Credit ratings: wealth transfer mechanism from taxpayers to private corporations

London riots provide a perfect attention diversion, or rather a smokescreen, of financial looting of the taxpayers currently implemented by the financial industry that goes largely unnoticed. As the first article on this blog, "The largest heist in history", showed the financial system was turned into a giant global pyramid scheme. Nearly three years ago, in the fall of 2008, it was obvious that "Unless and until the governments identify, isolate and write off toxic instruments held by financial institutions every pound put into “rescue” is very likely to end up being good money thrown after bad."

The current financial system has been operated as a giant global pyramid scheme (where lending with loan to deposit ratio greater than 100% is a pyramid mechanism) for at least last 15 - 20 years. It assures that the liquidity shortage is a systemic feature of the financial system. The excessive debt is not at the heart of the current crisis. The politicians and the "eminent" financial pundits that repeat this constantly to justify the public spending cuts (which quite often can be a very good idea as living beyond the means is disastrous) show the lack of competence on a massive scale. In the current crisis the debt is a manifestation of something far more lethal: too high money multiplier. No wonder that with such leadership the financial situation of the western world is going from bad to worse and whilst politicians are talking about solving the problems they keep creating new ones. The exception in the West is the German Chancellor Ms Angela Merkel. She appears to understand what it is all about and is very skilfully navigating for the benefit of Germany amongst her peers who are clueless.

All the money pumped into the system by the governments, since September 2008, in form of bail-outs and quantitative easing was wasted (as predicted). Basically it was used to prop up the financial industry itself - paying massive amounts for lavish offices, salaries and bonuses - whilst the rest of the economy kept on struggling. But as it was obvious over two and half ago years the financial industry keeps returning for more of taxpayers money.

The first ongoing form of financial looting is the bailouts of countries like Greece. The private banks that took on the risk themselves when they lent money now expect the taxpayers to underwrite the risk that they took. It is a perversion, an absolute distortion of the principles of free market economy which made the western world so successful for most part of 20th century despite two disastrous world wars and indeed social tensions. It is a version of a communism for the rich where the profits go to private coffers whilst the losses are underwritten by the taxpayers. It is a mechanism of funnelling taxpayers money to private pockets.

The second ongoing form of financial looting that appears to be gathering pace now is the use of credit ratings. It is quite crude and primitive. But, boy, it works.

For many years credit rating agencies have been assigning ratings both to private corporations debt and state sovereign debt. If it was just a matter of opinion it would not matter. Anyone, including the author of this blog, is entitled to his/her opinion. However credit ratings are a part of the fabric of the financial system. They dynamically determine the costs of borrowing: what a debtor has to pay to the creditor. The higher the credit rating the lower the costs of debt and vice versa. It has been clear that for some years the credit ratings of sovereign debt was, using the same standards based on historical statistical review of default occurrence, too low compared to credit ratings to the private corporations debt. For example the world has seen no default of AAA rated countries whilst many AAA-rated financial products turned out to be lethally toxic (and it was manifestly clear they were toxic at the time they were assigned AAA). With the downgrade of the US sovereign debt from AAA and the prospects of downgrading other countries', also the prospects of downgrading cities and local governments, this trend of underrating countries' debt in comparison with the private debt looks more prevalent.

The fact that, based on the same methodology, countries are underrated in comparison to private corporations is not just a matter of opinion as President Obama seemed to naively suggest putting a brave face over a big problem. It means the states (countries, taxpayers) pay more money for servicing their debt than if they were private corporations in the same circumstances. In the financial markets of global capital allocation the effect is profound. This asymmetry of the costs of debt constitutes a global wealth transfer mechanism from states (countries, taxpayers) to the private corporations. It is not an ideological opinion or a matter of political ideology but a financial fact. This does not imply whether it is morally right or wrong which is for each reader to decide (or even not decide at all). It is the way the financial industry works.

This wealth transfer mechanism of underrating the sovereign debt in comparison to private corporation debt, is basically a bailout by stealth provided by the taxpayers to the financial industry. It is yet another method that the financial industry is implementing to extract money from the taxpayers. It is not a conspiracy: simply it makes good business sense for the financial industry, whilst making politicians' financial competence look rather questionable. However due to the pyramid nature of the financial system this will also not be enough. Sooner rather than later money will end up in private hands as a way of wealth transfer. It will prolong the crisis, make the pyramid bigger and impoverish the countries and the societies. More austerity. And it will make the final implosion of the financial system even more spectacular than what you can observe with the LHC in CERN.

City thieving reached Inner City

It is impossible not to reflect that the kind of social breakdown that made streets of Britain look like the streets of Bagdad immediately after 2003 fall of Saddam indicates that City greed and thieving practices reached the inner city.

Bankers are got away with their crimes of stealing money from the taxpayers by organising a massive global pyramid scheme. Moreover they were rewarded for they with hefty benefits and bonuses. To the rioting yobs it looks as if they were given handout bags with trainers and mobile phone by the police when they were leaving looted shops.

What compounded the effect is that a lot of MP's were helping themselves with expenses. They got away with it. "It was a muddle not a fiddle" for most of them to quote a classic phrase. For yobs the MP's are thieves who were allowed to get away with thieving. The mainstream press, the beacon of elite and status in the society, were generating stories (therefore big money) through illegal means (phone and e-mail hacking). The got away with it. The police, a very senior one, was helping themselves by taking bribes from journalists for breaking the law (disclosing confidential information). They got away with it. And so on.

A very few yobs are able to express these so clearly (but one or two suggested just that when questioned by the journalists). But they have perception that those in authority - captains of the financial world, politicians, social elite (like journalists), the police - are criminals. So what they are doing are simply joining them. As they are yobs they are not committing en masse white collar crimes through insider dealings or giving dodgy credit ratings, but, in line with their social station in much more unsightly way, looting and causing mayhem. As it seems this is less dangerous than white collar crimes: since it is immediately visible it is dealt with instantly. Whilst the white collar crimes have a very long term eroding effect. The effects of which we see on the streets of Britain now.

But the outcome is predictable. The yobs will be punished (quite rightly) with harsh sentences whilst financial criminals will be rewarded with even more bonuses. And the social breakdown and moral destruction will continue. You may ask yourself where it all ends.

PS. Nobody should be in any doubt that this article excuses the rioters and yobs. It does not. They are criminals. However it is a reflection that whilst the government is rightly very quick to condemn and fight unsightly physical violence and robbery of the inner cities, it is nurturing the financial thuggery of the City. Basically financial yobs hold the government by the throat.

The largest heist in history continues

Rather than writing a commentary upon the current events on the financial markets, why not re-read the analysis that is nearly three years old: "The largest heist in history". In particular:

"Governments became the ultimate customers of pyramid purveyors with the hope that when they offer their custom it would somehow stop the giant pyramid scheme from collapsing. This is extremely naive and very dangerous. The incredibly fast growth to infinity of pyramid schemes, which is only accelerating, will ensure that the government will not stand a chance to sustain it, unless this massive pyramid scheme is brought to a halt and liquidated. But there is no sign of governments contemplating doing that yet.

If governments do not liquidate the global pyramid scheme, the money they injected will be, in time, converted into toxic instruments (eg securities) and cashed in by organisers and privileged customers of these schemes (or in the case of Albania, gangsters and their customer friends). As the amount injected is around 200 times less than the notional value of toxic instruments, the economy will not even see a difference. It will be a step back to September 2008, only now with trillions of dollars of taxpayers' money spent to sustain the pyramid scheme. It will be merely throwing good money after bad. But can governments afford to come up again with the same amount money and do it 200 times over or more? This is based on a very optimistic assumption that the notional value of toxic instruments is not increasing. If governments take the route of continuing to inject money, they will make taxpayers dependant on the financial system in the same way that criminal loan sharks control their customers—their debt is ever increasing and customers keep on paying forever as much as it is possible to extract from them.

In a normal free market economy a business that fails should be allowed to collapse. If a business is a giant pyramid scheme, like the current financial system, it must be allowed to collapse and its executives and operators should face prosecution. After all running pyramid schemes is illegal. Letting the banks collapse would have been a far more commercially sound solution than the current approach, provided the governments would have secured and guaranteed socially vital interests directly. For example, individual deposits would be guaranteed if a bank collapsed. Deposit accounts records, along with mortgage and genuine business accounts, would be moved to a specially created agency of the Bank of England which would honour them with government help. If a pension fund collapsed due to a bank collapse, individual pensioners would continue receiving their unchanged pensions from the social security system. This would guarantee social stability and a normal flow of cash into the economy.

The hard part would be to liquidate financial institutions while sifting through their toxic waste and to distinguish genuine non-toxic instruments and the results of pyramid scheme operation. Deposits, mortgages and business accounts are clearly non-toxic in principle. However, in the modern banking they were mixed with potentially toxic assets. This would be a gargantuan task.

(...)

Unless and until the governments identify, isolate and write off toxic instruments held by financial institutions every pound put into "rescue" is very likely to end up being good money thrown after bad. (The governments, as ultimate customers of the global pyramid scheme, are supplying the pyramid purveyors and beneficiaries with tax payers' cash and the largest heist in history continues.) Alongside the liquidation process, but after the toxic waste has been isolated and fenced off in failed financial institutions, governments must launch a fiscal stimulus package and go after the pyramid purveyors and beneficiaries to recover any cash and assets from them and bring them to justice. As the financial pyramid scheme is global, any action—including the recovery cash and assets—must be global, too. It is intriguing that banks in traditional offshore financial centres like Belize, US Virgin Islands, Bermuda, do not appear to suffer from liquidity problems. They do not require rescue packages even though a lot of them are subsidiaries of much larger banks which are affected by the current crisis."

Hence what is happening now, considering the way governments and organisations such IMF acted, was obvious that it was going to happen: "The largest heist in history" was published by the House of Commons Treasury Committee. No benefit of hindsight whatsoever.

Irrational exuberance: two double whammies of the US debt limit increase

It is a rather unorthodox way of solving debt problems by taking on yet more debt. It is even more unorthodox if the servicing of the existing debts is impossible without taking such additional debt. This is a classic example of a downward debt spiral: sliding into bankruptcy. Yet this is exactly what the US, as well as Britain and many countries in the Eurozone are doing.

What the solution is for the US now, the debt limit increase of another $2.1 trillion on top of the existing $14.3 trillion, will come back later to haunt the world markets: the US will have to continue to borrow to meet their financial obligations. Unless and until the US produces a balanced budget, the problem will keep growing. And they better do it soon as such balance has to be sustained on average through ups and downs of the economic cycles in a long term. This, in fact, was a golden rule that Gordon Brown preached but was never able to put it in practice. US talk of a $2 trillion (or even $4 trillion) debt reduction over 10 years is farcical at best.

Rating agencies, by the nature of their business and, more importantly, their conduct create a lot of uncertainties in the markets. The credit rating is not just a figure that became popular recently. It is typically part of any creditor-debtor agreement on the financial markets. The lower the credit rating, the greater the interest rate that the debtor has to pay to cover the costs of the additional risk. Whilst it seems to make logical sense, such methodology is a source of instability.

If a debtor is less likely than before to satisfy the creditors then its credit rating has to be decreased. Consequently the interest payments on debt have to go up. But with the increased interest payments the debtor is even less likely to satisfy its obligations. Hence another rating downgrade is very likely. And so on.

The credit rating agencies would only have a stabilising effect on the markets if countries in debt had the scope to readjust their finances in order to prevent the downgrades. And they act as if they have such scope. The credit rating agencies methodology and practice is a typical recipe for a downward debt spiral.

Moreover the credit rating agencies credibility has not been enhanced by a rather inadequate (to put it mildly) assessment of many financial instruments in the run-up to the credit crunch of 2007 - 2008. The fact that the agencies did not come clean on what went wrong then should also be a point of reflection.

The US debt is a different kettle of fish to all other financial papers due to its value, and the fact that two-thirds of world reserves are held in US dollars. A downgrade of the US debt will have grave effects on the world markets. Moreover, as many American politicians ask "why we let these guys even be in business" the US may administratively deal with the credit rating agencies; effectively dismantling the financial markets as we know them.

Hence despite the US amassing a huge debt, the agencies seem to be determined to keep AAA rating. This, of course, makes a mockery of the rating system.

An AAA rating of the US debt allows the debt papers to be traded and considered by the financial markets as good as cash. But it is not cash. It is debt and it will have to be repaid at some point. As long as US debt papers function on the financial markets as cash they are effectively printed money that fuels high inflation. For that reason in the last couple of years, we observed high inflation in commodities and other durable assets, such as real estate.

Not unexpectedly the price of gold has been reaching record levels and Swiss Frank started behaving like a commodity rather than a currency. It is becoming clear that the investors use the time to convert as much as possible of the US debt to as much as possible "real wealth". It is clear that the AAA rating of the US debt does not reflect the confidence of sophisticated financial investors. And the world at large is artificially propped up on confidence. It is yet another bubble that is going to burst.

The real effect on consumer markets is that despite very low levels of lending to businesses, very low wage inflation, very low growth, the consumer inflation is accelerating. It is a state of stagflation.

The real effect on financial markets is that the financial bubble keeps on growing. The financial bubble is not an esoteric term describing imbalances. It is a simple formula, a ratio of the liabilities that the financial institutions have or may be demanded to settle, to the means of such settlements such as cash or financial instruments which are considered as good as cash. At present, with an artificial AAA rating, the US debt appears as a mean of settling financial obligations. This has the effect of making an already huge financial bubble look smaller. It is exactly as if an ordinary person mistook the figures on his credit cards statements for his savings.

However once the market returns to its senses, i.e. that the US debt is debt not cash and may not be repaid, its entire value will have to be subtracted from the means of debt settlement AND added to the liabilities of the bubble formula. The effect of subtracting the US debt from the bottom of the bubble ratio and adding it to the top will be the first part of the double whammy. The scale of the financial bubble will be seen instantly. This will have an immediate effect on any dollar denominated transactions and capital and is very likely to lead to a huge credit crunch.

But unlike the credit crunch that happened in 2008 which followed a period of very low inflation, the US debt induced credit crunch will have been preceded by a period of a very high inflation. This will leave the world, or at least a huge part of it, facing huge public debt, very high prices and very limited means to pay. This is the second part of the double whammy: a formula for sliding into poverty.

This article was first published in The Arab Financial Forum Newsletter August 2011, Issue 1