|"....As the mortgage blow-up has shown, many of the “modern finance” techniques that have been designed in the last 30 years have shown themselves fatally flawed. Of all such innovations, probably the one posing most current danger for the world’s financial system is the credit derivatives market.|
Like most modern finance products, credit derivatives were marketed as hedges. A bank could reduce its credit exposure to a particular borrower by entering into a contract whereby another bank would make payments to it if the borrower fell into bankruptcy.
Needless to say, once Wall Street’s trading desks got hold of credit derivatives, all thought of hedging was lost. Instead of selling a credit exposure once, banks sold it 10 times, or even 20. Instead of selling credit exposure to another bank or an insurance company, who would be able to handle the credit exposure and could be relied upon to pay up in case of trouble, credit derivatives traders sold credit derivatives to hedge funds, private equity funds and any riff-raff that walked in off the street.
As a result, the credit derivatives market is a time-bomb waiting to explode. It will remain quiescent while credit losses on the underlying loans are low or moderate, but at some point rising credit losses on the underlying loans will be multiplied by the credit default swap mechanism to produce a payment requirement that is several times the size of the underlying defaulted loans. Theoretically, that mega-payment requirement would be offset by mega-profits in other corners of the web of counterparties. In practice, the losses are likely to be large enough to cause counterparties to default, particularly if they are “men of straw” such as hedge funds, so the profits will prove ephemeral while the losses prove all too real. Losses of even a modest fraction of a $50 trillion principal amount would bring down most of the banking system.
It is in this context that the Bear Stearns crisis must be viewed. When the Knickerbocker Trust went bankrupt in 1907, J.P. Morgan was able to bail out the banking system because the Knickerbocker had limited relationships with other banks. Even when Drexel Burnham went bankrupt, the authorities were able to solve the problem by allowing a two-stage process, whereby the expansionist Michel MIlken and other top management were removed in March, 1989, while the institution continued to do business on a sharply reduced basis before its final bankruptcy in February, 1990. This was hard on Drexel’s shareholders, who might well have salvaged something substantial from the wreckage if Drexel had been forced into Chapter 11 early enough, but it was good for Drexel’s network of counterparties, who were given time to get out.
As the above discussion has shown, the network of counterparties for a major house such as Bear Stearns is now many times the size and complexity of that constructed by Drexel and poses huge systemic risk. Bear Stearns may not be too large to fail, and it has no depositors requiring insurance of their money, but its network of interlocking obligations is far too complex and extensive to allow it to cease payments.
The Fed is doing everything it can to stave off disaster, but frankly, it is not rich enough. With assets of about $800 billion, having instituted $400 billion of rescue programs in the last week plus unspecified intervention with Bear Stearns, it is pretty nearly tapped out. It does of course have available a further source of liquidity, the Federal printing press. With inflation already moving at a brisk trot, use of that source will replace an incipient recession with a deeper and highly inflationary recession.
Thus the participants in the AEI seminar were misguided in touting Treasury bonds as the last safe haven. In an era of inflation, long term Treasury bonds yielding less than 4% are not a safe haven, they are a guaranteed route to loss, particularly for any investor so unfortunate as to pay tax. The fact that five year Treasury Inflation Protected Securities now yield less than zero, even though the inflation figures on which they are based are comprehensively fiddled, is a sufficient indication of the incredible laxity of current monetary policy. Of course, since house prices peaked at about 45% above their equilibrium level, a 30-40% burst of consumer price and wage rises, perhaps two years at 15% inflation, may be just what is needed to bring house prices and incomes back into balance. In an era of very cheap money, all investments are overvalued (the stock market still has much further to fall) but Treasury bonds are perhaps the poorest buy of all.
This is not a pretty picture. The losses to come are probably large enough to wipe out the banking system, and the interconnected network caused by modern finance is sufficiently fragile that the failure of any one major house, if carried out through normal bankruptcy processes, would be sufficient to bring down the world economy as a whole.
It is as if the US power grid had been installed without fail-safe mechanisms, so that a local outage caused by a snowstorm in Vermont or a hurricane in Florida could cascade through the whole system and wipe out power service for the entire United States. Needless to say, failsafe mechanisms have been put in place precisely to prevent such an occurrence. When we dig ourselves out from what seems likely to be an unprecedented banking system catastrophe, we will no doubt design similar mechanisms to prevent contagion throughout the banking system. They will destroy much legitimate business, just as did the 1933 Glass-Steagall Act, which de-capitalized the investment banks, making it almost impossible for companies to raise debt and equity capital for the remainder of the 1930s.
The barriers to new business caused by the new control regulations will be the last but by no means the least of the enormous costs imposed on mankind by the crack-brained alchemists of modern finance."
This article is actually too kind to our current leaders. Remember, Bush took over an economy that was generating budget surpluses (thank you, Bill Clinton) and then methodically destroyed it through massive overspending, an unaffordable war, and deregulation of a (now obviously) fragile banking system.
All those homeless victims begging for handouts at the bottom of freeway offramps? In several months, you might start seeing people you know. (By the way, if you still have a roof over your head, stop being a selfish shithead and start giving a few bucks to these humans.)