If the world economy were an ocean, finance would be the currents and swells shifting resources from one shore to another. Sometimes the flows are steady, the surface looks millpond smooth ... but then, out of the blue, things start to get rough ...
A capitalist economy is a complex system involving many interdependent markets. To recap from the last thread's example: a car producer sells its products in the car market, and needs to buy inputs – raw materials, energy, labour – in lots of other markets.
But as a producer needs to buy inputs before making and selling its product, it often needs to raise finance from investors. Later, it will pay them back out of its profits ... if it makes any.
Traditionally, companies can raise finance capital in two ways: by selling shares in the ownership of their company; or by borrowing. Markets trading shares are called equity markets. Markets trading loans and bonds, forms of borrowing, are called debt markets. In today's very complex financial markets the distinction is not always quite so clear, but we can use it as a handy starting point.
Equity markets
Equity markets trade shares in the ownership of companies. Company Law sets out different ownership structures for companies:
• In a partnership, the partners share responsibility for the company’s decisions. They share the profits; and also any losses and debts. Law firms, accountancy firms, architect or GP practices, are some kinds of companies which are commonly structured as partnerships.
• A limited company is a special legal structure to limit the liabilities of the company’s owners. Shareholders have a share in any profits; but if the company goes bust, they are only liable for debts and losses up to the value of their shares. NB. a partnership may be a limited company too: in English law, this structure is called a ‘Limited Liability Partnership’ (LLP).
• A public limited company (PLC) or listed company is a limited company whose shares are traded on an established stock market – e.g., the London or New York stock exchanges, the Paris Bourse. Anyone can buy and sell these companies’ shares through a stock broker. Only companies over a certain size can be listed, and they have to publish regular accounts. The first ever PLC was the Dutch East India Company (or: Vereenigde Oost-Indische Compagnie, VOC). Its shares were traded on the Amsterdam exchange from 1602.
Stock exchanges, where the shares of big PLCs are traded, are just the most visible face of the equity market. Many shares are traded in private deals between individuals and companies.
Private Equity funds are investors who specialise in doing equity deals away from the listed markets. The shareholders of a limited company are its legal owners. But a big corporation has millions of shares, and so many thousands of ‘owners’. Only shareholders who own a sizeable percentage of the shares have any real control over the company’s actions. Often, the managers or executives of the company, who are technically employees, have much of the real power.
Shareholders are entitled to a share in the profits of the company. But if the company is going to keep on growing and competing with rivals, it will need to re-invest some of its profits back in the business. Managers and owners decide how much to invest in future production. What is left is then distributed amongst shareholders: this payment is called a dividend.
Big companies do not always pay out dividends, but shareholders can still make a profit by selling their shares – if the share price goes up.
Corporations
The word corporation comes from the Latin corpus , a body.
In Roman and medieval law, States recognised certain institutions or associations as legal persons – ‘bodies’ with legal rights and responsibilities of their own. For example, the Corporation of London, the governing body of the City of London, was granted its first royal charter in 1067. Many Lord Mayors and other individuals have been born and died since, but the corporation goes on with its own legal life and history.
Some say that the oldest business corporation was Sweden’s Stora Kopparberg mining corporation, chartered in 1347 and finally closed in 1992. Two important corporations in early capitalist history were the British and Dutch East India Companies (1600 and 1602), licensed by the British and Dutch states as monopolies to exploit the trade and colonisation of India.
Corporate law differs around the world, but everywhere it creates some form of legal separation between the corporation and the individuals who own and manage it. Corporations are usually Limited Liability companies, which protects individual owners from responsibility for the company’s debts. But corporate law often goes further still, e.g., to protect individuals from legal responsibility for the company's criminal
actions.
Debt markets
There are two main ways in which companies can borrow money: getting loans from banks; or issuing bonds.
A corporate bank loan is basically the same as if an ordinary person gets a loan, only bigger. Any loan involves a contract. The borrower and the lender agree:
• the term of the loan, or when it must be paid back (e.g., 3 months, or 3 years);
• the interest rate (e.g., 5%, paid each year);
• any ‘collateral’ or ‘security’ which the borrower will forfeit if doesn’t pay back the loan (e.g., in a mortgage loan, the security is the house).
If the borrower doesn’t pay back the loan, this is called defaulting. Banks make loans to companies, individuals, governments, and to other banks. One important financial market is the interbank loan market, where banks lend each other cash to balance their books in the short run. If banks stop trusting each other, this may be one of the first markets to collapse.
A bond is to a loan what a publicly listed share is to private equity. Basically, we can think of a bond as a tradeable IOU, a loan contract that can be bought and sold by anybody in the bond markets. Originally, a bond was a piece of paper with something written on it like ‘I promise to pay you £100 on 1 January 2100’. When the date comes round, known as the maturity date, whoever owns the piece of paper can demand the money.
Bonds may last for long terms, often 10 or 20 years. Short term bonds, which only last a year or two, are usually called ‘notes’ rather than bonds. Like all loans, bonds have an interest rate, also called a coupon. Fixed rate bonds have a standard set coupon, e.g., 5% per year. Variable rate bonds, like variable rate mortgages, have a coupon which moves against a reference interest rate. For example, a bond might be set at 2% over ‘Libor’, which is the standard London inter-bank lending rate.
The bond’s issuer is the borrower that uses it to raise money. The bond’s buyers are the investors who lend money to the issuer.
The bond’s arranger is a bank (or consortium of banks) that prices, markets, and often underwrites it (i.e., buys any bonds itself that it can’t sell into the market). In terms of issuers, the three main kinds of bonds are-
Sovereign Bonds, issued by Governments; Corporate Bonds, issued by large companies; and Financial Bonds, issued by banks (and other financial institutions) themselves.
A very brief history of banking and debt markets
There are 4000 year old records of loans from Babylonian temples to merchants. Not only were money lenders based in temples, but the temple authorities often ran the business. Modern banking is usually traced back to medieval Italy – the word banca refers to the bench on which moneylenders would conduct business. The House of Medici opened in 1397. Italy’s Banca Monte Paschei dei Siena, founded 1472, is still going.
Medieval, like contemporary, banks could make money both from lending – to states, merchants, and the rich – and from taking deposits.
Banks offered safe storage of gold, silver, and other valuables. The basic idea is called deposit banking: savers deposit money in the bank; the bank can lend out the same money to borrowers, and charge interest. So long as too many savers don’t come to withdraw their money at once (a ‘bank run’), the bank can ‘cover’ loans with deposits. Early bank notes were simply receipts (‘letters of credit’) for the metal coins a saver deposited in the bank. As banking networks spread across Europe, a merchant could use the same receipt to withdraw coins from different branches of a banking house, e.g., in Antwerp or Venice.
From the beginning, European debt markets were associated with the financing of war. Fortunes were made by the Venetian bankers who funded the crusades. The invention of bonds, or tradeable debt securities, goes back to the Dutch war of independence (from Spain) in the 16th century. The rebel Dutch state issued perhaps the first sovereign (i.e., government) bonds. The Netherlands was the leading capitalist economy of the time. Other Dutch innovations included the foundation of the Bank of Amsterdam in 1609, possibly the world’s first central bank, guaranteed by the City government. The Bank of Amsterdam began to expand on the old deposit banking model by (secretly, at first) issuing overdrafts: letting depositors take out bank notes (receipts) for more than they had deposited. The Dutch East India Company was the world’s first issuer of both listed shares and corporate bonds.
By the 18th century England had taken over the role of leading capitalist state. The Bank of England was established in 1694, copying the Amsterdam model. It was set up by Scottish merchant William Patterson in a deal with the government, which used it for military financing. The first loan, for £1.2 million at 8% per annum, funded the re-building of the Royal Navy. England also ledthe way in advancing bond ‘technology’, issuing large standard issue ‘Treasury Bonds’ that were widely traded in the coffee shops of London. From 1694 on, the British state has been continually in debt, largely from war financing – its debt first rose to over 100% of the country’s annual economic production (GDP) in the 1750s, and stayed there for more than 100 years.
The use of paper money took off in the 18th century. In 1844 the Bank of England was given an effective state monopoly (in London) on printing bank notes. Before then, any bank could issue as much ‘money’ as it wanted – it was up to customers to decide if they trusted its reliability or not. New Bank of England notes had to be backed 100% by reserves either of gold or of government bonds. I.e., the Bank had to keep the same value of either gold or Treasury bonds in its vaults to match the paper money it issued. The Bank became the ‘lender of last resort’ to commercial banks: if they got into trouble, the central bank would lend them the money to cover any ‘bank run’. Similar ‘gold standard’ models were adopted around the world in the late 19th century. States either held their own gold and silver reserves, or pegged their currencies (fixed their exchange rate, and so limited the printing of new money) to Sterling or the US dollar. This system remained generally intact until the 1929 crash.
By the end of World War II the United States had clearly taken over from the UK as biggest capitalist power. The UK government was crippled by its war debts: 250% of GDP in 1945. In the Bretton Woods agreement of 1944, a new world monetary order was agreed which fixed most world currencies to the US Dollar. US Treasury Bonds became the ultimate ‘safe’ asset against which risks and interest rates on all other debt was measured. And the World Bank and IMF, based in New York, were set up as ‘lenders of last resort’ – and financial policemen – for the world economy. In 1971, the US left the Bretton Woods agreement, unable any longer to support the world financial system, as its own debts — again, largely war debts, from Vietnam — massed up.
In the 1970s and 1980s, the US and other ‘advanced’ capitalist countries followed neoliberal policies and ‘deregulated’ their financial markets, allowing banks and brokers to develop whole new types of finance involving derivatives and securitisation. As manufacturing industry increasingly switched to the ‘developing world’ (topic of next thread), the finance ‘industry’ became the leading edge of capitalism in the US and UK.
For much more on the history of debt, see: David Graeber – Debt, the first 5000 years
A snapshot of world financial markets
The table below shows the amounts of financial assets in existence worldwide, and how they are broken down into different kinds of securities: equities, bonds and loans. All figures are in trillions of US dollars (a trillion = a million million).
Source: McKinsey Global Institute NB: the 2012 data are for the end of Quarter 2 (middle of year) rather than year end. We will look at securitised loans at the end of this thread.
The table shows how world financial markets grew massively in the 1990s and 2000s. This was the neoliberal boom period of ‘financialisation’. The markets shrank in the 2008 crash, but have since reached new record levels, although growth is not as fast as before. Both equity and debt markets shared in the boom. Government and private debt both boomed, but especially non-government debt. In earlier times, debt markets were mainly made up of government bonds, and only the very biggest companies issued bonds. Now it is common for corporates, and especially banks and other financial institutions, to borrow heavily on the bond markets.
Source: McKinsey Global
The next table breaks down the figures geographically for the years either side of the crisis.
Source:McKinsey
Note how the most ‘developed’ countries are far more ‘financialised’. China in fact produces around 22% of the world’s GDP, but only owned 12% of financial assets in 2008. The next table gives a further snapshot of financialisation in different parts of the world. The figures show total financial assets for each region as a proportion of GDP, for the middle of 2012.
Meet the Investors
Who are these capitalists? Shareholders are, technically, the owners of companies and their capital. Bond investors and lenders (including
bank depositors, who ‘lend’ to banks) are the owners of ‘financial capital’, and get their share of the profits in the form of interest. It is not so easy to get figures on capital ownership. The sums above are estimates of the size of global investment funds, from a report by the City of London’s lobbying group ‘TheCityUK’ published in November 2012.
It's hard to know if those numbers are at all accurate. Note that they don’t match up with the global financial assets figures above – but then they miss out other major investors, which include banks and corporations. ‘Private wealth’ means rich individuals and families. Note that they are still the single biggest group of investors. However, ‘Institutional Investors’, taken together, control more capital than the idle rich. These are institutions that manage the pensions, savings, and insurance premia of the world’s middle classes and better off workers. As with share ownership, we should distinguish legal ownership from actual control. Technically, these assets may be owned by individual savers; in practice, they are controlled by investment executives, called fund managers.. These companies decide where to invest the funds they manage, and take a percentage of the profits.
Some of these funds are bigger than countries. Here are the top 15 in the ‘Pensions & Investment’ 500 (as of December 2012). The amounts are their ‘assets under management’ (AuM):
A rising group of investors in recent years are the Sovereign Wealth Funds. These are investment funds set up by states: often ‘emerging market’ governments such as the ‘BRIC’ nations (Brazil, Russia, India and China) or the oil-rich gulf dictatorships, which have large amounts of capital to invest on international markets. (See next thread [4] for more on this point.)
Buy, sell...and in the middle
In between borrowers and investors come a host of middlemen, including :
• Stockbrokers – middlemen who buy and sell shares for their investor clients
• Traders – who buy and sell bonds and other securities for clients
• Underwriters – bankers who buy securities from their clients when they are first issued, then sell them on to the market
• Insurers – e.g., offer insurance in case investments default
• Structurers – arrange complex securitisation bonds (see below)
• Derivatives dealers – see below
• Lawyers – lots of them
• Analysts – analyse securities to decide how risky they are, and what they should be worth
... and many more.
Arranging tricky financial deals is one of the most profitable parts of banking. The fees for arranging deals are usually a tight secret. Traditionally, these roles were filled by specialist banks called investment banks. In 1933, following the financial crash, the US State passed the ‘Glass-Steagal’ act to regulate and keep investment banking divisions separated from traditional deposit-based or commercial banking. This law was repealed in 1999, and the same multinational banks now control both ‘commercial’ and ‘investment’ banking.
Risk and return
The basic principle of pricing a security is: the riskier it is, the more profit or return (i.e., interest) it should pay. Traditionally, US government bonds, called Treasuries, have been considered the ultimate ‘safe haven’, and so paid the lowest interest rates. The assumption is that the US government will never go bust, and will always honour its debts. The coupon (interest rate) on US Treasuries is used as a benchmark for pricing other debt. The spread of a bond is the difference between its interest rate and the rate on another bond. For example, after the failure of the G20 meeting in November 2011, the spread on Italian over German 10 year bonds went to 459 basis points (4.59%, one basis point = 0.01%). That means: markets demanded an extra 4.59% return to buy Italian instead of German bonds.
Bond pricing (NB: slightly more technical)
When bonds are first issued they are usually sold, in large multiples, with a face value of 100 cents each. For example, if a fund wants to invest $1 million in new bonds issued by General Motors, it would buy one million bonds each worth 100 cents. Suppose the coupon rate is 4%. Then each bond pays an annual interest of 4% of 100c = 4c.
Now imagine that something happens to make that bond seem more risky: e.g., a dangerous design flaw is discovered in recent GM cars, and thousands have to be recalled. Potential new buyers of GM bonds will now demand a higher return to match the increased risk that GM might go bust and not pay back its debts.
The way this works is that GM bonds start to sell at a discount: e.g., existing holders of the bond who bought them at 100c each now can only sell them for 80c. The bonds still pay 4c interest on their face value every year, so a new buyer will get the same payback for a lower initial investment.
Bond traders say that the yield, or return relative to price, has gone up to 4c/80c= 5%.
Higher risk, higher return.
Italy’s yield in that example above was 6.66%. Of course, if the bond actually defaults, the investor gets nothing at all.
Rating agencies
The infamous rating agencies – the big three are Moody’s, Standard & Poors, and Fitch – are companies that specialise in assessing the risk of debt securities. They publish a rating from AAA (the highest) down to D (default) depending on how likely they believe a bond is to default. For many kinds of bond, they are paid on commission by the borrower issuing the bond. So, clearly, they are completely impartial.
Many funds base their investment decisions on rating agency reports. Market prices are often guided by ratings. Also, pension and some other big funds are restricted by regulation to only buy investment grade bonds, meaning bonds with ratings of BBB and over. This gives the rating agencies considerable power: for example, if they decide to ‘junk’ a country’s bonds, give them a rating below investment grade, millions in pension fund money can quickly pull out. However, remember that rating agencies only have this power because they are given it by the markets – by investors and other institutions who listen to their advice.
Financialisation and the New Financial Markets
The figures we looked at above started to give a snapshot of the wave of Financialisation in recent decades: financial markets grew rapidly, and rather more rapidly than the ‘underlying’ production of physica commodities. I will dig deeper into the causes of this trend in the next three threads.
As well as the growth of finance overall, Financialisation has also involved the creation of new kinds of financial markets based on securitisation and derivatives.
The new finance 1: securitisation
The great housing boom of the last 35 years was fuelled by a new kind of bond market. In the US, until the 1970s mortgage lending was largely done by small local lenders called the ‘Savings and Loans’ or ‘Thrifts’, the equivalent of UK building societies. This sector was deregulated in 1980 and 1981, and later many of the ‘S&L’s were hit by crisis and went bankrupt. Investment banks made this crisis into an opportunity. They bought up mortgages from the crashing S&Ls for cheap and moved into the mortgage industry.
To help things along , the loans were guaranteed by US federal government agencies with cute names (Freddie Mac, Fannie Mae, etc.). Unlike traditional mortgage lenders, investment banks didn’t have deposits that they could use to make mortgage loans. Instead they invented a new technique called mortgage backed securitisation (MBS). They borrowed money by issuing bonds secured against the expected repayments on the mortgages.
Basically, this works as follows:
• The mortgage company, with its arrangers and lawyers, sets up a kind of paper company called a ‘special purpose vehicle’ (SPV).
• The SPV issues a bond, promising to pay interest to the bond investors who buy it.
• As the mortgage borrowers pay back their mortgages over, say, the next 30 years, the company will pay the money into the SPV.
• So long as the money paid out to the bond investors is lower than the money paid in by the mortgage borrowers, the SPV is in surplus. The mortgage company keeps the difference as its profit – after paying out cuts to the banks that arranged the deal for it, the lawyers who wrote up all the complex SPV paperwork, any insurers who underwrote the deal, etc.
At first the new idea was strange to analysts and investors. The first US mortgage securitisations were strongly backed by the US government, through its federal agencies. Because of this state guarantee, they were rated AAA by the rating agencies, and so investors bought them. Over time, investors got more used to the idea and new kinds of securitisation were rolled out. Car loans and credit card loans were the next targets. Banks and lawyers, with the support and encouragement of the US authorities, lobbied for new legislation and regulations allowing for new kinds of SPV structures.
‘Shadow Banking’
Securitisation became a powerful force in reshaping financial markets: it slashed away the old deposit banking model. Banks could lend out large sums to new hordes of customers, but without needing to get in any deposits to cover its loans. In the 1990s and 2000s a new wave of ‘specialist finance companies’ got in on the act, selling credit cards and mortgages from call centres, paper companies funded entirely by securitisation. This consumer credit boom spread from the US through UK and Europe. By 2000 the global investment banks were arranging securitisation deals from Mexico to Kazakhstan. In the US, the new frontier was ‘sub-prime’: including mortgages to people with dubious credit ratings; funded by bonds sold to investors hungry for higher returns. The 2008 crisis began when investors’ faith in the sub-prime securitisation collapsed, bringing the new financial architecture crashing down.
The new finance 2: derivatives
The idea behind derivatives is not really new. The Greek philosopher Thales is said to have made a fortune on futures contracts. Predicting a great harvest, he placed orders with olive farmers for their whole autumn crop, agreeing a fixed price in advance. When the harvest came he got masses of olives cheap, and sold them on at a profit.
In general, a futures contract is an advance agreement to pay a set price for a good at a future date. When the future date comes around, if the market price for the good is higher, then the buyer of the futures contract makes a profit; if it is lower, then she loses the difference. The first standardised futures exchange began in Chicago in 1865, where farmers and traders made futures contracts for wheat harvests.
But the derivatives market really took off after the collapse of the Bretton Woods fixed currency exchange system in 1971. Fluctuations in international interest and exchange rates became crucial in financial deals. For example, a business looking to invest in a different country could use derivatives to fix the exchange rate it would pay in the future.
On the one hand, derivatives offer a form of insurance. If I buy a futures contract to change money next year at today’s rate, then effectively I insure against the risk that the rate goes up and I have to pay more than the current price. However, I give up the chance to save money if the rate actually goes down. This use of derivatives is called hedging.
On the other hand, derivatives can be seen as a form of gambling, or speculation. The other party in the currency futures contract may gamble that the rate will go down, and so make them a profit.
Derivatives markets look even more like gambling when neither of the parties has any involvement in the actual good (wheat, currency) except the hope of a speculative gain. Two parties could make a contract just because they are betting different ways about what will happen to a reference asset – whether it’s an interest rate, a currency, the weather, or the chance of someone else paying their mortgage!
An option is a contract that gives a party the choice to buy an asset at a set price in the future – or not to buy. Other types of derivatives include swaps, swaptions, and more. The biggest class of derivatives contracts today are interest rate derivatives. These are used to hedge against the risk of losing out on investments which pay a return linked to a major interest rate.
Securitisation + derivatives
As the securitisation market took off, investment bankers brought the two ideas together to invent credit derivatives. Credit default swaps (CDS) and Credit Default Obligations (CDOs) are insurance contracts – or, seen another way, gambles – about whether debts will default or not. There is now a major market in CDS contracts on sovereign bonds. CDS agreements also became routinely written in to mortgage securitisation deals, helping investors reduce their risk by hedging against defaults. A scandal broke, though, when it emerged that investment bank Goldman Sachs had used CDS deals to gamble that sub-prime bonds it had issued itself were going to explode – the financial markets equivalent of match fixing. Complex CDO contracts involving bets on packages of mortgage and other debt became another way to expand the securitisation industry. They spread the ‘exposure’ to risk on sub-prime mortgages and other debts to wider ranges of investors. CDO investors never actually had to buy any mortgages or bonds, just bet about what would happen to debts other people were buying. Investments in these deals are usually confidential, and the sums complex. Whole new levels of complexity were reached with ‘CDOs- quared’, and even ‘CDOs-cubed’ – bets about bets about bets on debt defaults. The bankers and their fans saw these new markets as the cutting edge of ‘financial innovation’, unleashing more capital and ever faster growth. They helped financial markets expand rapidly – but also become more volatile, uncertain and unknown. With so many investors around the world potentially involved in betting on a mortgage in Wisconsin, in complex and often secret ways, who will be in trouble if it goes bad? What knock on effects will that have on other investors? Can anyone keep track?