Financial Armageddon – Our Slippery Slope

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.