Derivatives trading. A bigger threat than global warming?

I’m a layman in these matters, my knowledge is not huge but there are some very concerning things going on in the world of finance so I think it’s worth putting in my two pence worth.

The events of the past two to three years in the World’s financial community have touched us all in some way or other. Savers interest rates have crashed, the UK’s pension systems are in turmoil. Final salary pensions are all but gone and a funded pension of any sort is further away than ever for large swathes of the UK population.

HBOS and RBS are the most obvious signs of the problems in the UK. I contend that these spectacular banking failures are only the tip of a large and toxic iceberg which has yet to be revealed.

To illustrate the point let us look at banking.

Back in the late sixties applying for a mortgage was a much more rigorous process than it has been lately.
After an interview with the bank manager, agreed over a Senior Service or a Capstan from his cigarette box a mortgage of £10,000 would buy a nice semi or even a bungalow in the London suburbs.

Very traditional banking. A mortgage issued, well within the borrower’s ability to pay, collateral firmly based on a physical asset i.e. a house and all a good fit within good banking practice. All risks clearly understood and obvious.

In 1985 the borrower sells his bungalow, to pluck a figure out of the air for around £200,000 at the time, buys a house and I mean a house in the Isle of Skye and still has a slush fund of around £150,000 available to live on. This is an outrageous moan about the current de-population of Highland folk but it makes the point.

On the financial front I’m still not complaining. Inflation has kicked in and the whole arrangement is clear and obvious in terms of risk.

Let’s have a look at Futures Trading.

Futures Trading has clearly been around for a very long time. However the significant date is the early 1970’s when contracts on financial instruments were introduced in the United States.

This co-incided with the introduction of significant amounts of computing power and the networking of world-wide markets.

From that day to this the whole world has sent their brightest and best into the world of financial engineering.

The significant word is “securitisation”. I guess pretty early on the gurus realised that if you could parcel up packages of: let’s say mortgage debt. These securitised packages are capable of being traded. Every trade generates a charge or a commission. This introduces the notion of profit from this previously quiet backwater of owed money.

So what’s the effect of this? The sub-prime problems in the United States are now a ghastly piece of history. We are paying and will be paying for a very long time for this particular disaster. It goes way beyond that.

Look at the sub-prime mess again. These ‘assets’ were far travelled.

When the music stopped practically every civilized country was holding significant amounts of this rubbish.

Before the collapse the ‘securities’ were enthusiastically traded across the World by the brightest and the best. Why?

Well to generate commission of course, which leads to profits, which lead to bonuses. Massive bonuses which bear no relationship to risk.

It’s now clear that this was a bubble of enormous proportions, there were no assets. The promises to pay were worthless.
The commissions were still paid. No bonuses have been clawed back. The party has moved on.

Now here’s the real lesson from this debacle and it strikes me that it has not been learned. Not by Gordon Brown, not by regulators round the World.

Governments used to have control of their own money supply. This has been passed to speculators. Financial Engineers now have the absolute freedom to pump up the World’s money supply with fresh air on the one hand and on the other to draw down fabulous amounts of value for their own profit, bonus and commissions.

‘Quantitative Easing’ in the UK is a rather sad illustration of the old-fashioned thinking of our current Chancellor. All these billions of pounds have been sucked in by the speculators, securitised and are now on the high speed trading merry go round to generate more fresh-air profits. It was always a nod back to a former Age when the UK had control of its own money supply.

Money does not come out of a phone.

Millions of trades a second for no other reason than to generate commission, gargantuan bonuses paid. All of this is inexorably weakening the World’s finances.

There will be another crash, don’t know when. It may be far in the future but when it comes it will make the events of the last few years look like a walk in the park!

In fact I am convinced that rampant, unregulated financial derivatives trading could easily lead to a complete collapse in confidence in the World’s currencies with all of the devastating consequences that would cause.

Remember the old-fashioned bank manager I started with? Guess he was probably always a mythical figure but the transactions carried out with a clear appreciation of asset values and risk. Modern financial trading is all about just that. Trading, asset values and who is ultimately going to pay don’t feature in any obvious way. I am sure there are lots of derivative products around based on consumer credit both here, in the USA and elsewhere. Remember ‘maxing out your credit cards’?
That debt is still around. A lot of traders are crossing their fingers that it will be paid but will it?

Unfortunately the situation has already passed out of the control of National Governments. Hucksters with a handful of ‘phones and a few computers can wreak untold havoc on the World’s financial system. Gordon Brown may claim to be the ‘best qualified man to deal with the current situation’. I doubt that. I have a shrewd idea that he does not have much understanding of what’s happening in the financial markets and if he doesn’t know God Help the rest of us!