Pete’s blog

I was supposed to be writing about governments this week, but I had some desperate pleas from my friends to explain what on earth is going on with everything at the moment.

I’m just going to touch briefly on South Africa’s politics at the moment, maybe I will do a longer blog on it later if I have some time. What is happening in South Africa at the moment is called democracy – it is a good thing, it is supposed to happen like this, stop worrying. Mbeki has set a very important precedent by leaving as easily as he did – in a democracy as young as ours, the precedent of the quick and easy changing of leaders is fundamental. Worried about South Africa becoming like Zimbabwe? Don’t. What just happened is everything that Zimbabwe is not. What if Mbeki had clung to power and refused to step down… would that not be typical Mugabe-style leadership? And compare what is happening in South Africa to what is happening in other developed nations – especially Britain. Gordon Brown is under considerable pressure from his own party to resign… sound familiar. The Israeli Prime Minister Ehud Olmert has just been forced to resign, because of – believe it or not – allegations of corruption. Change happens, change is important and the smoother that change is the better and the healthier the democracy is. As for Trevor Manual, have you perhaps considered that he has out stayed his welcome? You know that he is currently the longest sitting finance minister in the world? 12 years. And anyone remember how everyone said when his predecessor – Chris Liebenberg – left, the country would collapse? And when Tito Mboweni took over from Chris Stals, how the country would collapse? Change is good. How do you know that there is not someone even more brilliant waiting in the wings?

But onto what I really want to talk about – the end of America, the end of capitalism and the end of the world… You might have noticed that the world economy at the moment is in a bad state. Major banks are failing and the US government has just passed a bail-out package potentially worth more than South Africa’s GDP. What is going on and what does it mean for us?

First, what happened? This is the same ongoing credit crisis that was happening at the beginning of the year. Read my previous blog Buy Now Pay More Later -  for more details. But basically the banks created these really complicated financial instruments and then sold them all over the place and bought them from other banks and repackaged them and sold them again. Everything is now so knotted and twisted that no-one really knows how it all fits together. So at one end is a bunch of people that borrow money to buy a house or a car and at the other end is a financial instrument that is supposedly worth something. Unfortunately the people at the bottom end are having a lot of trouble paying for their houses and cars because they were given more debt than they could afford and the overall economic situation has not been good for them. In the good old days this was quite simple, there was the guy in debt and there was a bank. The bank repossesses the guy’s house, sells it on the market and offsets the amount that they get from the sale against the amount outstanding on the loan. Either the sale amount is more than the loan and the bank doesn’t take a loss or the sale amount is less and the bank shows a loss. Easy to work out. And you can also do a estimation of the number of people defaulting and the average house price and calculate how much money the bank is likely to lose in a year. Unfortunately you can’t do this anymore. The bank cut their loans into various sizes, repackaged them and sold them to other banks. So when Joe Soap defaults on his repayments, no-one quite knows which banks will be affect and by how much. Sound disturbing? It should!

So now you have all these banks who are going to have losses, but they have no idea how big those losses are going to be. If the losses are too much, the bank collapses. So banks have 2 concerns, they might collapse and other banks that they deal with might collapse. Paralysis. Banks are terrified to lend money out, because their current debt book might be bad, and because any bank they lend money to might collapse and not be able to pay them back. Unfortunately short term debt is the oil that keeps the system running. Companies borrow money from the banks at the end of the month to pay their staff, who then use their salary to pay their monthly bond repayments or other debt to the banks, closing the debt circle. If the bank does not lend to the company, the company cannot pay their staff, who default on their loans, which then affects the bank, making them less willing to lend out more money.

This is vicious circle the bail-out package is trying to address. By buying up the dubious debt from these banks and by injecting money into the system, it removes the uncertainty and banks start lending money out to everyone again… we hope.

So that is what happened and what the bail-out is all about, but what happens next? Um… I have to say I don’t know. This really could go either way. The one extreme is that there are no more bank failures, the economies start picking up again and in two years time everyone wonders what the fuss is all about. The middle path is that there might be a few more smaller bank failures, but most of the financial institutions hold together. America goes through about 10 years of recession or very low growth, but eventually recovers, hopefully a little wiser. The worst case scenario is that another major financial institution fails, resulting in a domino failure of the entire financial system. America goes into a depression which could last as long as 20 years, dragging the rest of the world with it. The most probable scenario is the middle one, but let’s have a look at the worst case scenario.

The danger is very real. The crisis and the buy-outs have resulted in there being fewer banks, and banks like Bank of America and Citigroup are getting larger. This is called concentration risk. Now if one of the mega-banks fail, the effect will be disastrous. Fewer players, with more of the market… very risky. America is almost certainly heading into a recession, which means that there will be more defaults, foreclosures and bad debts. This is not over yet and only time will tell what the future bank failures are going to be.

But on the positive side it helps to compare the current situation with the Great Depression. There are some very key differences. Firstly a lot of protections were put in place after the Great Depression – for example unemployment insurance and federal insurance of bank deposits ($250 000 of each savings account in a bank is guaranteed in the case of a bank failure). Both of these would have a major mitigating role if things do go pear shaped. Secondly after the First World War, countries cut foreign trade and turned inward. The first great globalisation of the Victoria age was brought to an end and there was little integration – countries suffered alone. And thirdly, the America economy in the 1920s/30s was a lot less sophisticated and diversified. The service sector was very small, the industrial sector was new and the financial sector was very basic. The Great Depression was very strongly tied into the agricultural sector as a result. It was farms that were being foreclosed in those days and in many ways it was the flow of agricultural goods rather than credit that came to a grinding halt because of that crisis. A lot of lessons were learnt from then and have been learnt since.

This crisis isn’t new. Japan and Sweden have been through something very similar, they survived. In fact Sweden got out of their crisis very well. The scale of it is the problem this time. And there were warning signs too, Enron being the biggest. A company built on complex financial deals, that when unravelled had no substance – sound familiar?

So what happens now? Well for us on the street, we wait and hope… and get money ready for the biggest opportunity of our lifetime. Now is one of the best times to buy shares. Trust me it will be difficult if you do, expect not to make any money for at least a year, but your future gains will be far more. Just one warning, only invest money that you do not need – buying at the bottom is great, but predicting which is the real bottom is as difficult as predicting the top of a bubble. You do not want to invest all your life-savings at the bottom, only to have the bottom fall out from under you.

If you do not have any extra cash, and most people out there are suffering badly at the moment, then you must just tighten your belt, learn about financial discipline and support each other. It will get better, and when it does, remember what you learn in this time.

But in summary, things are bad, corrective measures have been put in place, adjustments are happening, things are going to get worse before they get better, but I don’t believe that everything is going to collapse.