Friday, 28 March 2014

profit of doom

One of the recurring themes in the history of money is that every system for its creation and management contains within itself the seeds of some unforeseen future abuse.
There is a widely held belief that the financial crisis of 2008 was caused by the creation of securities backed by American sub-prime mortgages. This is not true, although selling mortgages to people with almost no ability to repay their loans certainly didn’t help. The real cause of the crisis was an arcane activity known as ‘re-hypothecation’.

This piece of financial jargon needs to be explained. Most people, when they buy a house, have to take out a mortgage. Legally, they own that house, but the bank or other lender has the hypothetical right to repossess the house if the borrower falls behind with their repayments. This is hypothecation. If the lender uses the house as collateral for their own financial transactions, this is a simple form of re-hypothecation.

Of course, investment banks, brokers and other financial players don’t pull this stunt with mortgaged houses, but they do something very similar when buying bonds, commodities, futures and other financial products. In fact, according to the International Monetary Fund (IMF), the average number of times that the collateral for an initial trade is pledged to secure further transactions is four, a degree of leverage that would have made Archimedes break out in a cold sweat.

I should underline what this means: if four is the average number of times that the collateral for a trade is re-hypothecated, then the amount of collateral backing the global financial market is 25 percent. This should make everyone nervous, because with this level of under-capitalization, the global financial system is what might politely be termed ‘another accident waiting to happen’. The old practices have not been abandoned, and it is only a matter of time before the crisis of 2008 is repeated, probably with more serious repercussions than last time.

Although re-hypothecation lay at the heart of the 2008 crisis, this activity became possible only after the Glass–Steagall Act was repealed in 1999, thus destroying the wall between investment and commercial banking that had been put in place by President Franklin Roosevelt in response to the Great Depression to protect the savings of ordinary Americans.

Another effect of the Commodity Futures Modernization Act (CFMA), the official title of the legislation that repealed the Glass–Steagall Act, was to deregulate the trade in credit default swaps, collateralized debt obligations and other financial legerdemain. However, despite the obvious connection between CFMA and the financial meltdown that occurred almost a decade later, then Treasury secretary Laurence Summers continues to deny any responsibility for the resulting mess, although the president under whom he served, Bill Clinton, has since conceded that his signing of CFMA was based on bad advice, advice that one must assume came from Summers.

Despite the liberalization of financial markets that occurred in 1999, US Treasury rules continued to restrict re-hypothecation to a maximum of 140 percent of the original collateral. Unfortunately, such a rule did not exist in London, which is why AIG, Lehman Brothers and other American financial institutions carried out most of their transactions there, using UK-based subsidiary companies. Did you ever wonder why Lehman Brothers and Bear Stearns were allowed to fail, while other US financial institutions were given what were effectively cash handouts on the grounds that they were ‘too big to fail’? And did you ever wonder why it took $85 billion to bail out AIG? Surely a firm that was this much in debt deserved to go under, especially given that its losses were a direct result of re-hypothecation in London and not merely a temporary blip.

Allowing an ailing company to fail is the archetypal response in a genuinely free market, so President George W. Bush got it right with Lehman Brothers. He went wrong subsequently because the collapse of Lehman Brothers revealed a complex web of re-hypothecated financial transactions, and the realization that this kind of behaviour was widespread in financial circles induced panic among senior US administrators. The reasoning appears to have been that if Lehman Brothers, a relatively small investment bank with no retail business, was in such a mess, then the collapse of a larger financial institution in a similar pickle would trigger a catastrophe of unimaginable proportions, especially if that institution had a retail banking arm. This was the origin of the ‘too big to fail’ scenario, which merely encouraged more reckless speculation by banks, whose operators could continue with business as usual, safe in the knowledge that they had an implicit promise of rescue if they made catastrophic errors of judgement.

Although he hasn’t said so publicly, President Bush, like his predecessor, must have been given bad advice, and also like his predecessor, that advice is likely to have come from his Treasury secretary, who in this case was Henry Paulson. It should not be forgotten that Paulson, as a former CEO of Goldman Sachs, was one of the people behind the move to convert sub-prime mortgages into products that could be sold to unsuspecting investors, although this doesn’t excuse the Royal Bank of Scotland and other European banks that bought these intrinsically worthless securities and subsequently lost huge amounts when these ‘structured investment vehicles’ went sour. It doesn’t take a financial wizard to work out that an investment offering a rate of return that is above par must entail an increased risk.

Of course, other banks got into difficulties for other reasons. Northern Rock, for example, borrowed on short-term money markets to fund its mortgage business. I would have thought that a child in a kindergarten would instinctively grasp that borrowing short to lend long is not a sustainable business model.

It is a mistake to imagine that the surviving institutions have learned the lessons of 2008. In 2011, Goldman Sachs re-hypothecated assets worth $28.17 billion, but even this staggering total pales into insignificance when compared with JP Morgan Chase, which re-hypothecated assets worth $546.2 billion, and Morgan Stanley, which added $410 billion to the total. Although I cannot find more up-to-date figures, it must be reasonable to assume that this financial skullduggery not only continues to be practised, but is also on a similar scale.

It must have seemed like a good idea when financial systems were globalized in the 1980s, and so it was. Globalized finance meant that international trade was made easier, but in the intervening years, partly as a result of the deregulation of financial services in major markets, the global financial system has become an end in itself, hence the massive proliferation of what are euphemistically called ‘derivatives’. It has become a system for channelling more and more money into fewer and fewer hands. There was a time when a country’s stock market index reflected the overall state of its economy, but the Dow Jones Industrial Average has been at or near record levels in recent months, yet the US economy remains in the doldrums. The only beneficiaries appear to be the country’s big financial players. I have heard Goldman Sachs described as ‘a money-making machine’. It is nothing of the kind; it is a money-grabbing machine. It does not create wealth.

What of the future? The labyrinth of re-hypothecated trading positions, collateral for which is a mere 25 percent of what should be the case, means that the failure of one link in the chain will have a domino effect on financial markets. And any chain, whether actual or metaphorical, is only as strong as its weakest link. The only unknown is the location of that weakest link, but when the crash does come, some financial institutions will not be ‘too big to fail’. They will be too big to save. It may be time to check whether there’s room under your mattress for your hard-earned savings. After all, they won’t be much less safe than if you put them in a bank. And they will earn only marginally less interest.

Saturday, 15 March 2014


I must commence with an apology to anyone who clicked on this title expecting a vituperative diatribe against the evils of modern capitalism. I’ll provide that at a later date. Meanwhile, if you thought that I’d be denouncing the way that all the cash for infrastructure development seems to be going into my home country’s capital city, leaving provincial municipalities to scrabble for scraps from the rich man’s table, I’m afraid that I have bad news. I won’t be. Not yet.

However, I will be posing this question: are capital letters necessary? I had no thoughts on the subject until I started editing other people’s books and realized that nobody seemed to know the rules. Everybody was fine with the obvious ones, beginning a sentence, abbreviations, the initial letters of people’s and countries’ names, things like that, but I quickly discovered that there was a large grey area where authors appeared to be making up their own rules based, presumably, on what they considered important.

Thus a political scientist might have written about the British Government, or a Catholic apologist about the Pope, or a biologist about the Theory of Evolution. A schoolteacher might teach Mathematics, or Geography, or History, while other academics might refer to their place of work as ‘the University’. In none of these instances is an initial capital necessary, and their use in such circumstances isn’t easy to justify, except as an affectation.

I encountered the reductio ad absurdum of this approach to capitalization in a book on leisure management that I once proofread (I usually worked on science and philosophy titles, but also as usual I needed the money). After correcting several instances of “Leisure Manager”, my gast was finally flabbered by a passing reference to “the City’s Ice Hockey Team” (the Sheffield Steelers would have been acceptable with initial capitals). It was this absurdity that first suggested to me the idea that upper-case letters are never necessary but are merely a convention. Perhaps their use could be abolished.

However, I do foresee difficulties with any move to eliminate the use of capital letters entirely. It seems to be an elementary point, but it is clearly desirable that we continue to distinguish between ‘be’ and ‘Be’ (the symbol for beryllium), and also between ‘he’ and ‘He’ (the symbol for helium), although in both these cases the context should make it easy to determine which of these the writer intended. We would also need to know whether we were being led astray or were using LED lighting.

Mention of light-emitting diodes reminds me of the trend, over the last century, to change the way abbreviations are represented. At one time, it was standard practice to punctuate abbreviations (e.g., N.A.T.O.), but it is rare nowadays to see the North Atlantic Treaty Organization represented in this way. In fact, the trend has been, especially with pronounceable abbreviations, to dispense not only with the punctuation but also with all but the initial capital. You may think, given what I’ve written above, that I approve of this, but there are potential pitfalls. Thus, I would expect the average Westerner to recognize ‘N.A.T.O.’, ‘NATO’ or ‘Nato’, but what about ‘Asean’ (Association of South-East Asian Nations)? I suspect that many would have to reach for a suitable reference book, because if it is being encountered for the first time, its status as an abbreviation will not be obvious. And, it should be noted, both acronyms contain letters that under normal circumstances would be capitalized: ‘Atlantic’ in Nato and ‘Asian’ in Asean. However, another acronym that has been in the news lately—‘Libor’, London inter-bank offered rate—could be excused on the grounds that only the L represents a word that ought to be capitalized.

Interestingly, ‘LED’ is the only common abbreviation I can think of that is spelled out (‘el-ee-dee’) rather than pronounced as it appears (‘led’), which is probably the reason the capital letters have been retained, while terms such as ‘laser’ (light amplification by the stimulated emission of radiation) and ‘scuba’ (self-contained underwater breathing apparatus) have become so thoroughly naturalized in the language as ordinary words that many people will be unaware that they started life as acronyms, especially as any use of capitals now would seem distinctly bizarre.

There is one use of a capital letter that is difficult to avoid, and that is for the first-person pronoun I. A few years ago, I tried to eschew the use of capital letters entirely—signing my name dennis hodgson, for example—but it did seem strange to me to write ‘i’ for me. This is partly because the ninth letter of the alphabet is one of only two letters that comes as two separate pieces, and having a two-piece letter that is meant to refer to oneself seemed uncomfortably schizophrenic.

Consequently, although I continue to avoid using capital letters whenever I think they are unnecessary, I cannot provide a set of rules for their use. All I can do is to suggest that they are used sparingly, but also consistently.

Monday, 10 March 2014

the long and winding road

In Journey to the West: Part 3, I posted the photograph on the right with the promise that I would write about my exploration of the right-hand option ‘in due course’. The map below shows an extensive network of ‘roads’ to the west of the Sheung Yue River, which clearly merited a closer look, something I’ve been doing over the past couple of months. However, as I discovered, and in keeping with Google’s usual practice, almost all these ‘roads’ aren’t roads at all.

In fact, there are only two metalled roads on the map apart from that followed on the ‘journey to the west’ and the 100 metres or so southeast from A. They are the ones that cross the river (the river ‘crossing’ at X doesn’t exist!), and the rest are either dirt tracks or concrete footpaths less than a metre wide—the inevitable consequence of producing a map merely by inspecting satellite photos.

My first foray down the right-hand road didn’t get me very far. In fact, this road became a rough dirt track within 100 metres, and it came to a dead end after another 100 metres or so. Or so I thought, at first. However, I failed to notice a not very obvious path to the left of the shack on the left-hand side of the track in the following photograph (marked B on the map):

The first section of this path (B–B) was easy to follow but not nearly so easy to ride; the following sequence of photos gives a flavour of this part of the route:

The reason for the yellow railing is obvious, although there are plenty of places later on the route where there is an obvious drop off the side of the path and no protective rail.

Small streams such as the one crossed by this bridge become impassable torrents during heavy rain, so a reliable bridge is a necessity.

Approaching the river.

Once the first road has been reached, the route turns right to a small village at D on the map. The first 400 metres of D–D is a dirt track, and the next photo was taken on this section. E, the start of another dirt track, coincides with the prominent tree in this picture.

The dirt road comes to an end, to be replaced by a winding path through an extensively cultivated area. There are no serious difficulties, but a lapse of concentration could have unpleasant consequences. The next seven photos were taken along this section.

The right-hand branch is a dead end, although this doesn’t become evident until you’re almost at the junction.

As tin shacks go, this is a big one.

The bread trays on the right of the path are used as makeshift bridges by those working here to cross the irrigation ditch that runs alongside the path.

Although there is a significant drop off the inside of this bend, it’s the drop off the outside of a bend that you really need to worry about.

The slope here means that you need to be in the right gear to avoid wobbling over the edge of the path.

Nearing the end of the D–D section.

Having reached the second road at the end of the D–D section, the route then follows the road to E, where another twisting path heads towards a small temple almost literally in the middle of nowhere (there is a small village, but the only access for motor vehicles is an extremely rough and bumpy dirt track that this route follows from the hairpin bend 200 metres east of the temple).

The start of the E–E section.

The path starts by winding through a large grove of palms, and the next two photos give a good indication of the trickiness of riding along this kind of path: too slow and you risk wobbling off the path; too fast and you risk failing to make the bends. This short section is probably the most nerve-racking on the entire route.

Approaching the palm grove from the opposite direction.

The final three photos show sections of the path beyond the palm grove. The drop off the edge is big enough in some places to result in serious injury if you’re not paying proper attention.

The route that I’ve described here was the original ‘long and winding road’, but as usual I set about trying to improve it. The first thing to note is that all country paths present different challenges, depending on the direction of travel, so I set about finding a third route between the two metalled roads so that it would be straightforward to follow each path in both directions. I came up with C–C, which crosses the river at a footbridge, the location of which I’ve marked on the map, rather than at the nonexistent crossing point X. It thus became possible to follow the original route, then C–C, then a return via D–D, followed by outwards along E–E and finally a return via C–C.

This makes for quite a long and winding route that is more a test of bike-handling skills than of stamina, although our usual practice is to combine this route with the ‘frontier road’, which offers the option of taking in Liu Pok Hill, probably the longest category 1 climb in the area. In fact, we’ve taken to adding this to the ‘journey to the west’ in a kind of ‘grand tour’, which gives a route of around 100km, with Liu Pok Hill near the end. Not easy.

see also
Room for Improvement