The principles underlying sub prime

The biggest mistake South Africans can make is to presume that the American sub prime contagion that cracked the international financial markets in October of last year, has no bearing on this country.

Although sub prime products were devised and packaged in the USA for the North American market, their tentacles quickly found their way to the farthest corners of the international investment world.

However, the contagion was not the sub prime product itself but the underlying principle thereto which was an insatiable greed amongst international consumers in virtually every country in the world. It sucked up any asset in its way and eventually also every possible cent of available credit.

In this frenzy, consumers, analysts, rating agencies and financial institutions turned a blind eye to sound fundamentals and found a reason to feed the hungry consumer and profit thereby.

In the USA, prosperity since 2003 led to more and more riches every day. Americans bought more of everything: houses, cars, everything their hearts desired. And if they did not have the cash, they borrowed. When they needed security for loans, they borrowed more on their homes to buy more homes on which they then borrowed even more … Everyone could get credit.

The financial institutions devised credit structures for everybody. And when someone’s security was not strong enough it was lumped with others that were. If these lumps of credit were not secure enough they were packaged brightly and tightly, rated by a rating agency and sold to an unsuspecting investor blinded by prosperity and greed. Let the good times roll!

There were warnings by Greenspan et al, but no one heeded the calls. The greed was packaged like poisoned pills by the most reliable American and international banking institutions. They were re-rated after each package layer with a better rating by the most reputable and trusted rating agencies.

These packages were blindly accepted by the most reliable investment analysts and investment institutions on behalf of their trusting clients – often widows and orphans. But it was all driven by a greed to have more and make more – a process that blinded everyone.

South African and the rest of the world’s consumers were not far behind in terms of greedy consumption – spending everything they earned in the prosperous years since 2003, and in the process slurping up every bit of credit they could get and that was on offer from similarly greedy banking institutions that dished out credit cards, balloon payments on the latest model cars and higher and higher mortgages on homes and second homes and holiday homes.

Was it sub prime in another form? No, although some South African institutions also swallowed the poisoned American pills and offered a number of fancily structured investment products to the South African investor. But that was not really the South African problem.

The South African consumer’s problem was not the American product but the same flawed principles underlying the sub prime product. These were greed to have more and blind trust in grabbing whatever credit was available. There was no thought of the fact that the good times always end; that the assets which serve as security to the credit have cycles in which the value eventually turns down, the income that is generated by these assets always shrinks and there is always a time to pay back.

Joseph warned the Pharaoh in Egypt of old, after the Pharaoh’s dream that there would be seven years of prosperity, followed by seven years of famine. Truth is, these cycles continue through the millenniums to this day. The Pharaoh heeded Joseph’s warning and filled his warehouses during the prosperous years with the excess produced to feed the nation in the eventual years of famine.

But this was not done by any authority in South Africa. Here there was no Joseph nor a wise Pharaoh. Warnings were ignored. Excess was consumed. Credit was given to all and sundry on often flimsy security.

Now that the prosperous years have made way for less prosperous ones, the country is again confronted by problems that are not all that new. Because through the ages the tides washed in and washed out. If you do not save in the prosperous times to provide for the lean times that will always follow, disaster will strike.

Since 1992 household savings in South Africa have declined consistently to their current negative level. There are also other signs of heeding Joseph’s advice:

• The deficit on the current account has grown out of proportion from R111 billion in 2006, to R138 billion in 2007, to R145 billion in 2008.

•  The country’s electricity supplier has fallen from one with excess capacity that once supplied Africa to one that cannot even supply basic local households.

• Infrastructure of roads and railways have deteriorated to an extent of non-existence in certain areas of the country.

• Inflation is out of control.

• The South African central bank is ineffectively grabbing the only tool it apparently knows and is killing the goose that lays the golden eggs by increasing interest rates whilst interest sensitive inflation does not increase anymore, but imported inflation which is not interest rate sensitive is heaped onto the consumer.

South African banks have started to take back cars and now even homes from consumers that cannot pay them back, at such a rate that it already points to a crisis. What can a consumer do without the roof over his head? What can a bank do with hundreds of thousands of empty houses?

The International Monetary Fund warns of a recession in the USA and economic slowdown in the world. But South Africa’s problem has taken on a character of its own. Political and criminal factors are exacerbated by an economic and financial crisis and behind it all lies a lack of leadership exemplified in the tale of Joseph and Pharaoh.

The growing middle class in South Africa went on a spending orgy, albeit like the rest of the world. No one was there to teach them and to lead them, because the leaders –– political as well as financial – participated in the same orgy, and now it is payback time, but the cupboards are bare …

Heinrich Kruger
(Heinrich Kruger is the founder and current CEO and CIO of Kruger International, +27 11 726 7700 www.krugerinternational.co.za)