Global financial system implosion begins

[Falcon]

The Guardian's piece on the true, global significance of the UK's nationalisation of Northern Rock is very perceptive: banks lend more money than they have on deposit, treating tomorrow's expansion as collateral for today's debt. Since tomorrow's expansion depends on cheap oil, and there isn't any left, a system rigged for implosion is now beginning to do so. Northern Rock marks the end of one era, and the beginning of the next.
http://www.guardian.co.uk/commentisfree/2008/feb/18/northernrock.alistairdarling

 

[zoltan]

It wont implode, despite all the doomongering

 

[david dissadent]

It wont implode, despite all the doomongering

Do you know what a CDS is?

 

[Kanda]

Do you know what a CDS is?

You've never read a Zoltan post before? Or can have a guess at his area of work?

 

[jæd]

Do you know what a CDS is?

Yes thanks...

I predict a boom in doom-mongering and weekly "the-sky-is-falling-in" articles and a long-term decline in their accuracy... Chicken Little fancy-dress prices will also be a good buy...

 

[zoltan]

Do you know what a CDS is?

ish.

Whatever my opinion is of the rights/ wrongs of the system, I would never underestimate the capacity for business to evolve to make the best out of a crisis

 

[frogwoman]

I always got the impression Zoltan worked for an intelligence agency

 

[zoltan]

I always got the impression Zoltan worked for an intelligence agency

what ? and spend all day on this site ?

they have only just got department wide secure internet access at Thames house

 

[david dissadent]

ish.

Whatever my opinion is of the rights/ wrongs of the system, I would never underestimate the capacity for business to evolve to make the best out of a crisis

Its on a scale of probabilities, but the ability of less regulated sectors such as hedge funds and the investment banks to meet there obligations on the triggering of CDS's is quite questionable. If they go bankrupt this will trigger other CDS payments related to there debt as well, an effective chain reaction. The economist in there cover piece last week had a rather pithy statement "a banker who has to prove his credit worthyness, has none". It is not that there will be a melt down it is that the possibility certainly exists.

The Federal reserve is running out of money and rate cuts to throw at the markets. And its bailout of Bear Stearns may face a few legal hurdels as it is not chartered to cover investment banks.


But then agains as others are keen to point out. I dont really know what Im talking about .

 

[Skimix]

Do you know what a CDS is?

Its going to be interesting to see what happens...a lot of the protection was sold by hedge funds are in no position to fund them if there are a series of large defaults, so even if people have hedged their postions they'll be screwed if one side of it blows up.

 

[jæd]

It is not that there will be a melt down it is that the possibility certainly exists.

There is a huge difference for the possibility of something happening, and it actually happening..

But then agains as others are keen to point out. I dont really know what Im talking about .

Its not whether you know what you're talking about, but if other people do and their motives...

 

[Skimix]

There is a huge difference for the possibility of something happening, and it actually happening..

To quote Bill Gross from Pimco..

Mr Gross himself calculates that, if total investment grade and junk bond defaults approach historical norms of 1.25 per cent, $500bn of the total $45,000bn of credit derivative contracts could be triggered, “resulting in losses of $250bn or more to the protection selling party once recoveries are inserted into the equation”.

 

[jæd]

To quote Bill Gross from Pimco..

Mr Gross himself calculates that, if total investment grade and junk bond defaults approach historical norms of 1.25 per cent, $500bn of the total $45,000bn of credit derivative contracts could be triggered, “resulting in losses of $250bn or more to the protection selling party once recoveries are inserted into the equation”.

Just highlighting the important words there...

 

[david dissadent]

The Guardian's piece on the true, global significance of the UK's nationalisation of Northern Rock is very perceptive: banks lend more money than they have on deposit, treating tomorrow's expansion as collateral for today's debt. Since tomorrow's expansion depends on cheap oil, and there isn't any left, a system rigged for implosion is now beginning to do so.

You are describing fractional reserve banking, but I think you have it slightly wrong, it does not depend on growth but on repayment being relatively assured. If a person deposits £100 in the bank the bank can loan £1000 out to another customer, they borrow that from the bank of england that creates the currency. The £100 they have in deposit is set against the person loaning the £1000 pound back in say 15 years. It does not require growth but trust. This is a gross simplification of the system, others can shoot holes in it as they like.

The current problem in my view is better described, not as one caused by the fractional reserve banking system but caused by a failure of risk assesment and state oversite. The risk assesment is a sorry tale but one that has been told to death now. The big depositer banks no longer functioned as traditional depositor banks, loaning money to folks and carrying the risk. The system read like some kind of loonies had designed it. Mortgage brokerage companies went out to get as many people on too mortgages as they could, they did not carry the risk of the default and earned there money by how many people they could sign up. The banks provided the cash for the mortgage but they did not carry the risk. They wrapped them up in the now infamous CDOs and MBSs and sold them on. The ratings agencies then assesed the risk of these instraments as AAA our post orwellian Triple Plus Good The risk was spread around and no one did due dilligence on what they were buying.

Of course the hedge funds and investment banks bought these up sliced them up into even more complex instraments and then wrote CDSs as counterparty to there own risk. They are not overseen by the Federal Reserve so do not have to meet the feds stricter standards of fractional reserve and leveraged themselves at ratios in excess of 35 to 1 against loans from comercial entities that other hedge funds and investment banks wrote CDSs for and were counterparty to.

Nuerology may be more complex than working out who owes what to whom and who carries the risk.

But only slightly.

One result is that in some states home owners are refusing to pay back there mortgages as it takes a legal entity to begin forclosure procedings. It has occured to some of the brighter debtors and is now becoming more well known that in many states there is no legal entity owning the actual debt.

Its a wee mess. It may not be a depression but it sure as fuck is depressing.

Edit to add, if Ive made any mistakes here please feel free to correct me. Its a pretty complex thing.

 

[Jografer]

Just when you've missed one 'collapse of capitalism this week', another one turns up ...

 

[gosub]

I wouldn't entirely trust the Guardian, was two articles in the papers this weekend one on the Dad of someone I'm on a project with, who lives in a place beginning with B, and lost a packet on Bear Stearn but a lot less than they were claiming.
The other on a bloke I'm working on the project for who was somewhere else beginning with B and knows the other bloke, so despite getting the bloke's address right in the first article (which also correctly said he was off playing golf in Florida) they moved the first bloke to the other place beginning with B and intimated wrongly at exposure and some sort of crisis meetingshoddy journalism

Nobody can fully grasp the markets, particuarly as a lot of these failing mechanisms were designed as a deliberatly complex set of smoke and mirrors to mask bad debt. If swaps are in trouble (not saying they are) would be very bad news. Short term though can think of more immediate headaches, while China is good for the money. 0.9 trillion is a lot,and their financial sector grew so fast their regulation has been catching up ad hoc...anyway its not over yet

 

[frogwoman]

what ? and spend all day on this site ?

they have only just got department wide secure internet access at Thames house

i wasnt being entirely serious its just that you seem to travel to some strange places and know a lot of "secret" type stuff

 

[zoltan]

i wasnt being entirely serious its just that you seem to travel to some strange places and know a lot of "secret" type stuff

Life is too short not to go to iffy places and iffy places are usually full of these types, so I have had dealings with them

 

[frogwoman]

fair enough

 

[grimble]

"The Federal reserve is running out of money and rate cuts to throw at the markets."

As Ben Bernanke has said - the Fed owns the most powerful piece of technology in the world - the printing press.
I agree it's grim out there - but there's plenty of options for the authorities (not to avoid recession, as the US has been in one probably for 4 months now, but to avoid the end of banking/capitalism).

 

[gosub]

Fair enough on the printing press part from the resulting inflation, interest rates are another matter and they are really Japaning their economy

 

[Falcon]

I think you have it slightly wrong, it does not depend on growth but on repayment being relatively assured.

If everyone has collectively lent more than they collectively have and secured them on "assets" that have no value, on what basis other than an assumption of growth can repayment be assured, relatively or otherwise?

Discussions of MBS's, CDO's and other instruments of Magic Wand Finance, and fractional banking models are irrelevant here. It isn't about disagreement over the value of debt instruments. It isn't even about the growing consensus that their value is close to zero. The issue at hand isn't the failure of a particular form of financial instrument or model. The issue is the failure of the structure within which any such instruments and models are possible.

The financial system and the physical energy/matter system are completely separate intellectual systems that are universal and overlapping and which, for the last two centuries, have grown exponentially. This has spawned a number of weird assumptions: that the financial system sustains the matter energy system, that growth can/will continue indefinitely, etc. Most people ignore the physical system entirely, with comic effect (witness the deranged mindset of certain economists who assert that a physical, finite, unsubstitutable resource can be extended by simply demanding more of it).

They are incompatible. The financial system is abstract and can (and must) undergo indefinite exponential growth. The physical energy/matter system is bounded by physical constraints and cannot - the unique properties of hydrocarbon energy sources have allowed the matter/energy system to undergo a few tens of doublings (giving rise to the illusion of correspondence with financial growth), but that time is over now. The current price inflation is an inevitable consequence of the growing disparity between these incompatible systems (the ratio of money to physical outputs).

The CDO/mortgage fiasco is just the mine canary for the resulting large scale financial instability that such inflation generates. As the system trips over in the next few months from non-payment stage into large scale default and repossession it probably will be the trigger, but there are many others.

For example, this month the Federal Reserve gave the corpse of Bear Stearns to JP Morgan. This wasn't altruism, or Federal "intervention" - this was a desperate attempt to prevent Bear Stearns "assets" going to auction and being revealed to be worthless, instantly rendering similar assets by other big banks similarly worthless, triggering a universal margin call that collapses the system. There are an unrescuable number of financial institutions in the same position as Bear Stearns who will, within a few weeks, go public - and this is not a scalable solution.

Tackling the administrative complexities of who currently owes what to whom as the CDO fiasco unravels provides a gratifying sense of "tackling the problem", but the problem isn't being tackled and will shortly undergo a step change in complexity.

 

[bluestreak]

The books can alsways be fiddled. There will be victims, but the system will survive. That's what it's good at.

 

[yield]

The USA is in a massive balance of payments deficit. All large ticket transactions are denominated in US dollars. Foreign central banks are obliged to acquire dollars, in receipt for exports and to stop their currencies appreciating against the Dollar. They then need to recycle these US IOUs, being politically unable to purchase American assets, titles and privileges, they are forced to buy Treasury Bonds.

The US Government by printing Dollars, so depreciating the currency, they devalue their debt to the world and relatively increase the value of their international assets.

 

[david dissadent]

"The Federal reserve is running out of money and rate cuts to throw at the markets."

As Ben Bernanke has said - the Fed owns the most powerful piece of technology in the world - the printing press.
I agree it's grim out there - but there's plenty of options for the authorities (not to avoid recession, as the US has been in one probably for 4 months now, but to avoid the end of banking/capitalism).

The problem with inflation is the US federal debt. The US government is $9 trillion in debt and rising fast. Most of that debt is held by US sources, but it tends to be priced with yields of around 3-5% (give or take), if inflation starts creeping up to that level or higher the old ten and thrity year US bonds become worth less money every year to a US based debt holder. This is likely to see a large number of tha cannier ones selling there treasury bonds to get dollars and then using those dollars to buy other means of wealth store or accumulation.

The other major holder of US debt is foreign, either corperations, wealth funds of central banks. If the US starts printing money and backing it with junk bonds like the mortgage backed securities, the dollar will depreciate in value against foreign currencies. That will meen a net loss for a foriegn holder of US denominated debt treasuries. Many of these holders will also sell to get something else that will store value.

This will dump large amounts of US treasuries onto the market bellow face value. In order to compete with this and to attract buyers who are calculating in high rates of inflation and US currency depreciation the yeilds on the new treasury bonds will have to be rather higher. This means a structural long term cost will be added to the US government as it has to buy debt at a much higher interest rate (yield) than currently.

This has to be funded by taxes hence drawing money out of the economy retarding long term economic growth. It will inflict long term inflation into the US economy and reduce international trust in the US as a safe place to do bussiness. It is a kind of aborgation of duty to the lender. Given the fundamental weakness of the US manufacturing, its huge trade deficit and its dependence on oil that is priced in dollars so bound to go up as the dollar goes down, the US will look a great deal less attractive as a place to invest wealth to earn.

Furthermore exchanging dollars created for the very low value assets that the US is currently doing risks those assets (the mortgage backed securities and the CDOs and so on) going sour while and turning valueless hence the value of the dollars issued against them inflates further and the US dollar again depreciates more.

Bernanke has a printing press but so does Mugabwe. It is not a sound way of manuevering out of a sticky spot unless you get it just right.

 

[david dissadent]

They are incompatible. The financial system is abstract and can (and must) undergo indefinite exponential growth. The physical energy/matter system is bounded by physical constraints and cannot - the unique properties of hydrocarbon energy sources have allowed the matter/energy system to undergo a few tens of doublings (giving rise to the illusion of correspondence with financial growth), but that time is over now. The current price inflation is an inevitable consequence of the growing disparity between these incompatible systems (the ratio of money to physical outputs).

I would argue the opposite that the financial system is utterly bound to the physical system. Occasionaly it can get out of balance in the short term but it is always brought back into line. This is what is happening right now. The physical ability of Americans to provide sufficient goods and services in exchange for the prices of houses that they have paid is not meeting up. This disjuntion is now being felt throughout the system. This is not and never has been a financial problem about Wall street, this is about Joe six pack macking enough to earn enough to pay for what he has bought.

Id also suggest that the net amount of energy in the physical system is still growing. While crude and condisate is at a platue, and total liquids is only growing through non conventional high energy sources such as ultra deep sea oil, tar sands and biofuel, the amount of natural gas is still exanding healthily (not for the biosphere though) so the amount of net energy available is still growing. For the US economy the competition for that net energy from emerging economies is really hurting the cost more than the limits of oil availible. That is a factor inthis but not the main driver.

Well in my opinion anyway.

 

[david dissadent]

Nobody can fully grasp the markets,

Late last November, in a superb account of the demise of Citigroup CEO Charles Prince, Carol Loomis of Fortune magazine revealed that Prince resigned after he was informed of the consequences of liquidity puts -- options that allowed buyers of complex and presumably safe mortgage securities to hand them back to Citigroup at par if they became hard to finance.

Crappy Mortgages

Liquidity puts were about to make Citigroup the new owner of $25 billion of crappy mortgage securities at par, cost Prince his job, and put the company into the hands of Robert Rubin.

http://www.bloomberg.com/apps/news?pid=20601039&sid=aSE8yLAyALNQ&refer=home

Hmmm that is one real bad day when someone explains you have $25 billion comming back your way.

Yep the whole thing is just so huge and complex I doubt anyone knows most of what is going on.

 

[Falcon]

I would argue the opposite that the financial system is utterly bound to the physical system.

Well I would agree. I'm used to debating with people who assume precisely the reverse, and with whom it is therefore usually necessary establish as a first step that they are separate (in fact, often it is necessary to register the concept of the matter/energy system in their minds, so deeply is it taken for granted).

It is true that, for the period where the system is infinite acting with respect to energy supply (i.e. for the last two centuries), the availability of energy at any given moment is a function of finance. This is what provides economists (by definition, professionally incompetent in matter/energy system dynamics) their misplaced sense of confidence.

What almost no-one grasps, because almost no-one can conceive of it, is how the financial system behaves once it is no longer infinite acting with respect to energy supply.

 

[david dissadent]

 

[Falcon]

The past 10 days will be remembered as the time the U.S. government discarded a half-century of rules to save American financial capitalism from collapse.

Wall Street Journal, 27 March 2008