Those who wish to understand the current worldwide financial meltdown will find an instructive parallel in — of all places — Albania.
In 1996 the economy of Albania, recently liberated from the straitjacket of Communism, embarked on an enthusiastic wave of investment. Over the course of that year, nearly two-thirds of the population purchased shares in six new investment companies, attracted by promises of rates of return approaching 100 percent annually. The only problem was that these new companies held almost no assets. They were pyramid scams, in which early investors make money solely by persuading more people to invest. When the supply of new investors dries up, the scheme collapses, and the net effect is the massive transfer of wealth from the many at the bottom of the pyramid to the few at the top.
The Albanian government did nothing to control these scams, in part because they had swallowed the mantra about the self-regulating quality of free markets, and in part because top elected officials were themselves involved in the fraud. By late 1996, when the Albanian pyramids collapsed, the “value” of the investments totalled nearly half the gross domestic product of the country. And it was all air and nothingness. When the public realised this, riots broke out that killed nearly two thousand people, as angry investors confronted armed thugs hired by the companies.
Does any of this sound familiar?
The pundits have described our current financial collapse as a sub-prime mortgage crisis, and empirically that’s how it started. But the most generous estimate of the total worldwide value of “toxic” sub-prime mortgages is only $200 billion; that alone would not call for the titanic bailout costs that have already run into the trillions. Something much larger is at work here, and it’s called derivatives.
A derivative is a financial instrument whose value is based on that of another financial instrument. Derivatives are used as a kind of risk insurance. For example, if you have lent money and are unsure of getting it back, you can purchase a credit derivative that effectively spreads the risk of your loan: You pay someone else to share that risk with you. Sub-prime mortgages, being risky investments themselves, became the center of a huge market in credit derivatives. The theory is that the free market would accurately determine the risk involved in each loan, and thereby set a fair price on the credit derivative for the sharing of that risk. Governments should not regulate the derivatives market, the logic went, because this would distort the market’s ability to assess risk accurately.
The reality was that the derivatives market skyrocketed precisely because it was unregulated — just like the Albanian pyramid schemes. Wall Street managers, who have long known that they can get much richer by manipulating wealth than by creating it, had a field day with derivatives, because they did not have to report to anyone what they were up to. Trading in derivatives therefore became an end in itself, with little or no relation to the assets or risks on which they were based. Brokers went so far as to sell “second-derivative” instruments, which were derivatives based on derivatives. By one estimate, trading in the derivatives market in 2007 exceeded $1 quadrillion — that’s one followed by fifteen zeroes — an astonishing number, when you consider that it is 40 times the gross domestic product of the entire world for that year. And it was all air and nothingness.
The bubble burst in 2007 when the real estate market declined. Suddenly, when people defaulted on their home mortgages, the value of the house was less than the amount of the loan, and the mortgage bank was faced with a loss. So the bank called in its credit derivatives — but there was nothing there, because no regulation had ever required actual money to back up the implicit guarantees of a derivative. As with pyramids, the money going out of the scheme came entirely from the money coming in, and when that stopped, the derivatives market collapsed into a black hole whose mass, at least on paper, was many, many times that of the world’s economy.
From one point of view, the meltdown should not have had any lasting effect, because the market that collapsed had no real asset value anyway; it was all derivatives. Unfortunately, the greed of Wall Street runs deeper than that. The derivatives market, which was supposed to spread risk around and make it more manageable, actually served to concentrate risk, because the market was dominated by a few major players in New York, London, Frankfurt and Tokyo. When the crunch came, the emperors of the market — Merrill Lynch, Lehman Brothers, Bear Stearns — were found to be without clothes. Everyone, from grandmothers in Iowa to General Motors to dirt farmers in Bulgaria, had placed their savings and their trust in these invincible titans, and then they vanished. All you can see now are several thousand golden parachutes, bearing the august executives who made it all happen, settling softly onto the pampered watering holes of Aruba and the Cayman Islands.
And how, one might ask, could these executives not have seen it coming? Remember the real purpose of a pyramid scam: to transfer wealth from the bottom to the top. Since there were no reporting requirements, no one knows exactly what kind of commission the derivatives traders charged, but let’s imagine that it was just one hundredth of one percent. Taken against an annual volume of one quadrillion dollars, that’s $100 billion in commissions. Not bad for a year’s work of trading air. Awash in this kind of personal liquidity, the executives were a bit reluctant to dwell on the long-term consequences of the derivatives bubble.
It has been twelve years since the Albanian pyramid scams collapsed. The country’s economy suffered for two years before retrieving an even footing. There was no government bailout; instead, the directors of the six guilty companies were dragged screaming from their plush mansions and shot. We, of course, are a much more civilized society, right?
Birmingham, Alabama, October 2008
[ Return to Travelogues & Commentary index ]
Copyright © 2008 T. Mark James
This article first
appeared in the Gulf
News,
Waiheke Island, New Zealand, on 23 October 2008.