2008 Financial Crisis and who benefited from it

Author: Ken L. White

A bubble in the US housing market precipitated the financial crisis of 2008 and lead to

markets around the world being affected (Soros 2008 FT). There was excess money in the economy 

as a result of an artificially low interest rate and when all the credit worthy borrowers no 

longer demanded the money, financial institutions turned to ones who were able to repay 

loans at the lowered interest rate (riskier borrowers). These sub-prime mortgages would 

have only been the problem of the US if banks did not package the toxic assets with other 

assets and sell them on to third parties around the world. The inability of these third party 

institutions to verify what exactly made up these financial securities was a key factor in how 

high the velocity of trade in these assets was. Returns were dependent on these borrowers 

repaying their loans at the prevailing interest rates, which proved to be impossible due to the 

lines of credit on individuals and firms being restricted leading to massive defaults. 


Under FRFB, the artificially low interest rate attracts individuals who would otherwise be 

unable to borrow; they are able to do so and pay the lower rates once borrowing continues 

by other individuals in the future. This is the (X+r controversy); the banks provide X 

amount of money and require X plus interest. This model is unsustainable unless individuals 

continue borrowing and most of them repay debts. However, game theory tells us that what 

is optimum for an individual is not always socially optimal. The moral hazard problem arises 

when banks know that there is a bailout clause in the form of the government, should they get 

into trouble because the economy and banking system are interconnected. 


The crisis was similar to others that have occurred since world war two; however, it marked 

the end of credit expansion based on the dollar as the international reserve currency (Soros 

2008 FT). Soros (2008) states, “The boom bust process usually revolves around credit and 

always involve a bias or misconception”; this is usually a failure to recognise a reflexive, 

circular connection between willingness to lend and the value of the collateral, highlighting 

the myopic nature of individuals. 


The easy access to credit generated demand for houses that push the property values up, 

leading to more availability of credit. The bubble was created when individuals attempted to 

refinance their mortgages at a profit (Soros 2008 FT). Quantitative easing (QE) allowed the 

process to continue whenever there was trouble in order to stimulate the economy.

Market fundamentalism became popular in the US in the 1980’s; fundamentalists believe that 

markets always tend towards equilibrium. However, without government intervention they 

would not survive, so it was the government, and not the markets themselves that prevented 

the breakdowns.  


It is argued that had the products (securities) not become too complicated to calculate the 

risks associated with them, the financial system would not have crashed as it was the inability 

for objective organizations (government and credit rating agencies) to rate them that lead 

to banks being deceptive. The quantitative easing programme could have continued its 

successful trend of economic stimulation. 


The financial crisis affected the UK’s banking system as a whole. Many of the major 

institutions found themselves in dire need of liquidity in the form of government loans 

(bailouts). The government has a controlling stake in the Royal Bank of Scotland and a 

minority stake in Lloyds banking group resulting from the bailouts provided.

Since 2008

The government has sold some of their stake in Lloyds at below market price and still managed to make a profit. This sale sparked a ‘feeding frenzy’ among investors, only somehow the government managed to prevent some of them from gaining access to what the were providing. So the UK government profited from this investment (bailout of the banks) and those institutional investors  who purchased the shares sold by the government profited from this sale because of arbitrage (under arbitrage you are able to buy at a below market price and instantly make a profit by selling at market price to buyers, while taking on no risk).

The taxpayers who assisted in helping bail out these financial institutions received nothing from this initial sale of shares, however it is anticipated that within the next year more shares in Lloyds held by the government will be sold.

Some other stakeholders have feared off even worse than the investors and the government. These are the individuals who are in receipt of less now than before the crisis because of loss of jobs, inflation eating away at what wealth they do hold, falling house prices (outside London) and pensioners (those whose portfolios comprised of stocks and property).

Questions
1. How have you been impacted by this crisis if you have been living in the UK?
2. How much of your portfolio consisted of stocks (from financial institutions) and what was the capital loss or reduction in wealth faced by selling or holding on to these stocks?
3. Have the lower interest rates had a noticeable favourable impact on your mortgage repayment (if variable) and how long do you expect this to last?

The Fractional Reserve Banking system in theory and practice, and arguments for and against it being used

Author: Ken L. White

The fractional reserve free banking (FRFB) system came into existence following the

realisation that not all bank deposits needed to be repaid simultaneously. Individuals or

firms that deposit money at a bank receive a deposit account, which is a liability to the bank

on their balance sheet. With these deposits, banks could lend out the money to individuals

charging interest from lenders and paying interest to and depositors.


Legally banks have authorized to provide loans that exceed the deposits it holds by a certain

multiple because it is accepted that depositors will not withdraw at the same time. The

loans that it gives out in theory come back to the bank and they can do the process again. In

contrast to other goods and services, money is not used up in consumption or production; its

ultimate use lies in the fact that it is exchanged for other goods (Davidson 2012 pp. 198).

Central banks set and regulate the reserve ratios and hold some of the commercial banks

deposits as security against the possibility of bank runs. In the case of providing confidence

to depositors, central banks insure deposits (insurance) and are a lender of last resort to

commercial banks in the event of a bank run.


FRFB was seen as a monetary and a fiscal framework for economic stability (Warburton

1952 pp. 523). There is constant debate within the Austrian School of economics as to

whether FRFB should be allowed to take place. Many have argued for the benefits of this pre

and post 2008, and the evidence provided by all parties must be analysed.


The Austrian School economists prefer a gold standard (all bank issued media fully backed

by gold) to one where banks can generate redeemable IOU’s (Selgin 2000 pp. 93). Selgin and

White (1996) argued for fractional reserve banking; however are not defenders of fiat money.

Economist like Rothbard have long argues that FRFB is inherently fraudulent (Selgin 1996

pp. 86).


Many critics condemn FRFB for three main reasons, firstly, the practice is inherently

fraudulent and it only survived because of banker’s dishonesty or government mandated

deposit insurance (Selgin 2000 pp.94).

 Secondly, critics of FRFB say that under a gold standard, any bank created exchange media

not backed by gold will fuel the business cycle. In issuing spendable IOU’s to borrowers,

banks reduce interest rates below their natural levels, promoting investment at the expense

of other producers and consumers who find themselves bidding against bank borrowers for

scarce resources. The bidding war forces up prices and interest rates, restoring the purchasing

power of the money stock to its pre-expansion level. However, when this happens resources

would have already been allocated to unsustainable projects, given the amount of voluntary

savings available from the public (Selgin 2000 pp.94).

“The collapse of unsustainable projects (subprime mortgages), followed by the consequent

restoration of a pattern of resource use something like the pattern that proceeded the issue

of fiduciary media, marks the bust and recovery stages of the business cycle” (Selgin 2000

pp.94).


Thirdly, FRFB is vulnerable to bank runs when their customers lose confidence in them,

such as in Cyprus after a proposed bailout charge on savers. Fractional reserve banks by

definition are not able to meet the demand of its depositors at a given time (Selgin 2000

pp.94). Confidence plays a great role in the banking system, as we will see later.

My belief is that most individuals are blissfully unaware of the fact that their deposits are not

backed one hundred per cent by reserves; however, with the payment of interest on accounts,

they can figure out why they are being paid for the bank to safeguard their holdings.

Borrowers, such as those who took out subprime mortgages in 2008 were to me unaware that

in an efficient, non-FRFB system, the money that savers deposited would not be available to

them.


Economists who have critiqued the FRFB system have been looking at the fraud issue from

the banks perspective, however most of my analysis will be focused on the system’s ability to

affect economic growth and the reasons HSBC faired out better than its contemporaries since

the crisis.

The ability of the banking sector to affect the business cycle, not only domestically, but also

internationally was evident in 2008 driven by continuous globalisation and the expansion of

financial institutions.  Additions to the money stock are able to aggravate the business cycle.

However, this is dependent on whether there is a pre-existing increase in the public’s demand

for money at the going rate.

Austrian Business cycle tells us that if the expansion of supply of money creates an overall

excess of money, people will spend the excess (Selgin 2000 pp.97). This increased spending

will not be offset by a reduction of spending of other individuals and this stimulation to

overall demand for goods and services together with the pattern of spending prompted by an

artificially low interest rate will have adverse business cycle consequences described by the

Austrian theory (Selgin 2000 pp.97).

Student loan debt. When and how to pay it off.

Author: Ken L. White


These picture explain how I felt when I opened a letter from the Student Loans Company (SLC). 




This topic is very near and dear to me having completed two degrees and being the owner of the most important variable attached to those two degrees. Not the actual education or degree certificates, but the student loan company account with a debt that exceeds any graduate salary I could expect in today's economic climate.


The main thing that bothers me is that now when I repay this debt, I must pay tax on income before doing so. There are many factors to consider before paying more than the required amount back early, because you are taxed on your income, in real terms for every £1 you pay to SLC, it costs you that plus whatever rate of income tax you pay. 

For example, if your threshold means that you pay 20% income tax, for a payment of £100 to the student loans company, it will cost you £120. 

Be advised that this is important to you when considering what other debt you are able to take on such as mortgages or car loans. So understand it and use it to better yourself. 

Below are some of the ways which you repay and how much you are liable to repay depending on your level of income. You can elect to pay back more than the minimum if you wish to get rid of it earlier. However, consider your more urgent and immediate debt and get rid of those first (overdraft, credit cards etc). 

Repayments

You must pay back Tuition Fee Loans and Maintenance Loans. You pay interest on these. You don’t have to pay back other student finance, eg grants and bursaries.

How much you pay back

If your course finishes before 2016, repayments won’t start until April 2016.

Your repayments are linked to your income. You only make repayments when your income is over £21,000 a year. If your income drops below this amount repayments stop.

Part-time students sometimes start repayments while they’re still studying.

Each month you pay back 9% of any income over £21,000.

Your income per year	Monthly repayments
£21,000 and under	No repayments
£25,000	£30
£30,000	£67
£40,000	£142
£50,000	£217
£60,000	£292

Interest on your student loans

You pay interest from the time your first payment is made until you pay your loan back in full.

For courses that started on or after 1 September 2012 the following interest rates apply:

Income	Interest rate
While you’re studying	Rate of inflation (Retail Price Index) plus 3%
£21,000 or less	Rate of inflation
£21,000 to £41,000	Rate of inflation plus up to 3%
£41,000 and over	Rate of inflation plus 3%

Making repayments

You can pay some or all of your loan at any time without an extra charge.

If you’re an employee your employer will work out your repayments and take them out of your salary with your tax.

If you leave your course early, you still have to repay your student loan.

If you go abroad for more than 3 months you need to fill in an overseas income assessment form. Student Finance England will then work out your repayments.

With a rate of 9% on any income over £21,000 which means you will probably be paying this as most graduate salaries exceed this. 

Example

A total income of £25,000 means that (£25.000-£21,000=£4,000) on that £4,000 you pay 9% which equates to £360 annually. There are some ways to avoid excess payments, you can utilise you annual tax free allowance via an ISA. 





Questions

1. How much student debt did you have when you graduated and what year did you graduate in?

2. Has paying back over the compulsory amount drastically affected your ability to consume to any noticeable effect?

3. How has your student loan affected your ability to borrow for a mortgage or a car loan?

A brief discussion of behavioural finance (biases) and investment

Author: Ken L. White

An introduction to behavioural finance!!!!




Michael Pompian (2006) provides an in depth coverage of behavioural biases that affect
investors and their portfolios and even more importantly, how to manage these biases to the
benefit of the investor. Heuristics or biases are rules of thumb that allow us to deal with
informational deluge (Montier 2007).

Defined by Pompian as ‘the application of psychology to finance’, behavioural finance has
become an increasingly dominant part of investing and investment strategy, especially since
the run up in stock prices in the 1990’s, the dot com bubble and the recent financial crisis.
The human aspect of markets is the reason that bubbles form and burst. Markets would all
clear immediately and prices would reflect all information available if they worked in line with
traditional finance and economics.

Two of the most common biases that investors display are overconfidence and overoptimism
that stem from the illusion of control and the illusion of knowledge (Montier 2007). People
are poorly calibrated in establishing probabilities- events that they are certain to happen are
often less than 100 per cent certain to occur (Pompian 2006). An investor who has a large
amount of historical data on a company and its stock price and performance does not
necessarily make the best decision.

The illusion of knowledge is the tendency of investors to believe the accuracy of their
predictions or forecasts increases with more information (Montier 2007). For investors to
understand the importance of information, a Montier (2007) quote best explains; “The
simple truth is that more information is not necessarily better information; it is what you do
with it, rather than how much you have, that matters” . In analysing the FTSE 100 as a whole
and finding the link between it and the money supply and the index price, it should give
investors a better picture of where their success comes from skill or spurious reasons (their
knowledge and skills or upward or downward trends in the market).

Tests done by Slovic (1973) to assess confidence versus accuracy in relation to bets made
by bookmakers as a function of information sets, shows a relatively constant rate of
accuracy with a smaller information base of five data points. Accuracy also remains at a
similar level with forty data points 15 per cent. On the other hand, confidence at five data
points is around 17.5 per cent, but when the amount of data points increased to forty, it
increased to over 30 per cent. Instead of trying to acquire more information than competitors
do, investors should make better use of the information they have.




The illusion of control refers to people’s belief that they have influence over the outcome of
uncontrollable events (Montier 2007). An example of this is an individual’s willingness to pay
four and a half times more for a lottery ticket that contains numbers they choose rather than
a random draw of numbers (Montier 2007). Here information also plays a major role as the
more of it the investor has the more in control they feel.

Another important bias that investors should be weary of is self-attribution. The significance
of this on portfolio performance is that investors use the bias as one of the key mechanisms
for protecting self-image. Humans have a tendency to attribute positive outcomes to skilful
decision making and negative outcomes with bad luck or chance. Applying this to investor
behaviour, it could be represented by individuals holding on to losers and selling winners
(Shefrin & Statman 1985) meaning their portfolio performs below its optimum.

The opportunity to learn from past mistakes is very important to investor’s future success;
the self-attribution bias is one of the key limitations to investor learning as they do not
recognise mistakes as mistakes.

The anchoring bias mentioned earlier, researched extensively by Tversky and Kahneman
(1974) and highlighted by research asking participants to solve eight factorial (8!), presented
in two different ways gave vastly differing results. The first was 1*2*3*4*5*6*7*8 or second
8*7*6*5*4*3*2*1; the median answer on the first scenario was 512; the median answer on
the second scenario was 2250. So people appear to anchor on the early numbers in forming
expectations; the actual answer is 40, 320 (Montier 2007). This sort of anchoring applied to
investors in the stock market could have drastic consequences with regard to their earnings
potential. A stop loss strategy is an example of a tool that investors could use to limit losses
and combat the anchoring bias.

Northcraft and Neale (1987) highlight anchoring by real estate agents in the housing market;
this goes to show that anchoring bias can affect any asset market. Areily et al. (2003)
highlights the influence that even irrelevant anchors, such as the last two digits of an
individual’s social security number can have on valuing an asset, and the dangers this plays
on their perception of the maximum purchase price they are willing to offer.
If an investor forms his anchor by latching on to the current market price, this can be
hazardous as anchoring has obvious implications for valuations. The degree of anchoring is
heavily influenced by the salience of the anchor. The more seemingly relevant the anchor,
the more people will tend to cling to it (Montier 2007). An example of an anchor that would
lead investors to make losses by holding their position too long is the purchase price or a
previous price high in the share they own





I have not provided a reference page as the authors name and date of the publication should be sufficient for you to find the necessary literature.


Questions

1. Are you aware of any biases that may affect your investment portfolio?

2. Have you been anchored to a position without reasonable merit for doing so?

3. Have you been affected by the self attribution bias in your daily life outside of investing?

Investment traps that could reduce earnings potential

Author: Ken L. White

After questions from individual investors for general advice on their investments, I have formulated some basic traps that could get them into trouble.

This applies to you if you are a speculative investor, a high net-worth individual,  have a defined contribution pension, are saving to send your kids to university or you just have a small amount of money to play with. There are some simple traps that you can avoid that will benefit your returns. 



1. Focusing on the Short-Term   

There is a tendency to fixate yourself on the latest hot trend in the market where there seems to be continuous growth (invest in technology stock in 1999). There was extraordinary growth in the technology sector from 1996-2000, this was expected to continue almost indefinitely by investors. However, the tech bubble burst leaving many investors to lose almost half of their wealth because their focus was on the short term. 

This applies to you the investor in many ways; you can avoid this by creating an investment policy statement (IPS). This is very important to all individual investors because it enforces logical, disciplined investment decision making, and it limits the temptation to make counter-productive changes to an investment programme during periods of market stress. 

Before you choose an investment, ask yourself: what is your attitude to risk? Would you be happy to hold it for the long-term? Do you think the shares represent fair value? Are there other overlooked areas which may offer better long term opportunity?


2. Putting your eggs in one basket

When creating your investment portfolio, consider that if all your assets are in a specific asset class, you are open to all the risks associated with that sector. This was the strategy used by many in the UK in the 90's and 00's where they allocated all their resources to purchasing real estate. When the housing bubble burst, they held limited portfolios and saw their wealth drop dramatically. 

Investors who took a more diversified approach would have seen a far smaller impact on their portfolio. Having a well-diversified portfolio is a key way to reduce risk.


3. Holding over-diversified portfolios


Just as holding an under-diversified portfolio is damaging, over-diversifying is dually as detrimental to an investors returns. Building a portfolio of similar stocks, earning similar returns is damaging because the rate of return for the sum of the capital would mean higher earnings if you invested it all in one stock. 

A more effective approach may be to focus on a handful of favourite fund managers investing in different areas of the market. This would provide you with a framework for limiting the risk associated with undiversified portfolios as well as increasing returns from not over-diversifying.


4. Paying too many charges


After creating an investment portfolio that brings you a value close to that of your expected return, it is counter productive to have fees and charges that reduce or eliminate the returns you achieved in the first place. 

Consider two funds, each delivering a return of 10% a year, but one with an annual charge of 1.5%, and the other with an annual charge of 1%. If you invested £10,000 in each:

• The fund with the lower annual charge would be worth £56,044 after 20 years
• The fund with the 1.5% annual charge would be worth £51,120 – or £4,924 less.

Keeping costs to an absolute minimum could mean thousands of pounds more added to the value of your investments over the long term. We can help you keep costs to a minimum by rebating part of the annual charges you pay on funds through our loyalty bonus service.

5. Not knowing your risk preference

It is interesting that many individuals do not consider risk as important as reward when creating their portfolios. If a stock gives you a return close to that of Treasury securities, it should be very close to the risk free rate of return associated with these securities. 

Your risk preference should be clear and understood; if you are a retired individual, purchasing and holding a risky portfolio, that determines all your possible consumption may not be the best idea. If you want a high rate of return, you should be aware that you are agreeing with the risk associated with this high expected return. 

There are also two phrases that all investors should know Ex Post and Ex Ante. The expected rate of return is ex ante meaning before the fact, whereas ex post means after the fact. When you are investing in assets you should be aware that very few if any are risk free and treat them accordingly. 

Ask yourself 'Can I really get a 10% return from this stock when the average rate of return in similar stocks is 3%?'. The only way to justify this higher expected rate of return is if you as an investor assumes considerably more risk than in vesting in the stock with the lower return. 

These are just five of the investment traps you could fall into. If you need any advice on other traps, just comment below. Let the conversation begin!!!!


Questions

1. What are some of the charges that you pay that reduce your overall earnings?

2. How have you reduced some of these fees/charges?