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Now that we got past the
latest mega financial storm, I was thinking about what caused the mess. And
if there is anything anyone can do about it. After all, my site is called the
PrudentSquirrel.
They key problem in this
ongoing credit crisis
First, let’s define the key
problem. The entire financial and productive economy of the world is
leveraged roughly 60 to 1. In my article Credit Crisis II, we talked about
how that developed as a gigantic world economic and financial bubble
beginning about the end of WW2.
If you follow the economic
reports of the latest victims of the credit crisis, Bear, Lehman, AIG, Fannie
Freddie, and who knows who is next, the key reason for these firms demise is
their 60 to 1 leverage. Maybe in some cases it’s only 40 to 1 but it’s still
the same situation. Fannie Freddie have 60 to 1.
Technical advances and falling
commissions
How in the hell did the entire
financial world get leveraged like that? Well for one thing, the combination
of deregulation and cheap money, plus the internet and the drastic fall of
stock brokerage commissions created a situation where the financial cowboys
could not make any money, except on ever bigger deals. The securitization of
all manner of credit made it extremely profitable for every financial
institution to pile up the debt and leverage. As long as the party continued,
no one questioned the danger (mostly no one).
Computers and the Internet (I
was an Oracle Systems engineer) made it possible to create fantastically
complex financial instruments and asset backed securities and derivatives.
This made immense amounts of money available for credit. Then, the internet
made it possible for brokerages to get millions of people trading online, for
next to nothing. So all this money came into the banks and brokerages, and
with the power of computers, was securitized into what is now turning out to
be disastrously complicated and illiquid financial derivatives.
I know I’m bringing up lots of
topics but I am just trying to broad brush this.
No incentives in traditional
brokerage business
Since there was very little or
no incentive for stock brokers and financial geniuses to gain an income
stream from commissions that dropped to pennies a trade, they naturally
applied their financial genius to creating the biggest piles of money,
securitized credit, which even at ridiculously low commissions, generated
hundreds of billions of dollars in commissions a year for brokers and the
financial cowboys.
Then, these geniuses figured
out that they could make more money by creating a Credit Default Swap. This
is merely an insurance policy that is bought against someone’s bonds, and for
a very modest fee, someone like AIG would guarantee it against a default.
And, why did AIG not get any
private money to bail them out this week? Because, they had issued an
unfathomable $440 billion of these guarantees in recent years, and made lots
of money signing all this up….
But then, we all know that
asset backed securities, derivatives, and bonds are all turning to garbage
now, and so, AIG is sitting on one hell of a big pile of financial
liabilities as all their CDS are now coming due for payment. So, in a short
time, AIG becomes insolvent. And that is what happened in this particular
credit storm this mid Sept 08.
And Lehman too had the same
problems. And, most banks, insurance companies, and brokers, worldwide, are
into these kinds of complex securitized financial derivatives, to the tune of
an estimated $1000 Trillion as of now! (One Quadrillion). These numbers are
derived from the Bank of International Settlements, the BIS. If just 5% of
these go bad, the world has a loss of an entire year of GDP!
So, in this huge credit party,
basically the entire wealth of the world is leveraged something like 20 times
the entire worlds GDP of 60 trillion. Uhm, we have a serious problem here
folks!
Throwing hundreds of billions
a day out
Considering that the Fed just
this week put out about roughly $80 billion Monday, $65 billion Tuesday
providing market liquidity (really taking the worthless bonds and such as
collateral from the now bankrupt financial world), and $85 billion late
Tuesday trying to save AIG (which will fail anyway) that comes to a cool $230
billion of losses out there that the US taxpayer just assumed, and in only 2
days!
Then, of course we know the
ECB and the BOJ and every other central bank put out another roughly $100
billion of liquidity themselves in that two days…Russia just loaned its 3
biggest banks $44 billion…
And, we can say that
cumulatively, since August of 07, the world central banks have put out
roughly $2 trillion and counting if you add up everything they are doing, in
essentially bailout out all this bad paper. There is only one problem. There
is $1000 Trillion of it out there. And it’s going bad very fast. And, the
central banks realize there is NOTHING they can do to stop this.
Why do you think the Fed was
resisting bailing out AIG so much, till they realized it’s either do that, or
see a cascade of massive financial bankruptcies worldwide?
This is all called
deleveraging by the way.
Insoluble interlinkages
Now, another insoluble problem
that presents itself, aside from $1000 Trillion of deleveraging, is the fact
that these financial derivatives are all interlinked. That means that, unless
one major player is bailed out, everyone else goes bankrupt, just like
pulling on a big ball of string.
Just to show you an example of
these complex interlinkages, consider the Credit Default Swaps. First, the
financial industry creates lots of securitized debt and financial
instruments. These are the derivatives. Then they create the CDS to ‘insure’
against the derivatives failure. The only problem is, for someone like AIG,
since they greedily issued $440 billion of CDS to every financial institution
imaginable.
The other institutions were
thinking they ‘hedged’ their risk on their side, but then when AIG goes
under, now all those people lost their ‘insurance’. That’s the end of our
financial world because AIG put out so much of those CDS. And, they are
indeed too big to fail. So, the Fed inevitably had to bail AIG out.
Inevitable deleveraging
Now, I don’t want to scare
you, but the entire point here is that this deleveraging problem is
insoluble. At some point, the end comes, and the Fed and ECB and BOJ and
everyone else knows it. The party is about done. The only question is when.
The ONLY solution is to wipe
out all debts worldwide and start over. And we know that lots of financial
interests don’t want that to happen.
Imagine a new world
Now, I want you to imagine a
new world. In this world, everyone in debt, GM, AIG, you, the nations with
big national debts – imagine if all that is zeroed out.
Would not economic activity
start screaming? Would not the world enter a period of unprecedented economic
prosperity, for probably another 65 year prosperity boom?
Now, of course, some of you
are laughing at this proposition. But that is exactly what happens in a Great
Depression. Everyone goes insolvent, often currencies collapse, and national
debts effectively wiped out. After all the economic carnage, a new era
begins.
So, we are right on the cusp
of this. But first there is a little ‘work’ to be done.
When do they finally give up?
Now then. Since I believe it
is impossible to stop this deleveraging (debt destruction effectively) then I
am quite sure the world’s central banks are going to finally let go. It’s
just this time, the Fed blinked on AIG. But this is gonna happen.
If continuing efforts are made
to prevent this deleveraging, the entire population of the world will be
turned into debt slaves. Hell, they already are anyway, which is why economic
activity is falling as we speak, and tax receipts are falling. The end of our
63 year post WW2 prosperity boom is here.
Tax deferred accounts?
IF the world central banks
insist on bailing out the bad capital, they will run gigantic deficits. They
will eventually be forced to raise taxes. It’s impossible. This is one reason
we have been talking about the idea to subscribers that maybe tax deferred
savings are not quite what they are cracked up to be.
Basically, when the central
banks and each nation realize they are going insolvent too, they will raise
taxes on those ‘tax deferred’ accounts by the time you want to pull out the
money. So, I’m fairly sure that you’re going to pay a lot more taxes on that
pile of money than you think. If the world economy was not collapsing, then
that would not be the case. But it is the case.
Now, what are we supposed to
do?
Why gold is falling
Before we get into that, let’s
discuss why gold is falling. In a very basic sense, the world is experiencing
debt deflation. Deflation causes the value of money to go up (everybody
wants’ cash right?) Prices fall, and since gold is money, then, naturally its
value goes up compared to other prices that are falling too. So, even if the
nominal price of gold falls, then it still keeps its value because price of
everything else is collapsing.
And, if you want to talk about
paper currency, sure, the value of that rises too at first in debt deflation,
because everybody is fleeing into cash.
So, at the moment gold is
falling, and the USD, for instance, is rising. But, I am not bothered by
this. Ultimately, the USD will fall in value again, maybe even collapse, and
if you have some gold, you will at least have some money – whatever that
price turns out to be. And wise economies will bail out on this world
deflation and not let their currencies collapse. But, there will be pain
associated with that. But some nations will certainly see their currencies
collapse, and just suffer worse pain anyway. The end is the same.
Now, getting back to what we
might do. We could gather cash and spread it around, not all in one account.
We might buy some gold when the price drops (or silver). We might buy gold
stocks, but in a great depression, mining companies might have a hard time
operating profitably, so I consider gold stocks to be second best, but not
ruled out.
We might buy a place and pay
it off to live in. Store some wealth there. Sure, the price of the home
drops, but the home still has a use, and is valuable, even if the prices at
the moment are falling. A home never should have been looked at as an
‘investment’ anyway. It’s shelter.
I don’t like the idea of
having a loan on the house to benefit from an eventual currency collapse
because you may lose your income before the currency collapses, and then the
house.
Then, if you survive the
depression, living very frugally, when the currency ultimately does collapse,
and a new one is created, you could sell the home for the new currency, or
any real thing you managed to keep in the depression. A lot of people got
wealthy in the Great Depression as they found great deals on everything, and
bought the stuff at 10 cents on the dollar, and just waited the mess out.
The trick is surviving with
some real things paid off. Now, I can already hear someone saying, yeah
Chris, but they will raise property taxes. That’s right. But, unless you plan
on emerging from the coming depression with NOTHING, you better plan on
dealing with some taxation as the governments panic.
Another thing you can do is
maybe have some variety of currencies in modest savings accounts. If they all
don’t collapse, then you at least have that money. But, one problem here is
that in these economic emergencies, foreign exchange restrictions are put in
and your money is frozen where it is. And maybe they allow you to take a
modest about out each month. But you ain’t moving no $100 K overseas in the
midst of that emergency….The government does not want all the money fleeing
the country in these crises. So, they sort of lock down accounts.
So, these are just some
thoughts on the latest Credit Crisis this week, The credit crisis seems to be
heading to the Credit Crisis II scenario that I wrote about.
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