December 2, 2007

Global forces take command

Posted in Banks · 19 comments ·
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You would be mad to buy a house now. In recent days the Irish housing lobby – which has hijacked the economic debate in this country and made an absolute fortune in the process – has started to spin the line that ‘‘now is a good time to buy’’.

First-time buyers, the most hard-pressed financial subgroup in the country, are being urged by banks and estate agents to take the plunge. Do not be tempted, because you will only be the lemming-like suckers who bail out developers in trouble. Hold onto your cash. Guard it zealously, because prices are headed lower – not just here, but all around the world.

So while the Irish market rallied in midweek and surged again on Friday, the rest of the world is caught like a rabbit in financial headlights. Just consider the fact that Citibank borrowed last week from the investment trust of Abu Dhabi.

The giant US bank borrowed by issuing a bond that is going to pay an 11 per cent coupon (the interest rate).This is worse than a sub-prime interest rate. The problem for Citibank is that no one will lend it money. The moral of the story is that if you play with sub-prime, you eventually become sub-prime yourself.

I am writing this from the City of London, where the mood is sombre. Traders have moved from being worried about their bonuses last month to being worried about their jobs. The crucial thing to understand is that trust between the world’s large banks has evaporated.

No one wants to lend money to the bank that is about to announce another massive write-down from losses in the derivative markets. Because the banks have obfuscated, lied and been economical with the truth about their balance sheets, everyone is suspicious. There is no transparency in the market. Opacity rules the day, and there is a real sense that no one really knows where things are going next.

Therefore the attitude is one of ‘‘guilty until proven innocent’’. In conditions like this, the market dries up. With no one lending or borrowing, the world’s big banks have to depend on the central banks to keep lending cash.

Thus we have seen the Federal Reserve and the ECB pumping money into the system on a daily basis. Yet inter-bank interest rates – the rate at which banks lend to each other – continue to rise. So liquidity, the essential lubricant of the global financial system, has disappeared.

Now, this won’t last forever. The crisis will pass. However, it is likely to have serious ramifications for the world economy, because the crisis in the banking system has come at a time when the American economy is now headed for recession.

The banking system is the heart of every economy. It pumps credit into every nook and cranny of every sector. If it seizes up, the economy suffers the financial equivalent of a heart attack. And, as with humans, if the body is already weakened, the severity of the attack and the subsequent recovery will be affected.

In the US, house prices are falling faster now than at any time since the early 1990s, and the dollar is in free-fall. Meanwhile, there is a real risk of the credit crisis extending into the credit card, motor loan and commercial property sectors.

On a global level, the problem is that the only way the US economy will recover is if the Federal Reserve keeps printing money. This is what it has been doing. But there is a limit to this, because the people who lend money to America in dollars will only tolerate so much. They have effectively been defrauded, as their dollar investments have devalued so much.

Already, China has announced that it is not prepared to hold America assets indefinitely. Europeans must obviously be thinking the same way. The only way the US can redress this is by raising interest rates, and pitching the economy into recession. So it is caught between a rock and a hard place.

This dilemma has been faced by great powers in the past, most noticeably Britain, which had to allow sterling to go into free-fall after the world became aware that British power was waning.

It is far too early to begin writing the obituary on America pre-eminence. However, many people in the City of London are beginning to see the importance of big ideas and geopolitics in understanding the global picture. For the past two decades, the idea that geopolitics mattered has become less and less fashionable, as the financial markets became hostage to the ‘‘quant’’ virus.

Quantitative models, or ‘‘quants’’, have dominated the financial models of large investment banks. I noticed this first in the late 1990s, when the bank I worked for began hiring mainly Indian, Chinese and French mathematicians to build financial models based on tiny anomalies in markets. The banks then borrowed hugely, and made vast fortunes on these irregularities.

The era of the quant was also the era when understanding geopolitics came to be regarded as obsolete. It didn’t seem to matter what countries wanted, and why different countries had different interests. But now it is very much back in demand, as the financial markets realise that the political ramifications stemming from a credit crisis are very real.

If China decided not to buy American assets, what would happen? Why should Europe tolerate a rising euro against the dollar, when the European economy is hardly roaring? Why should world food prices be rising at four times the rate of inflation, and what will happen to world inflation when the pressure from rising food prices kicks in?

Pessimists believe we are entering a new era where the excesses of the past 20 years – the global policy of printing money with nothing to back it up – will come home to roost with cataclysmic results. They see house prices all over the world falling, commodity prices rising, and general chaos emerging. Many well-respected voices are predicting a definite recession in the US and, as they predict that all markets and countries will suffer contagion, some are comparing today’s market meltdown with the 1930s.

Optimists are saying that if the Federal Reserve can cut interest rates dramatically, the US consumer will start to spend other people’s money again and kick-start the economy.

The recession will be short-lived and the recovery will start with the dollar at a lower level, China that bit closer to becoming the biggest economy in the world and oil prices over $100 becoming the norm. Houses prices will fall significantly but plateau, and start moving up again.

It’s impossible to suggest which view is more accurate, but one thing is certain – these big global forces will have far more of an impact on the direction of our economy than anything announced in the Dail next week.


  1. David said: “Why should world food prices be rising at four times the rate of inflation, and what will happen to world inflation when the pressure from rising food prices kicks in?”

    In effect the trashing of the dollar will force the euro to play the same game.This will generate a new wave of inflation worldwide.This game is 10 centuries old David.Those with cash will wither and lose. Those with property assets will weather the storm and prosper in the end.The transfer of food resources to the production of fuel additives is much more worrying. It will cause much hardship , particularly in poorer third world countries.There wil be upheavel and widespread rioting ,if heavily subsidised european and american farmers,continue turning corn into ethanol-a process already well advanced in the USA and now commencing in Ireland.

  2. Michael

    John, I do not agree with your statement that those with cash will wither and lose, I have the cash to buy another property but am waiting for property prices to drop significantly before I do that. Those whom have borrowed lots of cash for their negative equity homes in the past year or more will wither and lose.

  3. Kevin

    John, you’re forgetting that the ECB don’t have the same option of trashing the currency that the Yanks do. The only remit of Trichet and the rest of the boys is to maintain price stability. We may see inflation becoming a bigger problem in the economy but it’s more likely to be caused by external forces such as the Chinese being unable to keep their currency artificially low any longer. Also, and most importantly, this is very unlikely to equate to the wage inflation that is required to maintain asset prices and break the “cash is king maxim. There’s only so much you can inflate a balloon before it blows up in your face… and once that happens there’s nothing you can do to stop all the air going out of it.

  4. paddy cullen

    Any form of property, commercial or residential will be severely affected by the downturn in property prices for many years to come. Unfortunately many homeowners who bought over the past year or so will also be exposed to great difficulties. People who took out a recent mortgage of 90% to 100% may be looking at very large losses if they sell and fairly hefty paper losses if they do not. Often the deposit for a home will represent an entire family’s/individuals savings. Already, many these groups have lost their entire savings, though they will probably not realise this. Many experts believe that house prices will continue to fall, slowly but unavoidably, for the next ten to fifteen years. Many people view their homes as a nest egg, a source of money in the future, to be used for a second mortgage or security for bank borrowing. So when the day of reckoning comes, these people will be disappointed. They may find that their mortgage exceeds the value of their house, leaving their savings wiped out. Others who are hoping to trade up, assuming an increase in the value of their existing homes will let them make a larger deposit on a more expensive home, and they too will be disappointed.

  5. paddy cullen

    My recommended strategy during this downturn is that, if you own a home with substantial equity, sell if possible and then rent. However, if you do not want or cannot become a renter, and are or unwilling to part with your existing home there are a number of different alternatives. These may not be so satisfactory, but they will offer some protection and are better than taking no action at all. The first one would be to investigate refinancing your property and investing the proceeds. The object of this will be to achieve an after tax return on the additional borrowed funds in excess of the interest payments needed on the loan. In some cases this may be possible and could increase your income. The second option (depending on you age profile) is to consider a sale and leaseback on your home, guaranteeing life tenancy. This type of product is currently now being offered by some financial companies in the Republic Ireland. If you are a first time buyer and you have absolutely no alternative and must buy a house, do it with the maximum possible mortgage. The reason I would recommend the maximum possible mortgage is that during a downturn, the home you buy is likely to be a depreciating asset. The idea here is that the smaller the amount of money in the house the lesser the chance of your savings losing value. Investors should hold their savings into low risk, high income producing assets that will enable their funds to grow. Property is a high-risk non-income producing asset, which probably at the moment is overvalued and which will virtually assure the decline of a person’s savings. A second reason for seeking a maximum possible mortgage is that in the years to come the financial environment now carries an ever-increasing risk. Personal liquidity during these times may be important. Funds tied up in property are illiquid and may not be available when you need them most.

  6. David Mc Williams

    Wise words Paddy, David

  7. Nick

    Asia-Pacific teenagers top OECD testsBy David Turner, Education CorrespondentDecember 4, 2007 10:07:00 AM 
    Taiwan has topped a prestigious international league table of 15-year-olds’ mathematical ability, vaulting ahead of far richer countries.
    The island state’s performance in the Organisation for Economic Co-operation and Development’s Pisa tests of mathematics and reading carried out in 2006 and released on Tuesday, reinforces its reputation as a high-tech Asian tiger. Taiwan also earns fourth place in the parallel Pisa science rankings, published last week, although in reading it is a mere 16th.
    Asia-Pacific’s strong showing is one of the clearest themes of the Pisa survey, It contributes five of the top 10 in the mathematics and science league tables, and four of the top 10 in reading — thanks to strong contributions from Taiwan, South Korea, Japan, Hong Kong, Macao, Australia and New Zealand. Mainland China did not participate.
    But the league tables show Finland is the most consistently high performer — repeating its sterling performance in the last survey in 2003. It comes top in science, and second in maths and in reading — where it is bested only by South Korea.
    The US, the world’s largest economy, is below the OECD average in science and maths, and fails even to make the tables in reading because a misprint in the test confused too many students and invalidated the results.
    The UK is around the OECD average in reading and maths, but a little above average in science.
    Germany, whose poor performance in the first Pisa tests back in 2000 provoked anguished soul-searching among its politicians, performs respectably rather than outstandingly. It is around the OECD average in maths and reading, but a little above in science. France achieves the average in all three categories, but no more.
    The OECD is rather shy of making comparisons with previous surveys, despite hundreds of pages of analysis of the tests. But it does conclude with disappointment that performance in reading has remained “broadly similar” between 2000 and 2006. The report concludes: “This, in itself, is noteworthy because most countries have significantly increased their investment in education in recent years.” But South Korea and Poland are shining exceptions: their reading results have improved strongly, both in absolute terms and relative to other countries.

  8. Dónall Garvin

    How to invest to weather the financial storm?

    My advice is to write a book on that…

    My feeling is that if you take a good long look at the situation – do the exact opposite of what would have been a good investment over the last 10 years (except commodities maybe, and esp. gold) you can’t do much worse than doing nothing.

    Also sell to rent if you can (rumours are that houses no longer sell)

  9. Glen Quinn

    Hi Donall,

    Actually doing nothing is a good investment strategy as it preserves your investment. You can do a lot worse by buying a particular investment at the wrong time and you end up with an asset that is losing value!

    I would just suggest that you pick a good savings account that has a good rate of interest and a bank that won’t go under.

    Ooooppppps I’m sorry, I think there all going to go under. :-)

  10. Conor

    Getting Irish people to follow a prudet investment strategy is much easier said than done. We simply have an obsession with owning a plot of land with a house thrown on top of it. Clear stupidity in some people’s eyes, but it is arguably a matter of history. Securing one’s plot of land has been a mainstay of national and individual pride sice the days of the Land League back in the 1870s.

    The issue of homeownership has come up recently in my own family. I myself am happy to rent for the time being; ivesting my deposit and any other savings until the time is right to purchase a home (probably around 2015 or so the way things are going). Nevertheless, my sister is getting itchy feet and wants to stop renting and get on the property ladder, and the rest of my family couldn’t be more supportive of her curious decision. They are all well-read, educated, generally sensible people, but any talk of property and all intelligence seems to go out the window.

    My family are fully-aware that property prices will have fallen by 5% by the end of the year and will continue to do so for the forseable future. For some reason they cannot see the logic in holding out and buying in the future when prices have stabilised. No, my sister is fully prepared to shell out approximately €500,000 on an asset which will be worth a mere €300,000 in ten years time. Admittedly, much of this negative equity would be spent on rental costs, but like Paddy mentioned above, surely keeping your deposit and other savings as liquid assets in the form of savings and investments that have the potential to increase in value is better than frittering away your hard-earned cash in the form of negative equity.

    But no, she is still adamant that buying is the best decision! She and thousands of other young Irish people are quite happy to throw their money into the air! They view rental as unsecure, the domain of students, young professionals but certainly ot something for families to enter into. Are inflated property values not even more unsecure. This contrasts greatly with the situation in cotinental Europe where in German for example, 70% of households are in the rental market with savings for the future put into diverse investment portfolios, rather than putting all of their eggs in the property basket.

    It seems callous to say this, but Irish people get what they deserve in the coming years. History provides us lessons to learn from, and not to multiply its mistakes to the nth degree! A portfolio leveraged 100% on one property is not a sensible one. It is too late for lessons to be learned. Those of you who can sell up now, get a job in the reposession industry, or better still – leave!

  11. VincentH

    Irish people are not idiots. The reason for the issues with property is based on the reality that renting is a mugs game. WHY, due to the lack of any reasonable legal protection and an foolish belief on the part of the landlord that rents should be a fixed % of the notional value of the property.

  12. laura

    I don’t think you need worry David, most people who could already afford to buy already have, and most of those who don’t are either a) priced out of the “morket” entirely or b) unable to put up sufficient deposit to get a mortgage now that 100% is out the window.

    But you are 100% correct in saying that the property industry have hijacked the economic debate. Of course they have, and the scary thing is what their paymasters will extract from the politicians they’ve been “digging out” in the past as recompense for past bribes….sorry…..”loans.”

  13. Vandala

    Rent control. Is the idea so unfeasible?

  14. Lonely Expat

    Being a neutral observer, I am seeing a huge range of views on the subject of where property prices may be heading and how fast they may get there. These range from optimistic (vested interest) to pessimistic (David MW?) with a fair smattering of in-betweens. We are talking about property values here – real assets for which real cash changes hands. Accurate data (rather than “qualified views”) should not be too dificult obtain if the owners of this information (banks / agents / Daft) were forced to make it publicly available. I personally would be very reluctant to invest in the current market without solid information on:

    1) Reliable data on mortgage applications, adjustments and refusals (banks)
    2) Average prices / square metre (historical and current) by location and type of accomodation (banks)
    3) Current rate of price drops and withdrawals from market per property / location (Daft)

    Finally, I have seen that price tags seem to be moving from “in excess of” to “in region of”. Does this imply “am prepared to accept more”, “am prepared for hard negotiations” or, perhaps on a more realistic note “am prepared to accept much less – just get me the hell out of this predicament”. How many retailers get away with “in the region of” labels?

    PS: Just to add to the general confusion, individual properties are simultaneously being offered at different prices – check out Daft, 22 Carlisle Street, South Dublin. This is “in the region of” 800k or 900k, depending on which agent you want to believe.

  15. joe martin

    Lonely expat:
    Im also seeing “reduced to sell” on the FOR SALE signs !! I’ve never seen that chestnut before !!

  16. shtove

    Nobody considering the prospect of deflation? Something has to contract when all the credit facilities are withdrawn – a bit of scrotum tightening in the snot green sea of debt.

  17. Remember also a lot of people who have bought into so called “affordable housing” in recent times may feel hard done by as prices are falling towards this “discount” level. these buyers are trapped with a council clawback if the property is re-sold in the next ten years.!

  18. Stephen

    Let’s not mix up the whole economy with the individual. *Someone* has to own every property, be it a person, a bank, an insurance company, an investment fund, or whoever. So when prices fall, *someone* takes a hit. As far as the economy is concerned, I’m not sure it matters who it is that takes the hit. No amount of cunning sale-and-leasebacks will save the economy at large, from an overvalued property market.
    The imbalances caused by the property bubble need to be worked out of the system, so even if property prices held up (e.g. no one had to sell, so no one did sell, so lower values were never crystalised), the problem needs to be solved. If property prices don’t fall much, due to huge efforts to stop them, then those same efforts will cause other prices to rise, to compensate.
    There are so many people waiting to jump into ‘distressed’ (i.e. so-called ‘cheap’) property; the central banks are doing everything they can. It seems possible that all this extra cash will cause general inflation, rather than property deflation.
    Only time will tell, mainly because the financial markets are so opaque, and they probably feel that it’s afr too important to be honest about things (Adam Smith would be weeping).

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