Does Anyone Believe anything about the Financial System?

Long into the European night, the talks to save Greece continue. In today’s Markets and Money, we’ll do something we can barely stand to do: we’re going to write one more time about Greece. If you can stand to read it, you may come to the same conclusion we reached.’

My former DR colleague Dan Denning wrote that in one of his classic essays. Here’s the catch: he wrote it in February 2012. Here we are three years later and Greece is still on the front pages.

Does anything really change in the financial world? Well, you could argue no if you happened to read the Wall Street Journal this week. What gives? Check it out:

Loans to consumers with low credit scores have reached the highest level since the start of the financial crisis, driven by a boom in car lending and a new crop of companies extending credit.

You guessed it: the subprime borrower is back! According to the WSJ, almost four of every 10 loans for autos, credit cards and personal borrowing in the US were to subprime customers in the first 11 months of 2014. That’s 50 million customers borrowing $189 billion.

With figures like that, you can see it’s a lucrative business to be in. And there are plenty of ‘nonbank’ lenders keen to get in on the action. Venture capitalists, private investors and hedge funds are backing these lenders, ‘seeking higher returns in the low-rate environment’ and ‘such lenders face far less regulatory scrutiny than do big banks.

Does anyone really believe anything about the financial system — you know, the one that collapsed in 2007 — has really changed? One lesson from history is that it doesn’t take long for banks and lenders to get around whatever regulations are put in place after a crisis and get back to the business of shovelling credit where the money’s good.

It doesn’t take much imagination either to think that the big banks could set up hedge funds and subsidiaries at a regulatory ‘arm’s length’ and get in on the action if they haven’t already. I mean, c’mon.

According to the WSJ, Americans are ‘willing to take on more debt’ with total household debt up $306 billion, or up 2.7% in the fourth quarter of 2014 on the year before. We’ll come back to this point later.

Hmmm. These lenders operate in what we know as the ‘shadow’ banking sector. How many times have you heard the worry expressed about this type of lending in regards to China? I’d wager many. But America? Not for a while, I’m sure. The point’s worth making because America’s shadow banking is estimated to be five times the size of China’s.

There is one positive from this for now, however. The subprime borrower hasn’t infected the US housing market (yet). In fact, the value of subprime mortgages have been about $4 billion a year since 2009. They peaked at $625 billion in 2005, according to Inside Mortgage Finance.

That’s important. As I keep banging on about, the biggest systematic risk to the banks and the economy as a whole is their property loans. So far, risks appear contained. But we’ll have to watch the trend.

Somebody must be watching it in Australia because they want in on the action here. The Australian Financial Review reported yesterday that a company called Pepper Home Loans believes ‘the market share of so-called non-conforming [ie subprime] loans could be five times what it is now if they can overcome the stigma attached to them.

Pepper believes these are already 1.5 to 2% of the mortgage market, while the RBA had it at 0.2% at the end of 2013. As land prices rise around Australia and continue to rise, it’s perfectly possible these types of loans will take a rising share of the market. Like I said, we’ll have to watch the trend.

So we have credit expanding in both the US and Australia. Which is to say, debts are rising. That makes sense given the ultra-low interest rates here and in the States.

But debts have to be repaid, or at least serviced by the economy’s output. The thing is, they’re almost always paid back in inflated dollars, or euros, or yen. This is the way the financial system is designed. It has to have inflation to go with the increase in debt. Otherwise you’d have a collapse.

Gold is a good barometer of the systemic risks building in an economy. That is, either too much inflation or not enough inflation and too much debt.

Gold is simply an insurance policy. But it’s usefulness as insurance is a question of timing. Gold is not something I keep a close eye on. But my colleague Greg Canavan does. Greg’s done more study on this market than anyone else I know. His latest research says gold’s beginning to rumble. And the first place to look — and profit — is in the stock market.


Callum Newman
for The Markets and Money Australia

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Originally graduating with a degree in Communications, Callum decided financial markets were far more fascinating than anything Marshall McLuhan (the ‘medium is the message’) ever came up with. Today Callum spends his day reading and researching why currencies, commodities and stocks move like they do. So far he’s discovered it’s often in a way you least expect.

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