Wall Street Crash - 80 Years On

As can be imagined over the past couple of months there have been numerous programmes on television and the radio marking the banking collapse of a year ago. Most were explaining what happened. Yet with and on the expectation that we can return to normal without the risky games that the banking sector of the economy were playing.

On the day that marks the 1929 wall street crash I would have thought that people would have learned the lesson by now. The 1929 crash was caused by an asset bubble of shares bursting. The damage was caused by the fact that people had borrowed millions to buy these shares. The way it worked was that for $100 you could buy $1000 of stock. So if a share rise of ten percent then you doubled your money. But if that same stock fell by even just five percent you had a debt of nine hundred dollars to pay. Therefore, when the Wall street stock market started to fall on that fateful day everyone tried to sell their shares causing prices to fall further thus creating a perfect financial storm.

It was the need to repay this credit and the loss of capital that created the depression in 1929. The banking collapse of last year was the result of a similar problem except this time the asset bubble that burst was house prices. This in its self should not have ever brought about the banking collapse but while the credit bubble was supported by rises in house prices far to little of the lending was secured. And this was part of the reason for the events that threw the world into financial crisis. The other part was the “Credit Default Swaps”.

These were deemed as being rather clever ways of providing security for property loans when there was no real security in the property asset. Especially where there was no real expectation that the person with the mortgage would ever be able to repay. These only worked while house prices were rising. As soon as property prices levelled off and started to fall, these started to poison the capital reserves of the banks. However, it was not until folks started to default on their loans did even the banks realise that these “Credit Default Swaps”, now regarded as securities, were undermining the values of the banks and especially the reserves of the banks.

The problem was not just the so called sub prime loans though. As house prices rose the banks had been inventive in the way they priced their mortgage products. In fact before the banking crash, it was impossible in Britain to get a straight forward repayment mortgage. Therefore, most mortgages were discounted for the first two years. The logic being that with house prices rising constantly even if the borrower could not afford the repayments once the discounted period ended, the rise in prices would cover this if they needed to sell or they could re-mortgage, getting another two years where you were not paying off any of the capital nor paying the full interest just the discounted rate.

As this all relied upon the housing market continuing to rise, therefore everyone was at risk of loosing their home if they were unable to maintain payments. But the banks failed to see or understand that trying to repossess homes from people was further undermining the banks balance sheets.

The problem was that the Banks along with governments around the world, were manipulating the housing and property markets. The banks knew they were safe as long as property values kept rising. Governments wanted property values to keep rising as all the lending against the values were funding the boom and providing the tax income states need.

Here is the crux of what really went wrong, as if someone earns a thousand per month that is all they have to spend. But if you then add in the spending power of several credit cards and many folks were able to live a much more affluent lifestyle than their income would normally allow. Add to this the ability to use your home as an ATM and you have the illusion that you are richer that you really are.

The banks were making good profits from all this, or I should say they thought they were. But profits from lending are only profits when the loan is paid off. While this is common sense, it was not to the banks. This was where most of the bonuses were generated, with selling more credit. Combined with the credit default swaps, the culture became one of selling more credit no matter what.

However the big difference between the 1929 crash and the 2008 one was the way that governments intervened. While the “New Deal” and similar projects helped lessen the effects of the recession then, the interventions were on the whole to little to late. This time though governments moved much faster, the only trouble was that they helped the wrong people and in the wrong way. By bailing out the banks in the way that Britain and America have done, the governments have allowed the banks to continue with the folly that created the situation in the first place.

By propping up the banks, particularly in Britain, we have created a long slow burn recession. While some tax payers money is involved, the majority of the way the bank bail out has been funded had been with governments borrowing from other governments. But it will be from future tax revenues that this money will have to be repaid. It is this fact that could cause a further crash in the future.

The optimistic view is that the banks recover and governments can sell them back to the private investors for a profit. This will greatly reduce the vast borrowing requirements of governments. However, governments have to expect the unexpected and with the British government borrowing so much from the capital markets, we have no room for manoeuvre when something unexpected happens. This could be a weather event like flooding or the H1N1 flu suddenly taking hold, or a terrorist attack causing a disruption to the economy and the government would become paralysed from this.

But also the problems that first caused the banks to collapse was the banks assuming they could repossess property to recoup losses, will start to happen again when the banks think it is all over. Therefore the way the banks were saved from collapse had built into its structure the means of a further financial failure. Except it will be the banks that are now owned by the government that will take the hit, therefore further undermining the economy.

The notion that an economy can just keep expanding is a false one. In the 1920s it was the assumption that shares could/would only increase in value that showed this was false. In this past decade it was the assumption that house/property prices would only rise that showed this was false. For real economic stability the needs to be a truly fair economic system that ensures that people are paid a fair price for goods and services and that those that gain the most, via taxation, contribute more to the communal need.