Broad Oak: your emotional support animal

Thursday, November 19, 2009

Dilution

It is generally agreed that our current financial mess was precipitated by the sub-prime mortgage fiasco. The system was already burdened by too much debt to absorb those new losses. The commentators have moved on to the American hobby of assigning blame: to President Clinton and the Democrats for forcing the banks to offer high-risk loans to the poor, the bi-partisan officials for deregulation, and to the poor themselves, for accepting 'free' money.

To me, a finance ignoramus, the real questions are:

a) How did a few million bad loans bring down such a huge system?

and

b) How did the system get so much debt?

The answer to a) seems simple. While the government could have paid the $500 billion or so in bad loans, or Wall Street could have given up bonuses for a couple of years, the way that the debt was securitized meant that each bad dollar in investment was multiplied by factors in the hundreds. All on paper, of course.

As for b), I note that Robert Rubin states that 'this could not have been foreseen'. I can only attribute this to a quasi-religious belief in the magic of the market. Several people that I know were worried at the trends over 15 years ago. Nominal house prices were rising faster than inflation and incomes combined, and too many people were using their homes as cash machines by re-mortgaging.

This fiat money was magnified many times by the system through derivatives, until we reach the current state. With a world's annual production of goods and services at about $55 trillion, there is an estimated $1000 trillion in derivatives. That is, we have mortgaged everything on the Earth for the next 18-19 years. That's what I call a sub-prime loan!

Homeopathic 'medicines' are made by diluting active chemicals with distilled water until no molecule of the ingredient is left. We appear to be actively approaching homeopathic wealth, diluted by paper.

9 comments:

OldSouth said...

'That is, we have mortgaged everything on the Earth for the next 18-19 years.'

A wonderful turn of phrase, conveying the reality of our situation.

Paddington said...

Thank you. I try hard.

sobers said...

The reality is that we have fuelled our so called 'economic growth' with debt for decades. That debt reached such dizzying heights in 2007/8 that a catastrophic blow off was always going to come. The house price increases and other bubbles were just the final manifistation of that debt build up.

Most of the increase in living standards of the last 50 years in the West is created by drawing forward demand from the future, allowing production and consumption now. This can only continue if the amount of debt continues to rise inexorably over time.

There is a great video of Australian economist Steve Keen on the Credit Writedowns blog (http://www.creditwritedowns.com/2009/11/steve-keen-debt-and-the-economy-how-do-we-pay-for-all-of-this.html) where he explains it all. Scary stuff mind.

James Higham said...

Read Denninger's piece at my place and it says that it was generated elsewhere.

Weekend Yachtsman said...

'That is, we have mortgaged everything on the Earth for the next 18-19 years.'

A wonderful turn of phrase indeed, but far from conveying the reality of the situation, it conveys nothing at all.

If I mortgage my house (which, thank heavens, I have not done), I owe the bank.

To what can the entire world economy owe money? And how?

This is all on paper (or more likely, on computer files). So, tear up the paper. Now who has lost what?

I can believe that the West is in hock to the Chinese, I can believe our fiat money is about to become worthless, I can believe that the UK owes stupendous sums to whoever it is who's been foolish enough to bankroll Gordon Brown's wastefulness.

But to say the whole world owes anybody anything is just absurd.

Paddington said...

Weekend Yachtsman - I agree with you. It has to be all on paper. However, the people who own that paper seem to believe that they own us.

Weekend Yachtsman said...

Paddington - well I suspect they're about to find out that they don't. Unfortunately, the failure of fiat money is going to take a lot of good (ie basically law-abiding hardworking normal taxpaying) people down with it. Yours truly included.

Paddington said...

We be taken down too. I may be in worse shape, as I'm an academic, the tradional group to get the blame when things go haywire.

Paddington said...

We be taken down too. I may be in worse shape, as I'm an academic, the tradional group to get the blame when things go haywire.