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Here comes the big one

February 17th, 2008

My column in last week’s Fin was about the spreading crisis in financial markets. In the same week, we saw the first indication* that the crisis was spreading to the market for credit derivatives. The possibility of a full-scale financial crisis arising from these markets, which financial market bears have been talking about for years. Whereas the losses from sub-prime loans and related derivatives markets are likely to be in the hundreds of billions, the nominal volume of outstanding contracts in the credit derivatives markets is in the tens of trillions, and interest rate swaps are in hundreds of trillions.

Such amounts cannot possibly be repaid by anybody, so a breakdown in these markets would imply either wholesale bankruptcy or a government rescue involving the abrogation of existing contracts on a scale unprecedented in history. Either way, as noted in the article, large classes of financial assets, and the associated financial markets, may simply disappear. Hundreds of trillions of dollars in derivative contracts may be unwound, reversing the explosion of asset and transaction volumes over the three decades since the Bretton Woods system of financial controls broke down in the 1970s.

The latest news from the US suggests that a recession in 2008 is highly likely, if indeed it has not already begun. Employment is falling, consumer confidence is slumping, and indexes of activity in the service sector, which accounts for the bulk of economic activity, have declined sharply. The housing sector is at the centre of the decline, as a wave of defaults on subprime and other nonstandard loans has produced the first nationwide decline in home prices since the Great Depression.

At this stage, it is impossible to forecast the length and severity of any recession. It is, however, safe enough to predict that the US economy will return to positive growth in due course. Within a few years at the most, income will surpass its pre-recession peak. If the recession brings about an unwinding of the massive imbalances in trade and capital flows that have built up over the past decade, it may even yield some long-term gains.

The picture is much less clear for the financial sector, the excesses of which have brought about the current crisis. The crisis has effectively killed the subprime loan market, and produced a drastic contraction in the associated market for mortgage-backed securities, and derivatives of those securities such as collateralized debt obligations (CDOs).

With residential mortgage-based CDOs now almost unsalable, concern has now focused on other credit derivatives. Delinquencies are already rising on CDOs backed by commercial real estate loans, and new issues of such CDOs have ground to a halt. The panic is now spreading to student loans, leveraged commercial loans and a range of collateralized loan obligations.

The cycle of default, downgrade and debt deflation has not stopped there. During the boom, so-called ‘monoline’ insurers which were supposed to confine their business to a single activity, the provision of guarantees for municipal debt, extended themselves to insuring the AAA status of mortgage-backed CDOs, many now worthless. As a result, the main insurers Ambac and MBIA seem certain to lose their own AAA ratings and therefore their capacity to write new business.

A new competitor established by Warren Buffett of Berkshire Hathaway may partially replace the existing firms, at least for municipal bonds. But, the capacity to turn risky debt into AAA-rated assets through insurance is unlikely to return any time soon.

The problems are even worse for the rating agencies that issue the AAA (and lower) ratings on debt. The value of agency ratings was cast into doubt in the stock market bubble of the late 1990s when they gave investment-grade ratings to shonky enterprises like Enron and Worldcom, providing no warning to hapless bondholders until it was to late to escape from the inevitable collapse.

In the epidemic of unsound and outright fraudulent lending that generated the current crisis, the availability of AAA ratings for dubious credit derivatives played a crucial role. Thousands of these assets have already been downgraded, and large-scale defaults appear certain.

The failure of ratings agencies has some implications for Australia. During the 1980s, the good opinion of the ratings agencies was taken as a critical indicator of national economic health. Even today, the economically dubious decision of the NSW government to sell its electricity asset has been sold on the basis of the supposed need to maintain the state’s AAA rating.

Given this massive demonstration of incompetence, the idea that US rating agencies should sit in judgement on Australian governments, none of which has ever defaulted on obligations to foreign creditors, is simply laughable.

With so many pillars of the financial system displaying weak foundations, it is natural to wonder how the problems will be resolved. The general assumption is that, as with the real economy, the financial sector may contract briefly during the coming year, but will then resume its rapid expansion.

But the scale of the problems now becoming apparent suggests that the financialisation of the economy has exceeded the capacity of financial markets to manage risk. If so, large classes of financial assets, and the associated financial markets, may simply disappear. Hundreds of trillions of dollars in derivative contracts may be unwound, reversing the explosion of asset and transaction volumes over the three decades since the Bretton Woods system of financial controls broke down in the 1970s.

Such a development would have some bad effects, in reducing the range of options available to households and businesses to manage risk. But it would also reduce the danger of dubious financial innovations undermining the stability of the financial system as a whole.

* Felix Salmon has more on AIG and Naked Capitalism notes how problems with credit derivatives may interact with the slow-motion breakdown of the monolines.

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  1. February 17th, 2008 at 12:10 | #1

    surveying the world of money from low earth orbit, one gets the impression that science, mathematics, and computational power are merely being used to obscure the reality that no one has any idea what is going on.

    if every business uploaded it’s daily activity to the web, and nsa loaned it’s computer power to the project, is rational guidance of economic matters possible? or is capitalism just the polite name for economic chaos?

  2. Ikonoclast
    February 17th, 2008 at 13:59 | #2

    The financial “cowboys” complain about the costs of regulation but there are costs in lack of regulation too. We are about to pay them.

    Is it just my paranoia or is it all coming at once? I mean the perfect storm of economic disaster, energy/resource supply disaster, food supply disaster, fesh water supply disaster, ecological disaster and climate change disaster.

    Don’t know about you but I am getting a bad feeling about all this.

  3. Ken Nielsen
    February 17th, 2008 at 16:31 | #3

    John – you might be right, but I wish you did not sound so happy about it.

  4. haiku
    February 17th, 2008 at 19:09 | #4

    Ken – where does JQ sound “happy” in the above?

    He uses the word “laughable”, but this is derision towards the ratings agencies, not comic chuckling.

  5. jquiggin
    February 17th, 2008 at 20:40 | #5

    I can’t say I would mind seeing the Masters of the Universe eat a cold dish of humble pie, and there’s a certain grim satisfaction in pointing out the fraudulent nature of their claims to superiority.

    But of course, they’ve already cashed out and left the rest of us to pay the bill. The best we can hope for is to clean up the mess as smoothly as possible, and to try to insulate the real economy as far as possible. Some thoughts on this coming up, I hope.

  6. derrida derider
    February 17th, 2008 at 21:18 | #6

    John you’re possibly right, but I can’t help but remember the line about “economists have predicted seven of the last three recessions”.

    We’ve had these sort of computer-generated strategies using credit derivatives for thirty years now, and we haven’t faced disaster yet. In fact these markets seem to have become more, not less, robust over time (anyone remember their role in the 1987 crash?). It what you might expect as their risk management gets ever more sophisticated.

    Capitalism being what it is, it’s not impossible that the sky will fall in – but I reckon the odds are against it.

  7. derrida derider
    February 17th, 2008 at 21:22 | #7

    Oh, and I wonder all these people predicting disaster have moved their money into fixed interest bonds yet (ie have they put their money where their mouth is?).

  8. jquiggin
    February 17th, 2008 at 21:38 | #8

    I don’t think fixed interest is the issue. The crucial issue is that government bonds have turned out to be much safer than other allegedly AAA securities.

    It’s not clear if all this is going to be really bad for equity. If the real economy stays strong, maybe money will flow into stocks instead of bonds.

    As regards the thirty years, the amount at stake has doubled repeatedly over that time. This reminds me of a martingale strategy in g*mbling – you rarely lose but when you do you lose a lot.

  9. SJ
    February 17th, 2008 at 21:44 | #9

    Krugman’s latest New York Times piece, titled A Crisis of Faith” is similar to John’s.

    Krugman also reminded his readers that he’d written a column last year that was eerily predictive. (While it was written a year ago, it pretends to have been written today, which may be a bit confusing.)

    dd, we don’t often disagree. I think this is second time ever. You should rethink your interpretation of the word disaster. It means an event causing widespread distress of suffering. It does not mean an extinction event.

  10. SJ
    February 17th, 2008 at 21:46 | #10
  11. SJ
    February 17th, 2008 at 21:58 | #11

    dd Says:

    Oh, and I wonder all these people predicting disaster have moved their money into fixed interest bonds yet (ie have they put their money where their mouth is?).

    Why would it be necessary for someone analysing the situation to have taken a financial stake in the outcome? And furthermore why that one in particular?

    I’ve avoided bonds for a couple of years now, precisely because I suspected that this situation was going to occur.

  12. mugwump
    February 18th, 2008 at 01:48 | #12

    This reminds me of a martingale strategy in g*mbling – you rarely lose but when you do you lose a lot.

    Although not exactly what you meant, this is exactly the crux of the problem with the financial markets.

    Everyone is chasing higher than average returns at lower than average risk. Unfortunately, higher returns necessarily have higher risk (unless you’re Warren Buffet), so to satisfy investors Wall Street has to invent new products with high returns that haven’t yet proven themselves to be commensurately risky. That’s exactly what happened with CDOs: one could tell a (false) story of how the higher returns did not attract a higher risk.

    So far, no big deal. The real crux of the problem comes from the short-term compensation packages for Wall Street. Bonuses are typically paid in the year they are earned. If a financial wizard makes a billion dollars extra return for his investors one year then it doesn’t seem unreasonable that he receives a percentage of that return – say 1% or $10M (after all, it is just a contract between investors and their money managers). But what if that gain evaporates the following year? The financial wiz gets to keep his $10M, but the investors lose all their capital. So the incentives are misaligned: the investors (ultimately) want long-term gains, but the money managers do best from short-term gains.

    Investors should be demanding long-term escrow of bonuses – say 10 years. Otherwise, this cycle will just repeat itself.

  13. cold in my car
    February 18th, 2008 at 02:50 | #13

    DAVID WALKER THE CHIEF COMPTROLLER FOR THE GAO RESIGNED (fired) for his speaking out on the hirrible mess we are in. watch the vidoes. Very enlightening



    Walker has compared the present-day United States with the Roman Empire in its decline, saying the U.S. government is “on a ‘burning platform’ of unsustainable policies and practices with fiscal deficits, chronic healthcare underfunding, immigration and overseas military commitments threatening a crisis if action is not taken soon.[2] [3] [4]

    Walker has actively taken a public stance against the accumulation of massive federal budget deficits and public debt. He has participated in community lectures through an effort organized by the Concord Coalition, in a set of public appearances known as the “Fiscal Wake-Up Tour.� This has consisted of a series of trips acros the country, along with Robert Bixby, director of the Concord Coalition, in which a group of speakers make presentations in various communities regarding the size and impact of the US National Debt. This has been chronicled in the 2008 film, I.O.U.S.A..

    Northern Rock to Be Nationalized By U.K. Government (Update2)

    By Loveday Morris

    Feb. 17 (Bloomberg)—Northern Rock Plc, the U.K. bank bailed out by the Bank of England, will be nationalized after efforts to sell the struggling bank to a private company failed, a person familiar with the matter said.

    Posted by cold in my car · February 17th, 2008 at 4:42 pm
    Your comment is awaiting moderation.
    well gosh darn. AN LBO is happening that will be oversubscibed. all is good, we can all rest now.


    Posted by cold in my car · February 17th, 2008 at 4:43 pm

  14. cold in my car
    February 18th, 2008 at 02:55 | #14

    sorry, I didnt know this was an australian site.
    we here in America seem to be heading down the proverbial toilet. We started most of this and we are paying the price and will be paying the price for years. It is a sad state of affairs.

  15. February 18th, 2008 at 06:53 | #15

    you could say the roman empire ‘fell’ over a period of 300 years. comparing usa to the romans is consequently cold comfort- i was hoping for significant retribution in my lifetime.

    imagine not knowing this was an australian site! america’s cultural imperialism is almost complete. in fact, i have heard ‘buddy’ more often than ‘mate’ recently. the horror!

  16. February 18th, 2008 at 08:01 | #16

    I find this analysis fascinating and informative (not being an economist). However, I wonder if you could clarify your following statements: “If so, large classes of financial assets, and the associated financial markets, may simply disappear. Hundreds of trillions of dollars in derivative contracts may be unwound…” What happens in real world terms (e.g. survival of businesses, employment) and who is affected (investors, debtors, etc.) when financial assets “disappear.” Also what does unwinding mean in this context?

  17. gordon
    February 18th, 2008 at 08:17 | #17

    As an Australian who comments regularly at US sites, I’m happy to see Cold In My Car at an Australian site. I might not call him “buddy”.

    The value of the Roman Empire analogy used by David Walker is to call attention to the predatory nature of that collapsed economy. The Romans taxed the world for their own benefit, and gave less and less back over time. Eventually, their subject peoples feared and hated the Romans as much or more than each other or the barbarians who began to impinge on the frontiers. When, eventually, Alaric beseiged Rome, the gates were opened by a disaffected slave.

    We don’t need to go back that far to see the outcome of fiscal profligacy and financial irresponsibility, however. Not so long ago I suggested (at a US blog) that what in the US are referred to as “Movement Conservatives” look a lot like Fascists, and noted that:

    “US Fascism (like the earlier German variety) is fiscally and financially irresponsible and indifferent to the usual economic concepts of welfare. It does, however (also like Nazism) display talents for financial manipulation and trickery, and business supporters are rewarded without consideration of the economic distortions arising from such payoffs. Again like Nazism, US Fascism uses plunder (both of US citizens and foreigners) to fill the inevitable financial gaps”.

  18. Spiros
    February 18th, 2008 at 08:42 | #18

    “Investors should be demanding long-term escrow of bonuses – say 10 years”

    Who are these investors? Ultimately, ordinary people. But the ones who do the demanding are the funds managers and they get paid using the same corrupted bonus system. It’s not in their interests to demand reform of the bonus system.

  19. observa
    February 18th, 2008 at 08:49 | #19

    Well here we all are finally and the overarching question is how did it all come to this. Now we Austrian adherents reckon we know exactly why. Central bankers and their giant ponzi scheme has at last fallen over as predicted. Now normally this ponzi scheme, basically printing gobs more money via the fractional reserve banking mechanism, would have quickly resulted in inflation as it did in the 70s and as educated chaps like Mugabe know only too well, even in these profligate days. When you effectively print more and more money and put it in the hands of eager young household formers, they’ll quickly drive daily prices of goods and services skyward. However, this time round the demographics had changed. An aging generation didn’t need to spend it all right away, but started socking it away in perceived stores of appreciating wealth, expecting to draw upon it in retirement to purchase the real goods and services they would require. In that they were ably aided and abetted by hard working young Asian savers, who should have known better, but for their wiser govt heads directing all the traffic.

    Simply put, the lesson of Austrian economics was delayed by historically exceptional demographics. Print monopoly money and it’s inevitable that excess supply would create its own excessive demands. More and more financial intermediaries went looking for more and more dodgy homes for it all, until the game became obvious to the many. Govts and their central bankers have no real stake in seeing a dollar next year buying the same or more as it did this year, particularly with progressive income tax scales, whereas you and I do. If we stick a $100 under the mattress and in a year it buys say $102 worth of goodies, we’re a lot more circumspect about who we lend it to, than if it only fetches $98 worth. Govts and their indexed taxeaters couldn’t care less. Perhaps now their ponzi scheming has been so large and prolonged and the shakeout inevitably equally so, we’ll vow to never let the bastards get away with this again.

  20. February 18th, 2008 at 09:37 | #20

    Meanwhile back in Oz the RBA will crank up rates another notch on March 4. This will put a rocket under the Aussie dollar and make those Chinese widgets we’re addicted to even cheaper. But hey, who cares about the trade deficit these days? Who needs an export sector when we can dig stuff out of the ground and sell it to the world for ever increasing prices?

    I’m just wondering, if the resources boom busts, will there be any exporters left in Australia? Will we have anything to sell to the rest of the world? Will we know how to make anything or fix anything?

  21. mugwump
    February 18th, 2008 at 10:13 | #21

    Who are these investors? Ultimately, ordinary people. But the ones who do the demanding are the funds managers and they get paid using the same corrupted bonus system. It’s not in their interests to demand reform of the bonus system.

    Ultimately market forces *should* win out, but I agree it is not clear how to get to a more rational compensation structure from here. An investment firm that offers only escrowed bonuses will currently lose the best talent to one that offers instant gratification. However, now would be the time to push for changes since some very big and powerful investors have been seriously burnt by this latest Ponzi scheme (particularly big pension funds), and will be keen to demand more accountability.

  22. Spiros
    February 18th, 2008 at 10:29 | #22

    Any hope in this lies with organisations like Calpers (the Californian public sector pension fund, for those not in the know) which has huge amounts of money at stake on bwhalf of its members and has shown a willingness to take activist stances on various issues in the past.

    Let’s see what happens, but one would be ill-advised to hold one’s breath, waiting for any meaningful reforms.

  23. February 18th, 2008 at 10:32 | #23

    here’s a hint, mugwump:

    the economic structure of society is a close parallel of the political structure. both are unresponsive to ozzies neither members of political parties, nor board members of corporations.

    if oz were a democracy, serving the interests of the people, the activities of economic organizations might be led to that goal as well. which is why policrats and plutocrats aren’t about to let democracy happen.

  24. Peter
    February 18th, 2008 at 10:39 | #24

    The whole world is going to cave in. This is going to be bigger than the Great Depression.

    Doomsdaying rubbish!

  25. observa
    February 18th, 2008 at 10:59 | #25

    It normally would be a bit of doomsday rubbish Peter, but for the alignment of the planets that allowed this giant ponzi scheme to endure for a decade or so world wide. Noone knows how much doom and gloom is involved in unwinding all that now. Judging by the US Fed response, we’ll try and wash it out with high inflation, although our Reserve is now trying the opposite tack of sticking its finger in the dyke with higher interest rates, while Britain is nationalising Northern Rock as a response. Horses for courses I suppose, but the garbled response doesn’t exactly fill one with confidence.

  26. O6
    February 18th, 2008 at 13:55 | #26

    Prof Q, on point 8, I thought the point of a martingale strategy was that the St Petersburg paradox will hit one in due course: it’s a proven losing strategy. Not so? Is there an example of a bubble that didn’t burst?

  27. jquiggin
    February 18th, 2008 at 18:35 | #27

    O6, that’s pretty much right. As usual, Wikipedia is good


    On bubbles, I guess if it doesn’t burst (hasn’t burst yet?), it wasn’t a bubble.

    Peter, you’re the only one raising doomsday scenarios. The post says that, if there is a recession, the real economy will certainly recover over the next few years.

  28. Jill Rush
    February 18th, 2008 at 18:47 | #28

    Should we be worried about the future fund?

  29. Donald Oats
    February 18th, 2008 at 19:05 | #29

    The future fund (Jill Rush 28) is an interesting one. Last year I checked Nick Minchin’s web site and the official gov sites, and was more than a little surprised to learn that the fund is allowed to use derivative products, since in parliament I’m pretty sure they had ruled that out.
    Since public servant liabilities (ie their *total* superannuation, which includes their extra salary contributions) are supposed to be paid out of this fund, I tried to find out the implications – eg are there any guarantees in place against loss of public servants’ retirement funds? No joy.
    Anyone here know whether the future fund has no future :-0

  30. Will
    February 18th, 2008 at 19:09 | #30

    In all this I think it might be useful to try to distinguish between primary and secondary markets for financial assets, and their relationship to liquidity.

    The primary markets are where long-term money is raised for its primary purpose, to fund the development and/or operation of real capital infrastructure. The money raised goes directly to the borrower/issuer to be used for this purpose. This is where the betterment of our society happens.

    By the terms of the financial instructments themslves (equity, debt or some somewhere in-between), investors in the primary market are signing up for the long-term; contractually they will not get their money back for a long time. This makes perfect sense because the real capital infrastructure that is funded by this investment should itself have a long useful life and thus long payback period.

    Now it may be that a lot of investors in the primary market don’t really want to sign-up for the long term. Is it not reasonable to say that, perhaps, they shouldn’t be investing in financial assets? But wait, there’s a solution to this problem, and its called “liquidity”.

    Everyone seems to agree that liquidity is a good thing and that we need “well-functioning” secondary markets for financial assets to provide liquidity. Why? If you buy a long-term financial instrument you are deferring your consumption to the future, with some uncertainty. Why should you expect that someone else should be willing to defer their consumption, with uncertainty, so that you can change your mind and sell them the asset and get your money back when you like?

    In this sense the perfect secondary market is like an eternal and free put option. But why should you expect that option to be provided to you? And more to the point, if it is being provided to you, it might be reasonable to ask why it is being provided and who is bearing the cost?

    Of course the trading of financial assets in the secondary market does not affect the infrastructure funded by those assets in the primary market. The road funded by bonds sold in the primary market will be built, irrespective of whether the bonds subsequently trade or don’t trade in a secondary market, and irrespective of their price in that market.

    Now the argument will come that without a liquid secondary market no-one will be willing to provide the funding in the primary market and so no new infrastructure can be funded. Well this doesn’t make any sense. Ultimately someone has to (and will be, wittingly or unwittingly) put their money at risk for the long-term to fund long-term infrastructure investments.

    It will certainly be true that you might charge more for your money if you don’t have the benefit of a free put option back to a “liquid secondary market”. But if there is such a free put option, someone, somewhere has to be providing it and bearing the cost. So, as usual, it turns out that we don’t get something for nothing.

    What has this to do with monolines, credit default swaps and the credit ratings on which they all hang? Well they are all products for the secondary market. They are designed to certify and commoditize financial assets to increase their liquidity.

    (In fact we saw investors develop – CLOs, CDOs, hedge funds, that are entirely creatures and creations of the seondary markets. I recall hearing about a CDO manager who was buying covenant-lite LBO debt. When asked why he would accept debt with no controls over the borrower he said that he would never be involved in a work-out situation because he would just sell the debt before it reached that stage. To him covenants are a bad thing because they could cause default, which would hurt the price of the asset. Forget that default is the means lenders have to protect themselves.)

    But there are two obvious problems with this.

    First, investment risk cannot be commoditized and certified. Ever. It is nonsense to say that you should be able to invest in financial assets without attempting to understand the underlying risk because somehas has certified it.

    Second, the put option represented by a liquid secondary market might not exist when you want or need it. Irrespective of the underlying risk of your financial asset, it may just be that no-one wants to defer consumption to buy your risky long-term asset, or no-one wants to do it at anywhere near the price you did.(Of course you could deposit your money in a bank, like Northern Rock, and then there is a put option, provided by the government.)

    Now I work in a primary market for long-term investment in infrastructure assets where the investors have never counted on a secondary market. We try to understand the underlying risks, and structure the financial assets to give us information and control. We don’t rely on ratings or monoline wraps or CDSs. There are no CDOs or CLOs in my market. Not surprisingly, my market is going along pretty well today and infrasrtucture that makes sense is still being funded.

    To be honest, I’d not be too unhappy to see a lot of short-term investors turned into long-term investors in their long-term assets, and the real beneficiaries of the “liquidity” scam – the investment banks, rating agencies and other collateral parasites on the financing animal – get their flea-bath.

  31. MH
    February 18th, 2008 at 19:13 | #31

    Jill indeed you should, a random catch up with a lot of self funded retirees over the weekend revealed a similar story, losses on average of about $60,000 plus for each and some very worried older members of our society now that their financial assets are evaporating long with stock market share values. The key is the reduction in capital and the virtual seizure of capital markets. It will take some very creative thinking to correct the ferocious deflation now occurring in capital markets given that so many of the so called capital lenders were uncontrolled, unregulated and now find the only asset backing for the cash out their was a promise.

    A quiet word with someone from a very well respected financial institution, they had all their investments in cash when this all began some time last year confirmed my suspicious view of the world, keep talking up the market for the suckers to stay until you get your money out. Caveat emptor.

    I would not take any comfort from Warren’s play, it is merely a very cheeky reinsurance bid, but he has the liquid gold to make it hold, for a while.

  32. February 18th, 2008 at 23:22 | #32

    From comment #2:-

    The financial “cowboys� complain about the costs of regulation but there are costs in lack of regulation too. We are about to pay them.

    Ironically the current problems seem to stem mostly from the USA which also seems to be somewhat more regulated in these matters than places such as Australia. Although deciding if a place is regulated more or just regulated different is a somewhat tricky thing.

    Over at Catallaxy they note that in the UK bank nationalisation is on the agenda:-


  33. kyangadac
    February 19th, 2008 at 00:07 | #33

    Intersting times indeed – while Will is rightly reassuring about the real world, I suspect that the fly in the ointment is the value of the currency(currencies) that is being undermined. Thus long term investment can only be relied upon when a currency is not in danger of inflating. Similarly, the problem with investing in bonds as a safe haven relies upon government gaurantees about their redeemable nature – which, of course, depends upon the reliability of the government – remember revolutions etc.

    Many people have made the point that the $US depends entirely upon oil and US military power for its value as a global currency. Hence the perfect storm concerns alluded to make perfect sense.

  34. mugwump
    February 19th, 2008 at 01:31 | #34

    A quiet word with someone from a very well respected financial institution, they had all their investments in cash when this all began some time last year confirmed my suspicious view of the world

    There was enough warning MH. I am not a professional investor, but I transferred all my super to cash in the nick of time. No conspiracy, just watch the markets closely.

  35. mugwump
    February 19th, 2008 at 01:52 | #35

    Will, the put options in the secondary market are not free, although they were obviously underpriced for certain securities.

    I don’t see anything wrong with have secondary/derivative markets: they allow much more flexible packaging of risk. The latest problems have to do with mispricing of that risk (partly through over-reliance on the ratings agencies), in just the same way that a poor primary investment can go bad through inadequate risk assessment.

  36. February 19th, 2008 at 14:42 | #36

    Regarding #33. The value of the US dollar doesn’t depend on oil or military might. It depends on supply and demand. The keystone source of US dollar demand is the US tax system and the sheer scale of the US economy. However if the US dollar is falling in value it is ultimately due to monetary policy and the supply side of the equation. The US central bank has a lousy track record when it comes to protecting the buying power of the dollar.

  37. wizofaus
    February 19th, 2008 at 15:06 | #37

    Well to be accurate the U.S.’s military might supports the strength of most of the world’s economies, dependent as they are on a steady flow of oil from a rather unstable part of the world.

    But, as I understand it, the US dollar value is very much dependent on its status as the international reserve currency, and given that China holds something close to a trillion dollars worth of US bonds, then you’d have to think China holds the cards here. As long China is dependent on US consumer demand for its economic growth, its probably not going to do anything to risk devaluating the dollar further. But if the US slides into recession and consumer spending collapses anyway, who knows what China might do…

  38. mugwump
    February 19th, 2008 at 15:36 | #38

    given that China holds something close to a trillion dollars worth of US bonds, then you’d have to think China holds the cards here

    You’d think so, except that more than one trillion US dollars are traded every day on global currency markets.

  39. wizofaus
    February 19th, 2008 at 15:40 | #39

    True, but that’s a roughtly even mixture of selling and buying, and China has been consistently buying and holding US bonds. If China decides to stop buying and start selling, it would change the equation considerably.

  40. mugwump
    February 19th, 2008 at 15:57 | #40

    They’d be idiots to try and sell them all on the same day, but it sure would be fun to watch them try.

  41. Ian Gould
    February 19th, 2008 at 15:58 | #41

    Terje: “Ironically the current problems seem to stem mostly from the USA which also seems to be somewhat more regulated in these matters than places such as Australia. Although deciding if a place is regulated more or just regulated different is a somewhat tricky thing.’

    Well obviously, since government is the root of all evil, which ever country suffers most will retroactively be declared to be the most regulated.

  42. Ian Gould
    February 19th, 2008 at 16:00 | #42

    “Regarding #33. The value of the US dollar doesn’t depend on oil or military might. It depends on supply and demand. The keystone source of US dollar demand is the US tax system and the sheer scale of the US economy.”

    so when a Japanese company buys dollars to purchase Chinese steel or Iranian oil they do so because of “the US tax system and the sheer scale of the US economy”?

  43. Andrew
    February 19th, 2008 at 16:23 | #43

    Will #30… I think you understate the importance of secondary markets and ‘liquidity’ in marrying the sources and uses of capital. It’s all very well to say that real infrastructure will continue to get built – but if the investment banking community and global stock exchanges of the world all closed tomorrow – who’s going to facilitate moving cash from the savings account and superannuation of Ma & Pa Jones to Bedrock Constructions Ltd building the new rail link from A to B?

  44. MH
    February 19th, 2008 at 16:42 | #44

    Mugwump, likewise. The so called financial gurus I refer to (a very large and respected institution by the way) saw no contradiction in continues to counsel and sell to the moms and dads of Oz so called wealth products using the same blather you get passing for advice in the Fin Review these days, while within the walls they quietly moving their own assets to cash. Northern Rock is more than an interesting development, long time since we saw a western government nationalise a bank!

  45. Will
    February 19th, 2008 at 17:51 | #45

    Andrew #43 … My point is that the new rail link, which will generate return over the long term, ultimately has to funded over the long term. The problem is that everyone seems to expect that they can fund long-term assets with short-term capital. Stock exchanges, for example, deal in equity, which is meant to be the most “patient” capital. It has no rights of redemption at any fixed time. But investors in stocks don’t seem to recognize this, and they’re not encouraged to, because volume traded is how investment banks and brokers make their money. Clearly there is a mismatch of the expectations that have been created and the ultimate reality.

  46. Ernestine Gross
    February 20th, 2008 at 10:37 | #46

    MH, the UK government acted in a manner that is logically consistent with the contractual arrangements. When equity holders default on paying their loans then ownership shifts from equity to debt holders. Due diligence is also a well accepted procedure in commercial transactions of ownership of assets. The term ‘nationalisation’ is, in a sense, redundant.

  47. MH
    February 20th, 2008 at 12:19 | #47

    Ernestine, The UK government had no choice but to protect the very large dollops of cash they had already injected into th “Rock’ to stop it from failing, so I find it and interesting conceptual position that one can now claim it is prudent due diligence after the event.”Bollocks” it was political decision to stop the collapse of the fifth largest bank in the UK. Again the taxpayer foots the bill for due diligence gone mad. Had Northern Rock been subject to some due diligence while it was being so carelessly operated by its management it would not have put itself into a position where its liabilities exceeded its assets and it could have easily met redemption demands by the true owners the depositors without the need to resort to the taxpayers funding a financial smoking black hole. I guess management believed that it was the off balance sheet ‘dark matter’ that kept it afloat.

  48. Ernestine Gross
    February 20th, 2008 at 19:40 | #48

    MH, I suspect I was too cryptic in my reference to ‘due diligence’. If so, I apologise. I had in mind the UK government rejecting private bidders for the Northern Rock bank as an outcome of their due diligence process. Hence I agree with you that the UK government acquired the Northern Rock bank to protect the (currency) money it had extended to this bank. The main point I wanted to make is that the term ‘nationalisation’ has many connotations which do not apply, IMO, to this case. I don’t know what goes on in managers’ minds. However, I am not convinced that the problem consists of ‘off balance sheet items’ and ensuring that ‘assets cover liabilities’. IMHO, one of the problems is that the balance sheet approach is hopelessly inadequate to deal with complex financial markets as it has developed during the past 20 years.

  49. February 20th, 2008 at 19:55 | #49


    Regarding #41. I’m thinking of the Heritage index of economic freedom which indicates that Australia has a more liberal financial sector.

    Regarding #42. I did not say that the US tax system was the biggest source of demand for US currency. I said it was the keystone source of demand. Not the same thing.


  50. MH
    February 21st, 2008 at 06:58 | #50

    Ernestine, I was a little terse myself no offense. In a round about way I would agree about the inadequacy of ‘financial reporting’ processes, the crisis now unfolding is that at the regulatory level is that the creation of money moved into a parralel universe so to speak where oversight effectively relied on the market view of what was or was not an asset and what was or was not the value of both asset classes and income streams. More qualified commentators than myself strongly suggest that transparency disappeared as did notional valuation processes and this is why the credit markets is in a state of virtual gridlock. Established banking institutions cannot determine a proper valuation, especially in a falling market for many assets and the reporting processes prevent transparency – the outcome a major crises of trust. The asset value wind down and contraction of credit markets could have been a lot more orderly and manageable and IMHO then managed as are all cyclic ups and downs.

  51. Ian Gould
    February 21st, 2008 at 16:20 | #51

    The US Fed just cut it’s calendar 2008 GDP growth projection from 1.8-2.5% to 1.3-2%. Growth in the fourth quarter of 2007 was 0.6% so the economic is continuing to slow.

    That would seem to imply at least one quarter of negative growth if not a full-blown recession later in the year.

  52. observa
    February 21st, 2008 at 20:33 | #52

    Here’s a pretty good summary of the situation http://www.atimes.com/atimes/Global_Economy/JB20Dj09.html
    Cheap money started it all and the notion that public servants can control or oversee risk is nonsensical, particularly with fractional reserve banking. Take fractional reserve banking out of the equation and you wouldn’t have to manage the risk or bail out rotten banks like Northern Rock in the long run.

  53. Chui Tey
    February 24th, 2008 at 16:38 | #53

    Actually, if there are muni bonds at 60 cents in the dollar, they’d be pretty good buys. Where can I get my hands on them?

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