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05 Capitalism

Investment

Wikipedia - Capitalism says;

Capitalism is an economic system in which the means of production are privately owned and operated for a private profit; decisions regarding supply, demand, price, distribution, and investments are made by private actors in the free market; profit is distributed to owners who invest in businesses, and wages are paid to workers employed by businesses and companies.

This definition fails to mention that owners and workers, are both people and that both may do as they will with the money they get from the businesses. Anybody can put money in the bank and have it invested in businesses or anything else. This is providing of course that there are some profits to invest, and that workers are left with some disposable income after they have paid their living expenses. It can be the case that workers are thoroughly exploited and have no disposable income or less commonly that there is no profit and management wages also lead to no disposable income. 

I think a capitalist economy should be more simply defined. The capitalist is any person that invests directly or indirectly in search of a return;
  • they may invest in a capital item and benefit from the returned products or services.
  • they may invest in a commodity and benefit from a price increase.
  • they may invest by lending money and benefit from the returned interest.
This culture of investing I would define as capitalism, all other factors aside. Capitalism is a system of economics based on monetary investment and the main mechanism facilitating this is the banks.

Anyone that can open an interest baring bank account is an investor and that means a capitalist.

There are only two concerns for the naive capitalist;
  • the risk of default, and
  • the rate of return also called the yield.
If the yield is high and the default risk small, the investor should look to increase their investment. However if the converse is true they should look to decrease it.

The size of the investment is not the prime concern, only the yield and risk of default; and this implies one of the most absurd aspects of capitalist society that - the size of a debt is not the prime concern, only the yield and risk of default!

Indeed if the interest rate and default risk are good, the lender will hope that the debt will increase, but if the interest rate and default risk are bad, the lender will hope that the debt will decrease. The extent of a bodies indebtedness is not the prime concern to the capitalist lender, only the continuation of the interest payments.

The Risk

Default risk is a major factor in banking it reflects the risk that any investment will not provide the expected return. The leading debt default risk rating agencies are Moody and Standard & Poor. Standard & Poor's Probabilities of Default are currently;
  • AAA   0.00%
  • AA     0.01%
  • A       0.04%
  • BBB   0.26%
  • BB     1.12%
  • B       6.06%
  • CCC  25.22%
However more information about rating can be found through the following link. Ratings

The Yield

If in a given period an investment has a d% chance of default then the return r% would need to be 1/(1-d%) - 1 to make the investment return neutral.

So if the rate of a zero default investment is say 2% then an investment with 5% risk of default should return 2%+1/(1-5%) -1 = 7.3%

This can be worked backwards to calculate the assumed added risk of default based on the difference in yield between two investments.

Financial Instruments

David Hume in his 1752 essay "Of money", wrote: ‘Money is not, properly speaking, one of the subjects of commerce, but only the instrument which men have agreed upon to facilitate the exchange of one commodity for another.’

Since then the term financial instrument has come to mean, any record that establishes a transferable contract that grants a desirable set of rights to the holder, over property, or over some other body.

Such records may be represented by a paper document, like a share certificate, a record on a computer or in some other form. Here are some examples;
  • A document could represent a contract that entitles the barer to collect a bushel of corn from the Rochester Corn Exchange after 18th April 1831. Such a contract could be sold for a price.
  • Fiat Money, the physical notes and coins represent a contracts that relieve the barer of the obligation to pay tax to the authorities. (When handed to the authorities of course.)
Financial instruments may be divided into equity and debt instruments;
  • equity instruments indicate a right of ownership of part of the issuing entity, while
  • debt instruments indicate a right to claim interest and the return of the principle sum of, a loan to the issuing entity. 
As many types of equity and debt instruments trade on the financial markets as human ingenuity will allow but an understanding of all of them is not necessary in order to understand economics.

Investors buy financial instruments for the yield and in the hope that they may sell them for a higher price then they bought them for.

Here are some types of financial instrument;

Equity Investments

An equity investment generally means an investment in shares  of an enterprise which entitles one to dividends. If the price of the shares changes over time one will also be subject to capital gains or losses.

Equity investors may invest in a mutual fund or other collective investment which consists of a diversity of shares in many different enterprises so as to spread the risk.

It is primarily through equity investments that very large enterprises could be pursued by those other than the wealthiest of people.

See Investopedia - The Basics Of Outstanding Shares And The Float

See Wikipedia - Equity (finance)

Debt Investments

This section is primarily  from Wikipedia - Debt (finance)

A debt investment generally means buying contracts from lenders, such that you subsequently replace the lender in the contract, receiving all interest and repayments and taking on any risk of default.

Secured or unsecured debt - A debt is secured if lenders have priority claim against the assets of the borrower should the borrower default.

Public or private debt is a general term for all debt contracts that can be bought and sold. Private debt cannot be traded in the financial markets and is a contract between specific bodies. Trade-able secured debt contracts are called securities.

A bond is a type of security issued by certain institutions such as companies and governments. A bond entitles the holder to repayment of the principal sum, plus interest. Bonds are auctioned to investors in a marketplace when an institution wishes to borrow money. Bonds have a fixed lifetime, usually a number of years; with long-term bonds, lasting over 30 years, being less common. At the end of the bond's life the money should be repaid in full. Interest may be added to the end payment, or can be paid in regular installments (known as coupons) during the life of the bond. Bonds may be traded in the bond markets, and are generally considered relatively safe investments in comparison to equity because bond holders are paid before share holders in the event of default.

A syndicated loan is a loan is a loan where a group of lenders each put forward a portion of amount loaned.

Derivatives

Derivatives are any complex investment contracts that can be traded but actually are based on other investments.

Orders Value

Anything of value is an asset and anything of negative value is a liability. There are always risks linked to possession of any asset in that it may not maintain its value or that your right to control it may not be recognised by society. Some assets have direct value to the body in control them, these are primary assets.
  • The value of a primary asset is in controlling it directly. i.e. a tin of baked beans.
  • The value of a secondary assets is that it gives a right to control a quantity of primary assets. i.e. money can buy a primary asset.
  • The value to a body of a tertiary assets is that it gives a right to control a quantity of secondary assets. i.e. bonds and treasury notes entitle you to money which in turn entitles you to primary assets.

Investments In

The Government

Some lenders invest in government debt. i.e. lend to governments by buying government bonds.

To asses the likelihood of default one should look at government accounts i.e. tax receipts and grants, government spending, interest receipts and payments etc.

Government Institutional accounts;
  • Central Government -
  • Area Government -
  • District Government -

The Enterprises

Some investors invest in enterprises.

Enterprises may receive investment by selling shares or by issuing bonds. Thus one may invest in corporate equity or corporate debt respectively.

The return on shares is normally described by the p/e, the Price Earnings ration, the share price divided by the annual dividend, this is the inverse of the return on investment.

The return on bonds is described directly as a percentage.

To asses the likelihood of default one should look at many things in the enterprise as well as the accounts.

Comment

Who has control of the enterprise? The directors who are normally answerable to the investors some how.

The director who may be the entrepreneur who set up the enterprise is responsible for paying wages and paying interest on bonds or dividends on shares from the profits of the enterprise.

In theory the best directors will be favoured by investors, who will prefer to invest in their enterprise, and also by workers who will prefer to work in their enterprise. Thus the best directed enterprises should succeed in the long term. In practice of course where people invest or work will be based on current opinion not necessarily fact. See Public Opinion

Enterprises lead to on market products or services which will benefit the economy directly.

The People

Some lenders invest in mortgage type debt.

To asses the likelihood of default one should look at interest rates, disposable income and job security.

Comment

While governments kindly try to help house buyers to borrow for their new homes. The banks facilitate the relationship between lender and borrower. The mortgage borrower is the new working class and the lender is the non-working class or new gentry.

Mortgages lead to off market services (accommodation in a house usually) which does not effect the economy directly.

The practice of securing land for payment of money in English law dates back to Anglo-Saxon England. The practice has been named variously as vadium mortuum by Thomas de Littleton and mortuum vadium by William Blackstone, and translated as dead pledge in English and mortgage in French. It was dead for two reasons, the property was forfeit or "dead" to the borrower if the loan wasn’t repaid, and the pledge itself was dead if the loan was repaid. The debt was absolute in form, and unlike a "live pledge" was not conditionally dependent on its repayment solely from raising and selling crops or livestock or simply giving the crops and livestock raised on the mortgaged land. The mortgage debt remained in effect whether or not the land could successfully produce enough income to repay the debt.

Bubble Investing

Borrowing should promote a beneficial change in the economy i.e. set up some productive thing not simply promote a competitive bubble for a limited assets.

Imagine that there is some housing. Its price is determined by auction. But then imagine that instead of paying from savings people borrow to buy those houses, the price rises and the auction goes to he who indebts himself the most.

If the money is borrowed from the central bank inflation would results as this money filters into the economy but it becomes balanced by the interest payments. Eventually the majority end up indebted to the banks for most of their lives.

The banks inflate the bubble on behalf of investors which they then profit off. Then the banks plays a delicate game of milking the cow without killing it.

BIS - The real effects of debt

Skewed Market Demand

Banks have promoted lending and borrowing primarily for housing leading to an indebted population and borrowing secured on an asset based on the assertion that its price will not drop. This has lead to the subordination of the majority of the population through their mortgages and caused over emphasis on job security creating an inflexible labour force which hampers employers.

The borrowed money has directly benefited the building trade in terms of both profit and wages and indirectly benefited those who have bought and sold property at a higher price, but has consistently promoted house price inflation as banks relaxed lending constraints and interest rates dropped. Although the bank of England warned that they would have to raise interest rates in about 2005 political pressures lead to a decrease in interest rates instead.

(Marx believed that the "working classes" would always have the maximum number of children that they could feed on their wages. Perhaps he was wrong, perhaps they will take on the maximum debt they can feed on their wages!)

The economy is skewed, by a demand created by borrowed money not by earned money. Who could borrow was determined by banks!

Skewed Employment

Why has the added (borrowed) money in the economy not caused general inflation? Primarily because of cheap products from formerly communist countries (in particular China). You may recall that the prices for many products dropped when the iron curtain fell.

What has happened is that a great deal of western manufacturing industry has closed over the last 20 years but this has gone largely unnoticed in Britain as our government sucked up the unemployed into further education paid for by students getting into debt and also enacted legislation that created additional work over and above that needed for the productive economy, in areas such as health and safety, which private firms could take on. The government did pick up some of the cost of job creation through its own expansion in social services in certain areas. The result? A far less productive labour force.

The new labourers who determine whether the real producers can produce and how they should produce have been trained in using processes rather than intelligence
in order to allow those with less intelligence to perform. The result? An inflexible system where the less able hamper the more able.

The economy is skewed by jobs created by legislation not by the market demand for products and services.

Skewed Financing

Who is lending the money? As the new Far East middle classes make fortunes with the cheap labour at their disposal many put money in the bank. The bank looks to invest that money and Western banks offer the chance for them to invest. Western banks then lend the very same money to western borrowers.

The Future

The capitalist economy is a fine balance of lending/borrowing determined by interest rates and risk of default. Looking into the future;
  • Does the borrower have the ability to continue to pay?
  • Is their debt getting larger or smaller with time?
  • Are the means of payment already established, if not is there a plan to increase the borrowers capability to pay, or are both borrower and lender simply hoping for a miracle to give the borrower the ability to pay.
Interest rates determine the demanded yield and so by central banks manipulating them they can cause the lenders to demand less or more of the borrowers on mass and so try to avoid the economy collapsing in an avalanche of defaults.

Central bank puts more "offers to lend" against the "bids to borrow" in the open market thus bringing down the rates. In practice this simply means that the central bank buys bonds, usually government bonds.

The difficulties are that;
  • As interest rates drop new borrowers appear who may default when rates rise again, effectively locking in the need for lower rates.
  • The economy supply chains become more influenced by what you can borrow rather than what you can earn.
  • All money ends up in the hands of the banks.

Losing Our Balance

The capitalist economy is a very fine balance ever determined by interest rates and risk of default.

Most money is lent to banks (To say saved in would be wrong) who look to lend out that money for the highest interest at the least risk. Lending to an enterprise is difficult because the enterprise must be properly understood and the nature of enterprises is that they are all very different. Lending for a house or car is much easier because both assets are easily understood. Thus banks have extensively lent for housing, which they believed would not go down in price. These are secured loans. They sold these loans to other banks so they stopped worrying about the risk of lending and so it all blew up.

Banks invested in debt not equity and looked for capital gains not profit.

27 June 2011 BBC - Interest rates must rise worldwide, says BIS

The Credit Crisis

It is the job of the banks to lend money. As a borrower we ask that of them, and as a saver we ask that of them also. However savers do not ask them to lend irresponsibly or to buy up irresponsibly lent loans, as they have done. A loan is irresponsible;

  • primarily if the borrower will be put under undue stress in paying it back,
  • secondarily if the security does may not cover the loan, and
  • thirdly if the loaned money does not directly increase the borrowers capacity to pay interest. 
One kind of derivative was called the Asset Backed Security (ABS) represents an investment in a collection of loans secured by assets. One type of ABS was the MBS or Mortgage Backed Security where the security was the houses for which the loans were taken out. An MBS was a bunch of mortgages of varying risk.

From MBSs a new derivative was created called a Collateralized Debt Obligation or CDO now these contracts were created so that when house owners defaulted on mortgages, the low grade CDOs would be the first hit. The high grade CDOs would be the last hit i.e. only if nearly all mortgages were defaulted on. This is called "Mezzanine financing". Many of the higher grades of CDOs were able to get AAA ratings and so they encouraged confidence.

In the distant past when only building societies made loans for mortgages there was caution because the same building society was hit when there were defaults. However the ability to turn mortgages into a tradable contract meant that loans could be sold on so the initial lenders ceased to care and so we saw such things as self certified mortgages.

Of course easy loans pushed up house prices.

Around 2007 the realisation that CDOs were stuffed full of bad mortgages lead to the crash.

The Fuel That Fed The Subprime Meltdown

Through a chain of financial instruments banks invested in subprime loans on property often lending 125% of a house value based on absolute belief in an ongoing upward trend. An inexcusable mistake.

So the result of all these high risk loans was a greater risk of default and so the CDOs were worth less than originally thought and so some banks could not meet their reserve requirements. This was the "Economic Shock" that was talked about.

In order to "ease" this problem the central banks introduced "Quantitative Easing" where they either bought or swapped CDOs for more then they were actually worth. [TODO this needs more work. Exactly who did what. ]


(C)2010 Tom de Havas. The information under this section is my own work it may be reproduced without modification but must include this notice.