...with analysis & insight...
Boom: Bust: Repeat
It’s the tenth anniversary of the start of the financial crash that blew up the world’s dollar
controlled banking system. On 9
August 2007 the French bank BNP Paribas froze withdrawals
from three of its funds related to American sub-prime mortgages that were supposedly worth $2.2
billion. At that point they had suddenly become worthless as nobody wanted to buy into them at
any price. It was a shock. By bundling up risky, riskier, and very risky mortgages into ever discrete
mathematical proportions, the bankers had smugly assumed that they had virtually eliminated risk.
But on that fateful day, traders had begun to realise that the convenient bundling they had named
securitisation was in fact very far from secure. It was the epitome of a “The Emperor has no
clothes” moment. Slowly it began to emerge that the sophisticated spreadsheet formulae, and all
those complex calculations which appeared to eliminate risk, were fatally flawed. In reality the risk
had been magnified. Five months later there was the biggest drop in American home sales in 25
years, and a few weeks after that the first run on a U.K. bank since 1866 began. Then the
international banking system stopped lending/became immobilized/ followed a few months on by
Lehman Brothers filing for bankruptcy. The rest is history.
Now, a decade has passed and are we any wiser? Just how stable and safe is the financial system
today? The media is full of financial experts pontificating that the banks are far more secure now.
They confidently stress that there are fewer large banks but assure us that these banks have much
larger reserves. But to my mind these experts are “fighting the last war”, not the next one, because
when there is another crisis, and there will be, the causes are unlikely to be identical. What none
of these pundits seem to understand is that human nature hasn’t changed and it is merely a matter
of time before the next great crash.
Right now I know the next economic disaster is already gathering momentum, I just can’t tell
exactly when it will explode. Most financial schemes blow apart when the supply of new entrants
dries up. The majority of people with spare money are driven to seek schemes promising ever
better returns at supposedly no or low risk, so initially everybody who can piles in. Then something
happens - it can be trivial or important, but suddenly investors take fright and flight because the
suppositions they previously relied on no longer seem valid. That is what happened in late 2007
and 2008 when it slowly became apparent to investors that all those supposedly low-risk sub-prime
mortgage securities they had bought were worthless.
As you can see on the chart above which uses a crude measure of U.K. economic output (GDP), we
experience continuous mini-cycles of boom and bust. These are an artefact of capitalism, the
swings between investors’ optimism and pessimism. Small bubbles cause damage but the recovery
time is usually short. It is the really severe busts where the GDP growth line goes below zero that
causes harm to society. The early investors in any scheme are usually the financial wizards. The
bubble peaks when the get-rich-quick mentality drives other people, who really don’t know what
they are doing, to get sucked in. At that point a really large crash can happen at any time. As you
can see on the chart: the 2007/2008 financial crash caused the worst decline in GDP, and the most
economic damage in the last fifty years.
The reason I am so sure that another economic disaster is on its way is that a huge credit bubble,
and all the preliminary activity preceding a subsequent crash, is happening again. Oddly enough
what I’m talking about concerns people who really should know better. They were sucked in to
dubious financial schemes back in 2008 and now, only ten years later, they are being duped once
more. These are people who aren’t spending their own money but are charged with looking after
public funds - I’m talking about local councils. In 2008 it turned out that numerous local councils
had altogether invested over a billion pounds sterling in a few Icelandic banks. They did this
because they’d been sold the idea that they could get a higher rate of return at absolutely no risk.
The three Icelandic banks had been deregulated and could borrow freely from international money
markets and, on the back of paying higher interest on deposits, grew rapidly. At their peak they
were eleven times the size of the total Icelandic economy (GDP). When a run on Icelandic banks
finally began, the Central Bank of Iceland couldn’t act as a lender of last resort as it had nowhere
near the assets needed, so the banks had to be liquidated. This resulted in large losses for
shareholders and foreign creditors. The local councils in the U.K. were only saved by the
Government using terrorist legislation to seize Icelandic bank assets held in the U.K. Those councils
were lucky and, some years later, recovered nearly all their deposits as the assets of the three
Icelandic banks were eventually sold.
Having had such a close shave you would have thought that local councils would be far more
cautious but, just ten years on, memories seem to have faded and greed or optimism has taken
over. This time, yet again, many councils like mine, Torbay Council, which is already in debt, are
borrowing more money at low interest rates to make investments that they expect to turn into
profit. In short these supposedly secure public entities are borrowing money to gamble. As usual,
all this gets dressed up as prudent behaviour as councils take guidance from expensively hired
external advisors, who can’t ever be wrong, of course. Torbay Council, already considered to be in
special measures because of poor management, turned to Capita Asset Management for help. On
their advice it is now planning to borrow no less than £66 million to invest over the next four years
and has proudly announced its first judicious investment. This is the start of an investment
strategy based on buying property freeholds, preferably industrial property as the rental yield is
usually higher, and the management time involved is lower, than other types of property. The
Council can approve investment purchases that seem appealing, not just locally, but anywhere in
Its first purchase is a small local retail park (47,800 sq. ft.) called Wren Park that was on the market
for £20.6 million. We don’t know what Torbay Council paid for it because, although they are a
public entity essentially using our money, they wish to keep the price quiet. Is that because the
price was high or did they get a very good deal? To my thinking whatever was paid, it was too high.
I applaud the fact that Torbay Council’s first investment is a local investment, councils should
improve the local area they serve, not gamble on a wider market. But I’m appalled they have
chosen to invest in retail property. The retail industry is going through a huge shake-up at the
moment, so what has historically seemed a safe bet is in fact now high risk.
In the U.S. as of June 2017 there have been 4,723 major store closures, primarily as a result of the
rise of online shopping, although stagnant wages, and the higher cost of housing have also
contributed to a decline in offline shopping. In the U.K. last year, Amazon alone sucked £7.3 billion
out of retail sales, so the days of a retail park being a safe investment are well and truly over. This
is all the more relevant when the retail park is a small one dependent on a handful of retailers to
attract shoppers. I must admit my wife and I have only visited Wren Park once, some months ago,
just to see what was on offer. There wasn’t much. We haven’t been back since preferring a larger
retail park, (a short drive away from Wren Park) which includes a big Marks & Spencer and
Sainsbury’s, as well as having some other high street names. Like many local people, an awful lot
of our non-food purchases are obtained online using a combination of Amazon Prime and John
It’s pretty obvious that the level of advice Torbay Council received from Capita Asset Management
was based on the historic performance of retail investing, not the future where online shopping
behaviour will become even more established. Past performance is no indicator of what’s ahead
whilst the retail industry is going through such a massive structural change. The two flagship
tenants at Wren Park, Next and Mothercare, are already feeling the online pinch. Next’s profits
have fallen 3.8% this year, and Mothercare is to almost halve its number of U.K. stores, and to stop
selling clothes for older children. Both companies have blamed loss of profits and store closures
on online sales. Mothercare already gets 41% of its sales from the Internet so it obviously doesn’t
need so many physical stores. But Torbay Council has already booked £400,000 of the expected
rental income from Wren Park into next year’s budget, although I fear that some of the shorter
lease tenants may well not renew at the end of their leases. If that happens there is a real risk that
footfall to the remaining shops will fall further. Even prosperous towns like St. Albans in
Hertfordshire still haven’t managed to find a tenant for their prime location BHS store since the
chain went bust in April 2016, so the chances for a secondary location in less prosperous Torquay
don’t look good. With only 3% net profit after interest, and other costs, Torbay Council doesn’t have
a lot of margin to play with, so what appeared to be a low risk investment is actually a high risk one.
Other councils are also likely to discover that using debt to make an investment is much more
hazardous than it seems, even at low interest rates. Everyone seems to have forgotten those too
good to be true interest rates from Icelandic Banks.
But it seems that few people in the U.K. are being prudent. Never mind the wretched local
councils, the government itself is crippled with debt, at £52bn it has the sixth-largest government
debt of the advanced economies. Not to be outdone, according to the Bank of England’s figures:
personal debt in this country now amounts to £1.5 trillion which averages out at £28,000 for every
person aged over 16 years. Shocking as this is, it doesn’t include the £89 billion of student loan
debt which has doubled in the last five years. Mark my words: When people forget the last bubble,
the cycle starts again at every level, and the next financial crash is underway.