Capitalism and free markets.

What a great idea. It’s a shame no one has actually tried it out or bothered to let homo rationalus economicus that it’s an urban myth. We operate mainly in a state sponsored system of capital markets underpinned by arcane and often opaque trading rules and regulations.

The provision of capital is key to any functioning economy and has been since the beginning of time. Each empire had its own approach to coinage to support trade and the governing class or head of state. The first pillar of modern capitalism was established in 1694 with the formation of the Bank of England. Thus began the first stirrings of the fractional reserve banking system and the modern financial system.

I’ve previously covered the many bailouts experienced by the banking system and the Bank of England itself and in some ways our current malaise is no different. The central precept of free markets is that they should operate on their own merits - caveat emptor.

I’m not going to discuss that fallacy here but focus on the problems of bail outs. Why should a failing business be rescued by the state? The simple answer to that is when it has implications for the national economy or issues of national security (often regarded as twos sides of the same coin). We have seen the fiasco in the US, the UK and Europe. We have seen the banking system bailed out, private companies bailed out and yet we still hear the mantra of free markets, trade and market liberalisation and privatisation repeated.

Here in NZ we have seen South Canterbury Finance bailed out and most recently AMI. On both occasions the government intervened to provide capital from taxpayers for businesses which had clearly failed. In the case of SCF depositors were guaranteed under a standard deposit guarantee framework but bondholders also benefitted to the tune of $350m. Those bonds should never have been covered under a deposit guarantee scheme. Investors enjoyed a big free lunch here at the expense of the taxpayer. In the case of AMI, the government intervened to support an insurance company who didn’t have enough reserves on hand post the February 22nd quake. The government could easily make a good case for supporting AMI, in terms of providing it with backstop liquidity but in doing so it needed to be very clear that it was suspending any belief in free markets.

The moral hazard is clear but the implications have not been explored. On one hand the government wants to bail out private companies who are clearly responsible for their own position. At the same time they want to promote policies like privatisation because, wait for it, private companies are more efficient than public ones.

It’s very clear that the neo-liberal dream is in tatters but no one seems to want to wake up and smell the reality. Market morality is indeed quite hazardous.

One of the greatest financial inventions is leverage: the ability to create an asset of value in excess of your original investment.

Simply put this is how you can buy a house with no deposit or a small one. Consider the reality of leverage:

You buy a house for $500,000 and put down a 10% deposit of $50,000.

In a few years (certainly recent times) you sell it for $600,000. You have just made $100,000 from an investment of $50,000…a 200% return. Of course you have to subtract your interest but that is what you would have paid in rent anyway or so the theory goes.

In recent years this has been the name of the game. Between 2000 and 2008 New Zealand house prices rose 169%……..!! Yes that’s an incredible number………21% per annum on average. No wonder people thought this was an easy game. No wonder leveraged investments in property became the biggest game in town. But hold on: we are talking about houses not tulips. How could such an unusual bout of asset inflation happen right under the noses of the inflation focused RBNZ.

Well house prices are not included in the CPI calculation. Call me old fashioned but that’s ridiculous.

The major problem with any bubble is that it ends. In this case NZ has not had the same end as the USA with its sub-prime mortgage induced property collapse though the NZ finance company sector did its best to compete.

But the leverage has not been washed out of the system yet. House prices have recovered from the 2008-9 fall and now are back up close to their historic highs. Why is this? Why hasn’t the NZ housing market fallen back to more realistic levels?

There’s no clear answer but I’d like to suggest one: It’s not in the interest of the banks for prices to fall heavily. Why? Because they are the ultimate owners of the housing stock. If they lend 90% to a borrower and the price of that house falls 10% then the borrower has lost their equity and the bank owns the rest. That’s how leverage works on the downside. If the price falls further than 10% the borrower is into negative equity. So far so normal. The bank will just hoover up any savings or other assets held by the borrower. But at some point the bank is left holding the security. Banks don’t like that very much so they seek to sell the asset and recover as much cash as possible. If the borrower cannot cover the loss then the bank has to write that off.

But in a bubble situation the banks have to be very careful not to knock down the price of all property. Otherwise their entire lending portfolio will take a hit not just the one loan which went bad. So banks have a vested interest in keeping prices from falling too far.

Back in 2008 I called for land prices to fall 30%. They haven’t yet but it’s simply a matter of time. In fact they only fell 8.5%…not much of a fall considering the enormity of the rise. Wages are not rising at a rate which can cover the compounding interest on the debt pile (see upcoming post on debt) so the strains of maintaining the illusion will continue to show through. Therefore the banks have a big part to play in making sure house prices do not rise or fall too much whilst they reorganise their lending practices.

What needs to happen? Well a reversion to traditional lending practices will come back into vogue: where you can borrow 2-3 times your salary. Imagine that. Median wage in Christchurch is somewhere between $30-40,000 depending where you look and the average house price is $360,000. Scary……so the banks who are operating on the interest/cash flow model (see upcoming post on definancialisation) will find switching back to the traditional model simply isn’t possible as house prices would fall by rather a lot. You couldn’t find a house for under $200,000 these days so we would have to see a severe correction, probably in excess of 30% though very low borrowing costs would help ease that.

It’s clear that the same financial practices that we have seen employed in the global bond markets have also been applied to residential lending. The valuation model shifted from the established practice of ability to repay the mortgage to the ability to cover the interest. Why? Because the price of the house would always go up. Really? Isn’t delusion fun. The fact is that prices did go up….and up…and up. As they say the market can be wrong a lot longer than you can be right.

All this creates a major dilemma for banks (who are probably aware, one hopes, of their position) and regulators who clearly are not (always happy to be surprised): How to withdraw leverage (which was a ponzi scheme) from the residential mortgage market without causing a crash? How to realise that we have been deluding ourselves as to the  ”value” of our houses. How can we explain that 169% rise? Did we suddenly become more wealthy? Er no our trade balance for the period March 2000-2008 was minus $30.7bln!!!!

No we simply revalued our property again and again for no reason other than the banks were happy to go with the valuations (also pushed it has to be said by overseas immigrants paying cash prices) which just kept going up. If house A in one street sold for 20% more then all the other houses must be worth 20% more. Housing became a commodity and so was able to enjoy the commodity style price action……….of course housing isn’t a commodity as people actually live in them. And that is what is keeping the market afloat…..but don’t look too hard at the numbers. They might make you wonder exactly what it all means.

More on that in the upcoming posts on debt and definancialisation.

According to my colleague and friend, Branton Kenton-Dau , human beings are intentional devices. We are here for a purpose, a reason and our human form is a structure for expressing intention. I like that. Every time we act we are expressing something about ourselves even in the most nano way.

So when it comes to managing our money we are faced with the same questions: who am I and what is my intention?

It seems to me that we have 3 ways of using our money: Giving, Lending or Buying.

Giving is the simple act of directing one’s money to somone else with no expectation of financial return inclduing the original gift. But there is a clear intention that the gift should have some kind of impact. Simply this can be regarded as giving money to charity or a fundraising appeal. Your return is hopeful, that some positive outcome or impact will be achieved by way of your contribution. This is a powerful way of expressing your intention. Of course one can also give your time, goods and services for no financial return and this is a more hands on approach.

Lending, otherwise known as saving, is also a powerful tool. When you deposit your cash in the bank you are in effect lending to the bank. In legal terms you are an unsecured creditor of the bank. There is little intention here as we tend to see the process as the bank doing us a favour. But when it comes to peer to peer lending, microfinance or simply lending money directly to friends, the process takes on a deeper signifiance. There is a more direct energy involved and a desire to participate in an outcome. The personal connection to borrowers helps create this possibility. Another form of lending is to large business via corporate bonds. This is akin to saving in the bank except again there is a directness involved. A large business wants to raise $100m and I lend it $20,000. I’m a small piece of that but I’m essentialy helping to fund the business. But there is still some distance there as I’ve probably dealt through a boker or investment advisor. What I am keen to see is more peer to small business in developed countries. We’ve seen Kiva open up loans into the US now and soom we will see more acceptance in people lending larger sums to small businesses. Not so much microfinance as peer finance. What better way to create strong and trusted communities than people lending to businesses they buy from.

The third form of intentional money is the process of buying. This is two parts: buying for ownership in a business and buying for personal consumption. The latter is the world of ethical and values based purchasing. It’s a well developed market and I won’t got into that. But actually directing your money into businesses through ownership is another way to direct the flow of your financial intention. Whether it’s ethical investing at the macro level (buying into ethical funds) or at the micro level (investing in start ups that share your goals and values). The micro level is more interesting because the impact of your investment is greater. In the macro world of stock markets and large companies your investment is not so influential because of the way institutional investors control so much of the market.

We have many choices when it comes to dealing with our money. Each time we make a financial decision we have an opportunity to express our intention. Its a very powerful force. The more we align our choices with who we are, the more powerful our impact becomes. We become an efficient intentional system

As they say money talks.

Somehow I haven’t heard about Microplace but it’s an exciting addition the the expanding world of P2P lending and microfinance. It is different to Kiva because you invest in a security (like a bond) for a fixed term, usually 2-4 years and you receive a return, although minimal 1.5-3%. As I understand it the big issue is getting registered with the Securities and Exchange Commission. Microplace is backed by eBay which certainly helped whereas Kiva was a start up and was forced into going the non-profit route.

It’s great to have two companies to compare and contrast.

Kiva is more personal. I choose who I want to lend to and can received feedback and updated information on how the borrower is getting on. This is really important as it builds a web of social capital.

With Microplace you are buying a package of loans and so you don’t have that personal contact. Also there is the issue of return. I think it’s good you can get a return on your loan as long as it does not influence the rate being paid by the eventual borrower.

So you could actually lend to the same borrower through either Kiva or Microplace but somehow Microplace can get you a small return on your money. I’ll be digging further to see how they do this.  So far they have been very helpful and open.

In a way the securitisation approach is not much different from mortgage backed securities where people invest in a package of mortgages. Of course we all know what’s happened with those. However i would stress this is completely different in that all the loans are unsecured anyway. It’s also important to note that default rates on microfinance are a mere 1-3%.

When we cut out the banks and go direct we enable relationships of trust to be built. This allows the traditional aspects of social relationships to take place. No one cares if you default to the bank but to default to other people can bring personal shame and other social fallout.

These 2 companies are blazing a trail for the rest of the finance industry. P2P finance could well be the next big thing.

Dave Wetzel, Vice-Chair of Transport for London, writes an interesting paper focusing on the issues of transport infrastructure and increases in surrounding land values. The issue of land and its possible taxation reared its head recently here in NZ but has since had little media interest.

However, its time we really focused on land and its value within the economic system. One of the examples Dave looks at is the building of the Jubilee Line Extension back in the 1990s. It was a marvelous piece of engineering and brought new and convenient transport options to many Londoners.

It also brought wealth to people who owned land and property in and around the areas where new stations were sited. He quotes Don Riley, a London property developer, who calculated,

“..these land values alone, have increased by a staggering STG13bln when the construction of the line itself was only STG3.5bln.”

So this wealth has been gained for no effort (well there is always effort in speculation) and represents a windfall gain. So why shouldn’t some of that have been used to actually fund the line itself.  Dave uses this example to develop an argument for a Land Value Tax as a way of funding public infrastructure.

We don’t need PPPs when projects can be funded out of future wealth gains. This is a subject which gets little attention but deserves much more.