September 19, 2007

Roots of the credit crisis lead right to Bin Laden

Posted in Banks · 15 comments ·
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Driving past Northern Rock’s Dublin office just off Harcourt Street yesterday, I thought the queue of concerned depositors is reminiscent of scenes from the Great Depression. Hopefully, the customers who were lined up outside the banks will get their money out. Despite the panic, things look reasonably positive. But, what a shambles.

Where do you start to explain the Northern Rock debacle? In the old days it was simple: if a bank got into difficulties it was because depositors believed that something was fishy with the management — they might be trousering the deposits and spending them on speculative assets that were prone to crises. Now, however, with global markets interlinked in a 24/7 world of enormous capital markets, the security of your deposit can have as much to do with geo-political events as bad management.

This new interconnected world also means that events in one part of the world can have bizarre and worrying effects on seemingly unconnected places. As a result, bizarrely, the roots of the Northern Rock crisis and the subsequent falls in the stock prices of all Irish banks can be sourced in the most memorable event of this century.

Where were you when you heard about the Twin Towers? Did you ever think that one of the most unexpected impacts of the September 11 attacks would be the explosion of hire-purchase trampolines in the suburbs, deposit crises and ridiculous house prices in Portlaoise? Strange as it sounds, there is a direct link and here’s how it happened.

Every time you fill up at the pump, do you ever think about where the cash goes? Obviously, much of it ends up in the hands of the oil producer after all the others take their cut, particularly the tax man. Since the attack on the Twin Towers, and particularly since the occupation of Afghanistan and Iraq, the price of oil has increased from $23 peaking above $80 a barrel. At the time of writing it is $78. Once more, Arab oil producers benefit from a huge windfall as millions of Western drivers hand over cash to the sheiks. This is Osama’s handiwork.

The best way to gauge just how much of your cash has ended up in the Gulf as a result of Osama’s oil boom is to look at the foreign reserves of the region. The IMF calculates that the balance of payments of the Gulf went from a $30 billion surplus on the eve of September 11 to $212 billion last year. The crucial oil-trade balance has rocketed from $159 billion to $451 billion. This is your cash, and the cash of every Western punter and company that depends on oil for our daily existence.

But because the Gulf states are small places, they can’t absorb all this cash and the money has to go somewhere. It can’t all be spent in the Gulf. Also, given that the atmosphere in the US is one of overt suspicion and barely concealed hostility towards Arabs, especially Saudis, the recycled cash is not going back to buy Manhattan penthouses for rich Arab playboys. Not surprisingly, many Arabs have taken the hint and moved themselves and their money back home, with the result being huge price rises and rampant speculation in property in the Gulf, leading to the extraordinary emergence of Dubai out of the desert. This new metropolis is sucking in workers from Bangladesh and Pakistan, hookers from Russia and money from investors reading the property ads at the back of the ‘Sunday Independent’.

Because the Gulf states have pretty modest economies (Saudi Arabia is a smaller economy than Denmark), the bulk of the petro-cash, as happened in the 1970s, has gone back out into the world economy, looking for a profitable home.

All this recycled cash has had the effect of keeping world interest rates lower than they would otherwise be. As well as having old Germans to thank for our lower interest rates, Ireland has to acknowledge Osama’s role in the liquidity bonanza of the past few years. His attack on the Twin Towers, triggering the invasion of Iraq, has ensured that a wave of oil money from the Gulf is currently washing over us.

Irish banks and the likes of Northern Rock have been watching these developments and have gone out in the past two years, borrowing Arab money and then lending it out here to finance the last phase of the property boom which is now peaking.

Figures from the Central Bank reveal that our dependence on this foreign money is now verging on the addictive. Over four euros in every 10 lent to you and me is now borrowed directly by the Irish banks from foreigners. Who says we’re not living beyond our means? We are now hooked on oil money.

The extremities of the Irish housing market were receiving cash, not because they are great investments, but because the surplus cash has to find a home somewhere.

Ultimately, the wisdom of the investment is based on the underlying strength of the system and the ability of banks like Northern Rock to lay off this risk.

Like a bookie, the banks lent the money to people who wouldn’t normally get money in a month of Sundays. They then rolled all these loans into one special product and sold it on to the international financial markets.

As long as the people in places like Portlaoise were repaying these mortgages, the financial whiz-kids thought that they were getting money for nothing. These new financial instruments are called “mortgage-backed securities”. The underlying assumption was that people do not default on their mortgage.

So Osama’s oil money was recycled via new housing estates in Laois to London and Wall Street. Northern Rock were therefore not financing their mortgages out of deposits as was the traditional way. It was basing its ability to continue financing new business on the appetite of financial gurus for these so-called mortgage-backed securities.

In August, following widespread defaults on mortgages in the US, this market seized up. Contrary to what the banks thought, hard-pressed families do in fact default on their mortgages. When they did, due to higher interest payments and unemployment in the US, the financial markets ran scared. They ceased to finance the likes of Northern Rock, who were playing this game and the bank found itself with a serious credit crisis. It applied to the Bank of England for an emergency loan and the ordinary depositors smelled a rat.

The Northern Rock fiasco reveals just how precarious the international financial system is. Everything is based on a huge confidence trick, which, if exposed, can come crashing down around ordinary people who have no idea what is going on behind the scenes.

Somewhere in a cave in Pakistan, a frail Saudi Arabian fanatic must be smiling. Because, whether it was his intention or not, Osama has succeeded in undermining the Western infidels exactly where it hurts — in their pockets.


  1. And that’s before you mention the fact that interest rates were lowered in the aftermath of the Sept 11 attacks to keep confidence and the economy growing – only served to increase the tsunami of cheap money.

  2. In fact, the real culprit for the surge in the price of oil is not siting smiling in a cave in afghanistan, he’s siting with a grin at the oval office. World oil prices did not spiral out of control after 9/11 – they started spiralling upwards from 2003 when it started to become clear that the War in Iraq had destabilised the region (and hence oil supply).

    Bush’s terribly misjudged war is the real catastrophe.

    The other point I would make is that oil prices hit current prices in the 70s (in adjusted dollar terms) but it caused a greater shock then. In its aftermath diversification (like Nuclear in France) and efficiency (like miles per gallon ratios in the US) became a priority and were successfully addressed. When oil price stabilised a lapse began and motor and oil companies in the US were able to lobby again against efficiency laws. The current price will no doubt override these again and a new round of striving for efficiency and alternatives will begin. (this time with the added pressure from climate change)

    But the issue of energy security and the perilous financial matrix that you mention remains true. Basically the Sheiks are lending us our own money back through a complicated and volatile financial system. Along with climate change, this is another compelling argument to dramatically reduce our dependence on middle eastern oil.

  3. SpinstaSista

    And the moral of the story is don’t go a-begging to the bank manager for a mortgage you can barely afford so you can buy a bijou residence in Portlaoise, marry an Arab oil-sheik instead!

    Or we could look for oil and gas reserves off the coast of Ireland. Or maybe not. Now don’t get me started on Shell…

  4. The fall of the dollar is that with the deficit of 13.5 Trillion dollars deficit. Never in Americas history has the imbalances of the economy’s so evident .The dollar is still falling in value and America the steward of the world economies is showing itself to be unreliable.

  5. Dónall Garvin

    Where will this all end?
    Are we looking at a Great Depression 2.0 in 3-4 years time.

    The US FED reducing interest rates this week will be judged by history as having been a real mistake.

  6. john

    Well if there is lack of confidence in banks, gold is a good place to be, it has recently shot up again, also the american interest rate cuts has helped it. This is what marc faber has been predicting for so long that the Fed would have to cut interest rates to stop its economy from collapsing. Bernanke talked the talk about having to control inflation but ultimately he had to cave in and inflation is going to really take off now. Everything is happening exactly as faber predicted

  7. And irish landlords made huge profits on capital appreciation while young irish home seekers saw the price of a house soar beyond their reach because 40% of new housing stock was being bought every year by the speculators, because money was cheap in an economy which was boiling over and whose central bank has to apply the same low interest rates as Germany or other countries in recession.

  8. Anne Osborne

    “Inflation starts with expansion of money and credit. Inflation ends when the central bank is no longer able or willing to extend credit and/or when consumers and businesses are no longer willing to borrow because further expansion and/or speculation no longer makes any economic sense.”

    – Gary H. Stern, President of the Federal Reserve Bank of Minneapolis — 1995

    It looks like we’ve getting very close to this point, folks. Now the question is, what comes next? Hyper-inflation? Deflation? Anyone who’s been stocking up on gold over the past year has had the right idea. And if you think that’s a bit drastic, here’s what von Mises, the founder of the Austrian school of economics said many years ago:

    “There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of the voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved”.

  9. MB

    One problem with this scenario is that David paints the Irish economy as a hapless beneficiary / victim (depending on which generation you belong to I guess!) of these worldwide flows of capital seeking a good home. In reality, there are many tools of political economy that the Irish government could have used to mitigate the effects of globalisation and try to steer investment away from unproductive assets like property and into more productive areas like technology, R&D, renewable energy research etc. The problem with these productive areas is that it’s not easy money: you have to actually produce something to make a profit and it takes some time to realise the gains of your investment. A little more difficult than buying up a couple of off-plan ghetto flats that you only need to sit on for a year before realising a low-tax gain. Better taxation and incentives for productive investments could have reduced the more extreme effects of this however e.g. provide more incentives for R&D start-ups, increase taxes on rental income and gains from property speculation etc

    If Fianna Fail and co hadn’t been so heavily in the pockets of the builders of Ireland, they have been more open to consider other policy options. Instead they just shrugged their shoulders, claiming the free market and ECB control of rates as their excuse (as if interest rates are the only way to control investment patterns) and ignored it all. What a useless government – the only consolation is that they were voted back in this year so they now have to face the consequences of their previous inaction.

  10. Tomtaltach said,

    (Quote from previous post:)

    “In fact, the real culprit for the surge in the price of oil is not siting smiling in a cave in afghanistan, he’s siting with a grin at the oval office. World oil prices did not spiral out of control after 9/11 – they started spiralling upwards from 2003 when it started to become clear that the War in Iraq had destabilised the region (and hence oil supply).”

    True,the oil had continued to flow by subterfuge, during the long years of U.N. embargo when Saddam was still in power and the boycott enriched middle men who helped to break the embargo.The major effect was the death of thousands of children because of lack of medical supplies etc. Saddam was able to use the embargo to starve his enemies into submission.
    Now Iran are in Bushs firing line.They are pretty much aware by now that the only serious disincentive to America and Israel bombing your country, and reducing your economy to the pre industrial age is a small piece of modern technology called a “nuclear deterrent”.Just wait until the boycott of Iran begins-you think oil is expensive-you aint seen nothing yet!!

  11. John

    Wondered how long it would take for the finger of blame for all world ills to be pointed at the U.S. Next we will have the “they bombed the twin towers themselves” conspiracy theory posted. Ever consider that we in Ireland and our own government are to blame for many of our problems? America proving itself unreliable? When could we be relied on to do anything other than play the blame game?

  12. derek

    “Reminiscent of scenes from the great Depression.” That’s where you lost me. A spurious, needless and typically dishonest comparison.

  13. Davids article in the Sunday Business Post:
    “Ireland has become a fat, flabby nephew of an ailing Uncle Sam ”
    is a thoughtful piece,and as I read it it occurred to me that the best move for ireland right now would be to withdraw from the common Euro currency and link our new punt to the American dollar-as with the chinese who have played a good game here for many years.The american multi nationals who make everything from computers to clothing in China now,have total stability in export sales to their biggest market,and despite their vast profits being secured, the american government get a major discount on everything America imports when they trash the dollar and reduce the value of Chinas vast cash savings hoard now embedded in american bonds.Their investments are a hostage situation, for if they re-invest their huge surplus elswhere, they will compound the trashed dollar problem and lose even more.
    The Economist have a “McBurger” index of the price of a quarter pounder in each country and it has been surprisingly accurate in assessing the over or under-valuation of currencies worldwide.
    If they created a McHouse or a McApartment index, I wonder how much the “irish euro” would be overvalued against the rest of Europe and the world.? in other words by how much are we priced ourselves out of economic existance. You can buy a Chateau in Chantilly, or a Schloss in Salzburg for the price of a starter apartment in one propoosed Ballsbridge development.Certainly the country will have a rush of adrenalin for some years to come, as the property asset, strong, “noveau riche” in ireland continue to enjoy the good life for the foreseeable future,and the 40% of solid Fianna Fail supporters in farming, and the various state sectors such as Health, Education,etc,continue to thrive in secure well paid jobs, are immune to the coming downturn.in 5-10 years time we will have “America at home”, indeed its already arrived in the public patient, cancer treatment wards of our remaining public hospitals.

  14. Garry

    Nah, the roots of the credit crisis dont lead to Bin Laden, the regulators are responsible.

    What has happened is pretty simple, sub prime loans were ‘repackaged’ and bought by banks after having been given a triple A rating…. As soon as some people started defaulting, the banks stopped lending to each other as they dont know how exposed the other banks are on these repackaged sub prime loans; it didnt take too long to figure out a triple A rating doesnt really mean all that much….

    The bottom line is not that rates dropped so low that caused the problem, it was the misrepresentation of repackaged loans which has caused the market to panic…. The market no longer trusts the ratings system and wont lend to each other….

    Thats the bottom line, but who’s going to pay for this?

    The individual bankers who have sold the ninja mortgages often to people who didnt understand them?
    The companies who have recklessly created, packages, rated and traded these sub prime loans?
    The regulatory authorities who were asleep at the wheel?

    Of course not….

    The ordinary taxpayers will bail out the banks again by lending to them when they wont lend to each other so we all lose.
    But the biggest losers will be the honest guillible folk who believed the hype from the banks, estate agencies, and sundry snake oil salesmen about property investment. Some sub prime lenders here have already increased their rates by 0.75%…. The honest people will scrimp and save every which way they can to pay the loan back, which they might manage to do before they retire if they are lucky. They might be better advised to just walk away, after all there are loads of empty houses here which they could rent for a fraction of the mortgage.

    So lets not blame the bearded fanatic; lets put the blame where it belongs; … with the suits, and of course also with the “because Im worth it generation” who have badly overstretched themselves by fibbing on their mortgage applications …

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