Financial Armageddon – Our Slippery Slope

The Dow Jones Industrial Average, Last Two Days

The stock markets fell across the world today. We saw the biggest two-day decline in the S&P 500 since 2008, and the S&P 500 Index itself is at a twelve month low. Europe is teetering and it’s not just Greece anymore, not even the very scary Italy that is befuddling the markets. Doubts are beginning to be cast on powerhouses France and Germany and, of course, the euro is in shambles.

In the U.S. the volatility of our markets is at historic highs – day after day the markets spasm violently like the death throes of some giant leviathan. We are down 7% in the last 4 days, a kind of uncertainty you see in Banana republics. The economy is unable to generate any momentum, unemployment hovers at 20,000,000 people and 46,000,000+ are below the  poverty line.

What’s going on? You will hear a lot of nonsense explanations from pundits – like it was the Fed speech of Wednesday or an unemployment number blip. But you must understand the deep, deep malaise that affects us and that we seem unwilling to address. The most articulate expression of this came from Dylan Ratigan, who has an extraordinary financial commentary and news coverage at 1:00 pm (albeit on MSNBC). Try him if you want some sensible, fact driven analysis of the markets. He beats the pants off of Fox Business News or CNBC.

Here’s a paraphrase of what he says:

Our market volatility, instead of being driven by irrational fear, is in fact exquisitely rational. This is because the stock market knows that the underlying foundation of the financial system is completely bankrupt, shored up by little or no capital, regulatory requirements or transparency. The entire risk in the financial markets comes from a large chunk of it (99% or even more) remaining dark – outside the exchanges and unregulated by capital requirements, or reporting, or grown-up supervision. This segment includes $600 trillion dollars worth of credit default swaps* (see explanation at bottom) and thousands of other complex instruments, derivatives, private hedge funds and high frequency trading mechanisms.

So the stock market cannot adequately assess risk or or do a rational valuation of its assets. The largest chunk of the risk comes from outside its purview – the dark financial sector which is private, complex and corrupt. Thus the extreme volatility we are seeing today.

Yet our government continues to insure the financial system with its full faith and credit, buoying up a corrupt, too-big-to-fail, technically arcane,  private Ponzi scheme by underwriting it and implicitly promising to rescue it when it inevitably fails. Rescuing it at any cost, even to the point of complete financial collapse of our huge economy!

The way we dealt with the multi-trillion dollar banking collapse of 2008 was by printing huge amounts of money, flooding the financial sector with easy trillions courtesy of the tax payer, provide government bond insurance and government direct injections of capital and continuing the decade old harnessing of Uncle Sam to cover up the underlying flaw in the financial system. Instead of resolving it by pushing the complex derivatives markets into regulated exchanges and pushing capital requirements back into the banking system.

None of the underlying problems that led to disaster were resolved.

It was like you have a big fight with your family, find out that your sibling is stealing all your money, and instead of confronting the problem pretending that it’s not happening, giving him even more money and starting to take drugs to not have to think about it!

This has been a festering decade old problem, since 2000, when under President Clinton, a $600 trillion Credit Default Swaps market was invented by Larry Summers and Robert Rubin under the Commodity Futures and Modernization Act (CFMA) which created the highly technical, hugely risky, and dark, derivatives markets – i. e. no exchanges or reporting requirements and no capital requirements for risk. Some of it was a useful tool in hedging risks for legitimate financial activity but a vast, vast majority of it is idle, zero-sum speculation and because we cannot tell which part is useful and which bogus the tax payers continue to pay off for this $600 trillion dollar casino.

In 2009 our current administration tried to attack the problem by passing the so called Dodd Frank Consumer Protection Act – the creation of an oversight body to curb these underlying flaws and dismantle the casino. It was done in a watered down way, leaving much of the reform to be done in the future by the new Agency created for this purpose. Even this watered down action to fix our pathetic financial sector is now being reversed by the Republicans in Congress whose theology does not permit any reform and who are wholly bought puppets of the financial industry.

But this is not a Republican vs Democratic issue at the big picture level (although the Republican solutions are far, far worse). The Democrats have no desire or ability to make changes either. This shows the extreme power of big money to control our political process – although frankly even the big money interests must now be getting nervous at the extreme instability of the financial house of cards that we have in the Western economies.

Who is the boss? We had hoped it would be Barak Obama. But he has proved unequal to the task. Our economy continues to be schizophrenic with the top handful raking in all the benefits, and at the bottom  20% having inadequate or no jobs,  the middle class shrinking and zero-sum financial games replacing sound economic activity. Obama’s speeches on how he will create jobs, although better than the clueless schemes of the Republicans, seem hollow in the big context. They sound like someone trying to bail out the Titanic with a thimble.

Oh well. It’s a beautiful September day in the Bay Area. What am I carping about? It’s my birthday and I am flooded with good wishes and warm friends. Mustn’t complain.

* What is Credit Default Swaps (CDS)? These are contracts that are equivalent to insurance on some underlying debt. So if you are worried that GE might default on a given bond you can buy insurance against it defaulting by purchasing a CDS. If the bond fails you will be paid its full face value. The problem is that CDS are side bets and can be written to insure a bond many, many times over. These swaps today insure, on average, 600 times the bonds’ floats! Thus if a bond fails someone has the obligation to pay 600 times its float value. Suddenly there’s huge leverage risk. So when the Mortgage based bonds failed it caused losses in the trillions potentially wiping out insuring giants such as AIG and forcing the taxpayer to bail them out.
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9 Responses to Financial Armageddon – Our Slippery Slope

  1. Mahadevan Krishnan says:

    Happy birthday Ashok:
    The difference between FDR and Obama is that FDR talked the talk and walked the walk. He did not whine and complain about Congress not supporting him. Obama talks the talk (he is as smooth as a soothsayer) but walks the walk of Summers and Rubin and all the Wall Street mavens who have paid millions into his campaign funds and bend his ear with self serving dribble.
    The only saving grace of this mess is that it is self-destructive. Like a pure capitalist system in which one behemoth grows by acquisition after acquisition until it is the only behemoth left standing and finds itself fulfilling its mission by consuming itself, the multi-trillion dollar theft by the CDS miscreants will result in their ultimate destruction when the value of their theft is reduced to rubble. Sort of like a bandit who is so obsessed with gold that he amasses all the gold in the world only to find one day that his gold is worthless as it has become mysteriously radioactive and no one will touch it with a ten foot pole.
    Keep up the blogs. They are good for the soul.
    cheers,
    krish

    Like

    • Good to hear from you, Krish, and thanks for the Birthday wishes.
      I think our capitalist system used to actually be good for universal prosperity. It generated a robust middle class, innovation and rising standards of living without excessive predation.

      Now it has started feeding on itself like some grotesque auto-immune disease.

      All our prosperity has turned into the radioactive gold that you talk of. It’s sad that we can’t make simple fixes.

      Like

  2. hunter martinez says:

    Good read,
    You are chipping around the edges but is not quite going to the heart of the issue. The Predatory Elite have fashioned new weapons to devour the sheep, extract their wealth, and shackle them into slavery. It is a game as old as Man! There are 3 kinds of people in the world. Sheep, Wolves and Sheep Dogs….The sheep think the wolves are the guys in the streets with guns but the real wolves are the Harvard and Yale grads who have been trained from birth that they are above everyone and that people are objects to be bartered….It takes the Sheep Dogs to go after the wolves and expose them!

    Like

  3. Timo says:

    Firstly happy birthday and of course more importantly many happy returns Ashok.

    Why would CDS insuring company, i.e. AIG, sell insurance on ‘shaky’ ‘sure to fail’ GE like bonds?

    Like

    • Thanks, Timo, for the BIrthday wishes. Hope to share the many happy returns with friends.

      Why would AIG sell risky insurance – a good question. Here’s how the the scenario unfolded:

      It’s the 1990’s. AIG sells insurance on corporate and other bonds. Let’s say it charges 2% per year and perceives the risk of default to be 0.2%. So let’s say it insures $100 billion worth of bonds and collects $2 billion in insurance premiums. A year passes, no default. AIG makes $2 billion, pure profit. Big bonuses, large earnings boost. So it boosts its insurance writing to $500 billion worth of bonds, collecting $10 billion. Great jump in income when the bonds don’t default. Now AIG is looking for more bonds to insure. The supply of insurable bond debt (about $1 trillion) runs out. Bummer. Can’t grow the easy profits. What to do? In the beginning the financial industry tried creating new types of bonds by aggregating smaller and scattered debt instruments – thus we had mortgage backed bonds etc. Riskier, but heck, they felt they could insure them and make profits.

      In the end even the ability to create more bonds ran into a ceiling. So something creative had to be done to make the gravy train even bigger. The idea emerged – why not let people, who don’t own bonds, make a side bet on them. In effect insure against their default many times over, not limited by the float of the bond. CDS’s were born and they were so technically complex that even financial whizzes couldn’t figure the risk.

      So through these derivatives (CDS) each bond could be over-insured and the profits of “premiums” would increase. Eventually each $1 trillion worth of bond debt was insured 600 times or for a potential payout of $600 trillion if the bonds failed – in other words the amount of downside was larger than the net worth of AIG and all the other financial giants combined! But the amount of insurance premiums that AIG (and others, they were not the only players) could collect was no longer limited by the bond float of $1 trillion or so. They made large profits. Bonuses soared and AIG people either didn’t appreciate the huge risk or didn’t care. They were making the bonuses by risking the company and beyond, but the regulators or the owners of AIG (shareholders) did not realize this and could not stop it. The money managers had no incentive to stop the game – they were making huge amounts in bonuses. I read that the best money managers got $1 billion or more in annual bonuses.

      The Economist magazine had an article that says that they miscalculated the risk by factors of 100 or more. But even if they had to do it again, knowing the risks, the managers would do the same thing. They would get the bonuses and have nothing to lose. The only way to stop this is to have regulators restrict CDS’s and have logical capital requirements for the losses implicitly insured. Also to make the CDS’s transparent so everyone can assess what is going on. The administration has done none of this.

      Long explanation. There are books detailing all this: Fool’s Gold by Gillian Tett and Aftershock by David Wiedemer etc. Both are excellent.

      Like

  4. Akhil Kumar says:

    Ashok, Happy Birthday!

    Yes, we are becoming like a third world country more and more. Let’s face it the American dream is dead (died on 9/11). Education is out of reach of the middle class.
    As in third -world, the market has become unhinged from the broader economy, and will move out of sync since there are enough folks who have no where else to put their 401Ks, etc.
    The TIFs and COHs are continuing to do well.
    As long as there are a few Steve Jobses around we’ll all survive.
    So, who cares what’s the matter with Kansas!

    Akhil

    Like

  5. Raj Singh says:

    First, Happy Birthday to you, Ashok ji, healthy 100+ years, and then we will worry about the wolves…the bailout paul negotiated with congress contained a clause that no one would ask the wolves where and how the money would be spent so as to hide-and-protect the mega-mega bonuses they received and continue to receive…. Enjoy life while we can….and worry about the next generation and do something, if we can…. wall street is about “money-over-money” by extracting the last penny thru fast computer trades and by co-locating datacenters next to the trading floor… and smartest of the smarts being hired to write those algorithms… does it add to the GDP or takes away?… silicon valley startups rush to financial services to sell their latest products that help the wolves take a bigger bite… just like the entire world is happily helping china to be the biggest and the international wolf… america is run by bunch of attorneys whereas china has technocrats in their policy making bodies… america is bogged down by gay rights, its foreign policy is decided by asrael, its bills are written by lobbyists, its people live under fear of terror…. and paul walker makes trip to bejing and shanghai to teach chinese how to become a good-governance capitalist society… its capitalists wolves call themselves as global-citizens with US passport and are willing to move their wealth where the opportunities are to make even more money…

    ashok ji, come over to the west side of the bay and we will make dosa for you that has no oil and red chutney made of fresh tomatoes from the backyard….. enjoy-life-while-we-can….

    Like

    • Thanks, Raj, for the wishes and the offer of red chutney and fresh tomatoes. I must soon take advantage of your generosity. Off to the Central Asian Silk Route for two weeks – will surely see you upon return. Ashok

      Like

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