Saturday, 3 April 2010

The Trouble with ISAs

A friend of mine bought a Fixed Rate ISA (Individual Savings Account) for £5,000. The heavily advertised advantage of buying ISAs is that the interest they earn is tax-free.

So my friend 'bought' a Fixed Rate High Interest ISA - not that she was actually buying anything. What she was doing was lending £5,000 to the bank for one year.
The salesmen are clever to present the ISA as a product you buy, like a dress or a car, because psychologically it makes you feel like you're getting something. But you're not. The bank is getting something: your money.
But, hey, what about the tax-free 'high interest' - isn't that something? Well, guess how much that is. Wait for it... It's 3.1%. That's right, 3.1%
This means that, after a year, you earn £155.
Now, given that the true rate of inflation is at least 6%, by the end of the year, my friend will make a loss of at least £150.
But what does the bank get out of her ISA? Potentially they could get a small, or even a large, fortune.
As soon as they deposit her £5,000 it becomes (through the magic of Fractional Reserve Banking) £50,000.
How is this possible?
Well, banks are allowed to lend 10 times the amount of funds they have on deposit. So, once the £5k ISA goes into the bank, it turns into £50k of funds available to the bank.
Let's say the bank loans £50,000 to a businessman for a year at 20% interest. At the end of the year, the bank makes £10,000 in interest and £50,000 from the principle. A total of £60,000. And for the use of her money my friend gets £155 - a loss of £150 in real terms.

This, by any stretch of the imagination, is a terrible deal. My poor friend has locked her £5,000 up for a year so she can't do anything with it. The multi-millionaire publisher and poet Felix Dennis started his business with £5,000. Richard Branson started Virgin with less than £5,000.
But my friend can't do anything with her capital except wait for the year to end so she can get it back with a small bite taken out of it.
It couldn't get any worse could it?
Yes it could!
Suppose the bank has your £5,000 ISA (worth £50k thanks to Fractional Reserve Banking) but cannot find a businessman to lend it to at 20% interest? Well, it will place the £50k with its brokers.
Before the disastrous, bank-collapsing repeal of the Glass Steagall Act in 1999, commercial banks (like your bank) were not allowed to be investment banks (like Lehman Brothers or Goldman Sachs). The Glass Steagall Act protected depositors' money from being gambled away in the markets. But since the repeal of the Glass Steagall Act, all the banks have been free to gamble with your money.

This points up an interesting double-standard. If you tell the loan officer at your bank you want to borrow some money to go gambling, you will be looked at with horror and refused the loan. Gambling is profoundly irresponsible. Gambling is a sign of bad character. Everyone - churchmen, policemen, doctors, teachers, media pundits, politicians, your uncle, your mother, your father - says gambling is a very bad thing.
But it's okay for banks! Your bank will take your £5k ISA (worth £50k) and place bets with it.

Don't believe those who say stock speculation is not gambling. Of course it is. You buy a stock, share, bond, collateralized debt obligation or credit default swap and you cross your fingers and hope your stock, bond, share, security or financial instrument will go up. If it goes up you're a winner; if it goes down you're a loser.
All right, financial speculation isn't gambling if you're an insider trader. But insider trading is illegal and every year a handful of them are prosecuted. Only those at the top of the banking pyramid can get away with it.

So, it gets worse. Your bank passes your £5k (£50k) to its brokerage department and they start gambling. If they're successful, who knows? - they might make £500,000 from your money. But as the famous disclaimer says: "Stocks can go down as well as up."
Suppose the brokers buy worthless derivatives that have been given a triple A rating by one of the ratings agencies, or George Soros decides to short the currency your securities are in? Then your bank loses the £50k bet. Let's say, for the sake of argument, that the bank has no other assets. How can the bank pay its debt? All it has is your £5k ISA. It doesn't have £50,000 because the money it was gambling with (well, £45,000 of it) was imaginary - a virtual amount produced by multiplying your £5k ISA by ten (or even more sometimes).
So the bank only has £5k in assets and a £50k debt and it also owes £5k to you. The bank has to tell its creditors it can't pay them. The bank has more liabilities than assets. It's broke. It will have to go into receivership.
So what happens then?
Your bank's Chief Executive Officer goes to the Bank of England - the 'lender of last resort' - and asks for help.
The members of the Court of the Bank of England say they can bail out the bank by simply printing the £50k and giving it to them. This is known as Quantitative Easing.
However, too much quantitative easing dilutes the value of the money in circulation causing monetary inflation and too much inflation will bring down the whole financial house of cards. No, the preferred option is to get the £50k from the public via the tax system. After all, they only have to put up income tax by a tiny amount, or slip in a stealth tax no one will notice, to get the money.
But how can the Bank of England increase taxes? It's not the government is it?
Well, it turns out the Bank of England has a secret. When it was nationalised back in 1946, it became part of the government - a division of the Treasury - but its private shareholders were not paid off. Instead, they became shareholders in the Treasury. The Bank of England is a public-private partnership. Who are the shareholders? This is a closely-guarded secret but most of them are private bankers. If they like your bank's CEO they will raise taxes and give him the £50k. If they don't like him, they will let him go bust and take his customers.

This is what caused the banking crisis and Credit Crunch of 2008/9 - gambling with depositors' money and losing. This is why there are now 19 developed countries (including the US and the UK) that are technically bankrupt. The language of the previous sentence is misleading, however, because it is not the countries that are bankrupt, it's their governments and banks.

Recent events in Iceland are a perfect illustration of this. The Icelandic banks, in collusion with the Icelandic government, gambled with billions of dollars belonging to the Icelandic people and entrusted to the banks and the government for safekeeping. They lost the money. Then they called their losses "public debt" and demanded to be bailed out by the Icelandic people. The Icelanders refused. The creditors (foreign banks) demanded payment or else. The British government (on behalf of the Treasury/Bank of England's private banking shareholders) declared Iceland a 'terrorist nation' and, under terrorism laws, stole all the money held in the British branches of Icelandic banks.
But the Icelanders stood firm. They would not pay the debts of the government and the banks because they had not accrued them - indeed, the government and the banks owed them their money back.
The private banks that had loaned currency to the government and banks to buy the worthless derivatives that they (the private banks) had persuaded them to buy with phoney Triple A ratings and high rates of interest, demanded Icelandic assets (such as the fishing industry) to settle the debts. The Icelandic government agreed. The Icelandic people refused. Their argument was simple: 'why should we pay debts we don't owe?'
There was a stand-off.
Finally, the private banks said they had enough Icelandic assets already to cover the debts and Iceland owed them nothing.
What does that tell you? The whole thing was a scam. The big private banks (which include the International Monetary Fund, the World Bank, Goldman Sachs, JP Morgan Chase and the major central banks such as the US Federal Reserve, the German Bundesbank, the French Societe General, and the Bank of England) are now doing the same thing to Greece. And as in Iceland, the Greek people are protesting and rioting against their government for holding them responsible for debts they, the Greek people, don't owe.

In essence, governments and banks are parasitic entities. They both get their money by taking it from the people - in taxes, fines, and licence fees (govt), or deposits and charges (banks). Neither the government nor the banks create wealth. Wealth is created by business. Governments and banks get their salaries, pensions, expenses, budgets and bonuses by siphoning money from business transactions and persuading people, either by force or via inducements, to give or lend them money.

So it should be no surprise that the 3.1% "high interest" ISA - or the, even worse, 1.7% interest Flexible ISA - is a boondoggle.

It's the nature of the beast.