Wednesday, January 16, 2008

Neither a borrower nor a lender be

Many people, at least those not prone to blame the Government or the Yanks for the problem, are scratching their heads now wondering how the directors of the Northern Rock could have thought it prudent to operate under a business plan that was inherently vulnerable to a credit squeeze − around 70% of the bank's funding came from the wholesale markets i.e. international credit markets.

This means it was lending long term while borrowing short-term to keep itself afloat, so the moment last summer when the banks stopped lending to each other (not apparently a particularly rare occurrence) the game was up for Northern Rock, even though the its underlying assets (UK mortgages) were still sound.

Yet much the same kind of liquidity-dependence, albeit to a lesser extent, applies to UK PLC in general.

The City of London earns 19% of our GDP and in 2006 paid itself £19bn in bonuses. These sort of rewards have encouraged City types to squeeze more risk − and hence more opportunity − out of the system and they appear to have done this by fashioning an ever more complex, multi-dimensional game of pass the parcel... the debt parcel that is.

In this way the worldwide value of derivatives has approached twice the size of the global economy, and instead of taking their punts with other people's money, City financiers have in effect been taking them with other people's debt: every time someone signs up to a mortgage they package this debt up into some new kind of financial instrument that usually entails contrasting degrees of risk and transparency. And as the money from all this lovely leverage rolls in, their unfathomable incomes then force up the cost of homes wherever they decide to set up a pad. A cycle clearly, but not an endless one.

Now, your impractical cure for the world's ills might be buying organic produce grown in relative proximity to your residence. I'm afraid I tend to regard this plan as little more than well-intentioned snobbery, but I would have to admit that there's more than a whiff of exclusivity about my own.

I've been fortunate enough to have avoided ever becoming a net borrower and I would like others − especially those more in a position to do so − to consider this as a perfectly valid lifestyle choice.

It strikes me that a significant number of net borrowers are a danger to both themselves and society in general. You might say that they are deluding themselves into a form of debt-slavery by the attractions of a coach class version of capitalism, when the real action is going on down in the Square Mile. And as the bankers drive up the price of property, the mortgage-owners start to kid themselves that they are getting rich too, feeding their consumption habit with even more borrowing.

The soundtrack to this game of pass the parcel is now starting to slow down. The banks were the first to realise that the package itself was starting to feel fairly heavy. They might have thought it was pretty neat idea to use the very foundations of middle-class existence to fund their own more exclusive lifestyles, but given the way that the derivatives market can consistently outpace mere production, it is hard to be sure now just how wide the crater this debt crash leaves will be.

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