economic bay seemed to be polluted.

As the quarter unfolded, it became clear that the world’s credit system was drifting aimlessly, like a ship sailing with no wind. A lot of business that should have gotten done just did not happen, for lack of funding. Funding went away because risk aversion kicked in with a vengeance, and for a very real reason.

The last 12 months or so have been a time of repricing risk – and this occurred on a global scale. But the repricing was not orderly. The U.S. dollar was steadily drifting downward in value, and prices for most things were readjusting just on this monetary basis alone. Add to this some severe industrial disruptions, from power shortages in South Africa to floods in Australia to economy-stopping winter weather in China.

In the U.S., the downward repricing of risk rapidly became a collapse as flaws in the U.S. rating agency process bobbed to the surface. With so much distressed commercial paper floating around, many people were paranoid about risk. It was like the old game of “hot potato,” except nobody could pass their potatoes onto the next guy down the line.

For example, in one major presentation, I heard General Electric CEO Jeff Immelt spend a large part of his discussion defending GE’s “triple-A credit rating.” Normally, Immelt would be up there slapping the pointer against the screen and bragging about all the great products that GE makes and sells. Instead, he was busy trying to “prove a negative,” that GE does not hold bad paper in its money operations. But Immelt believed he had to defend GE’s stock price by dispelling fears of a rating markdown.

And through it all, the resulting stock market gyrations were a reflection of investor confusion about the future. Are we at the end of something good? Are we at the beginning of something bad? Is this the beginning of the end? Or is it only the end of the beginning? Really, what comes next? Will credit markets liquefy? Or will they stay dried out? Can we do business? Or should we hold tight and sit on the cash?

Paul Krugman of The New York Times recently told Fortune , “Large parts of the financial system will have to be reinvented.” And there’s no argument from me on that one. But so much of the financial system is broken that the question is where to even start.

It is apparent that much of the old way of doing business – particularly in the realm of money lending – was rotten to the core. In my view, it begins with the U.S. dollar itself. The dollar has been steadily deteriorating in value for decades, so inflationary expectations are part of the worldwide consciousness. That is, just because of the long-term decline in the value of the dollar, most people expect most things to go up in price most of the time.

So is it any wonder that people developed a “speculation expectation”? This fed into an entitlement mentality, as well, that tainted every rung of the credit ladder. A lot of people wanted to buy and flip, whether it was houses or stocks or commodities. So money lenders gave to people to enable buying and flipping. Flipping became a dominant, if not defining, element of the financial “industry,” of sorts.

But what an industry! For example, in the past five years, many people just plain lied through their teeth on everything from credit card applications to mortgage applications to the money lending documents for multibillion-dollar takeovers. It was pure and brazen fraud in many instances, verging on burglary in plain sight. The next level up the food chain – the brokers and loan officers – often just looked the other way and rubber-stamped the papers. “Hey, not my problem.”

This kind of bad buck-passing went all the way to the top of some firms, many with familiar names. There in the ethereal reaches of the nice office buildings in Irvine, Calif., and Fort Lauderdale, Fla. – let alone Wall Street – the chief executives knew, or should have known, how risky the portfolios were becoming.

But these corporate worthies let it happen. The pressure to “make the numbers” was too much. The money was just too good. The bonuses were too sweet. And besides, there is always the old excuse that “Everybody does it this way.” Yet it was not for nothing that the ancients defined greed as a deadly sin. At each step of the ladder of financial deceit, people just let it slide. They should have known better, and maybe they did know better.

Now looking ahead, we have a hell of a rocky road before us. And can we as a society really “regulate” our way out of that situation? Or is there a systemic problem with deeper roots? Really, what do the Furies have in store for us?

Regards,

Bryon King
for The Daily Reckoning Australia

Byron King
Byron King currently serves as an attorney in Pittsburgh, Pennsylvania. He received his Juris Doctor from the University of Pittsburgh School of Law in 1981 and is a cum laude graduate of Harvard University. Byron is also co-editor of Outstanding Investments.
Reddit

Comments

  1. So, what was actually said in this article?
    I didn’t read anything thought provoking, profound or new.

    This would be a good article for someone completely oblivious to all the problems of the global financial systems of late, but I would assume that for most readers here this article is about as trivial as they come.

    Thanks?

    Reply
  2. Well, in his defense, half the articles on the DR are repetitive…

    Reply
  3. …i be the thread of radiant ignorance that pass through the eye of the needle of knowledge with which to sew the fabric of understanding together within myself….in repetitious repetition i stitch through time, to the dawn of wisdom…..

    Reply
  4. Sure Byron, the banking system is corrupt, but not quite how you’re presenting it. My impression is that the nature of fractional reserve banking (a pretty much global phenomena nowdays) means that almost all of the money supply is made up of debt-money. That is, much of the money only exists because somebody has signed up to a loan agreement of some form. Of course, the loan has to be repaid in principle and interest, so, looking at the system as an unsteady equilibrium of loans created vs loans retired you’ll find that there is a big mis-match inherent. The interest to be paid on the aggregate loans outstanding must come from somewhere else. Of course the interest money could come from the ‘real’ money supply (i.e. the M0, or printed cash, if you will), but more than likely, it will come from an increase in the aggregate loan balance outstanding. Summary; the economy gets further indebted to the banking system, just to keep it stable. Of course, there are limits to this situation, as borrowers have only so much ability to take on further debt. To keep the system rolling, in a ponzi sort of fashion, the banking system must go further afield in search of ‘suitable’ borrowers, viz. sub-prime folks. This continual lowering of lending standards is needed, just to keep the debt-based money system working. It starts to break down, as all ponzi schemes do, because the last participants fail to live up to their obligations, hence the increasing default rate (and loss of capital/loan principle) must be offset by an increase in the interest paid by all the other diligent borrowers. This, however is at the limit of the expansion, and there are only two ways forward from here: One is for the government/reserve bank to physically print and distribute more cash (restoring the debt-cash balance) and the other is for much loss of captial/loan principal to ensue. The only way for a reserve bank to print cash, is for it to buy the worthless assets at their inflated prices. Even the FED doesn’t seem to be doing this yet. Cheap loans to the afflicted, yes, but no real bail-outs yet. The current monetary policy appears to be aimed at an “orderly” and sustained destruction of debt principle, distributing the pain across as much of the economy as possible.

    So, the system is only corrupt because money can be loaned into existence.

    Jonathan R
    April 10, 2008
    Reply

Leave a Reply

Letters will be edited for clarity, punctuation, spelling and length. Abusive or off-topic comments will not be posted. We will not post all comments.
If you would prefer to email the editor, you can do so by sending an email to letters@dailyreckoning.com.au