Derivatives: the "pub with no beer"

You could be forgiven for thinking that financial bloggers are hysterical and fantasy-ridden, far more so than the middlebrow newspapers that have only just caught on to the crisis.

Until you learn the facts.

The money system is so enormous and complex that nobody knows all the details, but it is estimated that in 2007, the entire world's GDP was equivalent to $54.35 trillion.

Derivatives - mutual insurance without the requirement on anybody to hold any assets - have recently been estimated by the Bank for International Settlements at over $1,000 trillion.

To put it visually (figures are in trillions of dollars):

And now a quotation on default rates - the percentage of bonds (promises to repay) that fail:

NEW YORK, Aug 1 (Reuters) - The U.S. junk bond default rate rose to 2.25 percent in July from 1.92 percent in June, as a credit crisis and sluggish economy pushed more companies into bankruptcy protection, according to data from Standard & Poor's released on Friday.

The default rate is likely to rise to 4.9 percent over the next year and could reach 8.5 percent if economic conditions are worse than expected, S&P said in its report.

Note that in the case of derivatives contracts, a default rate of less than 5.5% would equate to a wipeout of a whole year of the entire world's earnings.

No wonder that governments are absolutely determined that confidence in the system must be maintained, at whatever cost. It may take a long time to blow up a balloon, but it doesn't burst slowly.

And how do we get out of this threatening situation? How on earth, to use a different analogy, will the cat ever climb back down from so high a tree?

Lehman and that $8 billion

Lehman administrators have filed a court order for the return of $8bn that was transferred from the UK to the US just before the firm's failure. The radio news this weekend said (my phrasing) that it was Lehman's practice to park the money in the US overnight to earn interest.

Reuters says "Administrators for Lehman's European operations have questioned why $8 billion was transferred to New York from London just before the bank collapsed."

Was this really standard practice? Couldn't the money have been earning (possibly higher) interest overnight here? Do other firms do the same?

Or was it part of a Lehman plan to draw assets back onto US soil in preparation for its bankruptcy, in order to favour American creditors over foreign ones, as London Banker mooted on 12 September?

Another prophet foresees market panic

Thus Jim in San Marcos:

This week, look for a serious drop in the DJIA of 4,000 to 6,000 points and the close of the stock market for a week or two. [...] Most people have sensed something is seriously wrong with the markets and are heading for the exits (even the President said so). With the automated computer trading system in place, this could be very fast and furious,--sleep late and wake up broke.

Monday morning at the brokerage houses you’ll hear; “Sell everything; I didn’t sleep a wink the whole weekend.” It will be a group effort.

Carte Blanche; take cover!

We're back in the days of Dumas' Cardinal Richelieu (*), as London Banker points out. He quotes Section 8 of the proposed new US financial legislation:

Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency.

How is this to be subjected to democratic accountability?

I essayed a paranoid spoof on Friday, only to find it exceeded by reality. See Karl Denninger for more details of the amazing, autocratic powers proposed in the new US financial legislation.

This is not a sweary blog, but if that becomes law, head for the bl**dy hills.

Denninger also explains how the $700 billion limit can be manipulated to absorb infinite amounts of bad debt, by discounting on resale and then taking on more fresh garbage. He says:

I predict that if this passes it will precipitate the mother and father of all financial panics, although exactly when the "short bus" riders who inhabit the equity market will figure it out remains to be seen.

_____________________________

(*) see Wikipedia:

"Dec. 3, 1627

It is by my order and for the good of the state that the bearer of this has done what he has done.

Richelieu"

Another letter to the Spectator

Let's see if they bin this one: (n.b. I've made a few alterations in the hour since posting)

Sir;

Your leader (“Long live capitalism”, 20 September) calls for a “kick up the backside” to the banking industry. That kick should be aimed elsewhere.

Light regulation and free markets, which the Spectator advocates, depend on the self-regulating properties of a sound money system. But like many others, the British government has long used the fiat nature of its currency-cum-credit to solve temporary problems and create permanent ones. The long-term real growth of GDP is said to average 2.5% annually, yet since 1963 the Bank of England’s own statistics show that the M4 money supply has grown by about 13.5% p.a. Over the same period, RPI has averaged about 6.5% p.a. At this rate, the banks will ultimately own everything.

For the first 5 years of the New Labour administration, M4 growth was, not exactly prudently, but less recklessly, restricted to around 8.25% p.a. However, by 2003 the FTSE had halved from its 2000 peak, and there was gloomy talk of recession; and over the next five years M4 suddenly averaged nearly 14%. Then house prices doubled; hinc illae lachrymae.

How did this happen? The system of fractional reserve lending means that banks can loan out a multiple of what they retain in their vaults. State regulators set the rules for the required marginal reserves, and when reserve requirements are halved, lending can double, and usually will; like Labradors, bankers will have whatever is put on their plate.

Knowing this tendency, the British and American governments have not merely permitted this crisis to happen, but positively created it by a deliberate relaxation of monetary controls. Worse still, they have now decided that instead of destroying excess credit by asset deflation, bankruptcies and share collapses, the monetary inflation is to be consolidated by absorption of bad debt into the public finances.

I don’t see how this can end well. Some commentators are already saying that, if passed unaltered, the proposed American financial legislation could, once properly understood, trigger a major crash in US financial shares, possibly before this letter is published.

I think the Spectator and its economically savvy readers should put on fresh pairs of winkle-pickers, and gather in Whitehall and Washington for some kicking practice.

Yours faithfully

I'll stay on the outside, thanks

Actually, I hope all the top bankers and star traders keep their huge bonuses (one year's worth of which would keep people like us for life), and I hope none of them gets jailed for their corruption/criminal incompetence.

Because otherwise, I might have to believe in Big Brother, and love Him.

I don't BELIEVE it

So I asked for a strong tea. And when I lifted the lid to stir it, I saw they'd put in a single bag, but only half-filled the pot with hot water.

Suddenly, I'm less deterred by fuel surcharges on foreign holidays.