The reader’s letter comes from a Mr. D.P. Marchessini. I suspect that Mr. Marchessini is correct and the present credit crisis is the natural consequence of high leverage, the repeal of the Glass-Steagall Act and the creation of excessive and complex derivatives. The letter traces the sequences of events:

“In 1933, the United States passed the Glass-Steagall Act, which prohibited commercial banks from dealing in investments, and prohibited investment banks from doing commercial banking activities. This was a very sensible measure, and kept the banks in reasonable order until 1990.

“Unfortunately, in 1990, this Act was repealed — for reasons best known to the psychiatrists of the legislators. The result was that all the big Wall Street brokers became banks, as well as brokers, and the big banks started trading and speculating. This was combined with an enormous increase in “leverage” — borrowed money — by all the banks. Leverage is the ratio of a bank’s capital to its total assets.

“This used to be between five and seven times, pre-1990. But post-1990, it immediately started ballooning and, although the banks tried to keep it quiet, it was known that Merrill Lynch (NYSE:MER) was more than 40 times. Goldman Sachs (NYSE:GS) was 28 times, and Lehman Brothers (NYSE:LEH) was 30 times when it failed. Regardless what one thinks of such hair-raising tactics, the one thing that is clear is that they only work when the market is going up. Apart from their Balance Sheet, all the banks also had an enormous amount of ‘derivatives,’ which were kept off the Balance Sheet. Derivatives are an enormous cocktail of very exotic Options, on almost anything. In 1995, I was talking to someone at a dinner party, who was rich and supposedly very well connected in the financial world. I asked him what he thought the total amount of nominal value in derivatives were at that time. He said he thought perhaps $100 billion. In fact, at that time, they were $1 trillion. Today, they are $1.3 quadrillion — all off the Balance Sheet. They are also not included in any bankruptcy. Of course, this is the nominal value, and the actual amount at risk is much less. But five percent of $1.3 quadrillion is $65 trillion — still a tidy sum.”

I do not understand derivatives, certainly not at a level of $1.3 quadrillion. I am not even sure what a quadrillion is, though I assume it is 1,000 trillion. I do not feel ashamed of my inability to understand the global derivatives market, since the Sage of Omaha, Warren Buffett, himself has said that he does not understand them. What is clear is that they have been created in very large numbers. If Mr. Marchessini’s figures are correct, the gross value of derivatives is far in excess of the capacity of all the world’s governments to bail them out. Even a net value of $65 trillion is beyond the bailout potential of the major powers.

The Secretary for the Treasury, Hank Paulson, has asked Congress to authorise $700 billion as a bailout for those banks that have invested in sub-prime mortgages and other toxic assets. This is a sum one can reasonably understand. In London there are a large number of houses worth £1,000,000 or more. A thousand such houses are worth £1 billion. That is a solid reality. The $700 billion, which Secretary Paulson is asking for, is worth about £400 billion. It is therefore equivalent to about 400,000 good town houses in London.

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Plainly that would be a valuable estate, but it is conceivable. I can imagine the suburbs of London rolling out to Heathrow and the West. If one started at Canary Wharf and went on to Heathrow one could easily identify 400,000 houses worth £1 million each. If the U.S. Government chose to pledge itself for 400,000 such houses that seems reasonable. This may involve very large figures, but so does the Federal Budget.

It is the trillions that cease to be meaningful. I know several billionaires; I have certainly never met a trillionaire, let alone a quadrillionaire. If these derivatives hang over the whole banking system, then they should presumably be wound down and, over time paid off. They represent potential liabilities of the banking system, even if they are off the banks’ balance sheets. They cannot simply be consigned to a bad bank or simply be allowed to go into default. Even if Mr. Paulson gets his $700 billion, what will that do to settle the problems of quadrillions of derivatives?

Source: The Trouble with Trillions

In 1987, which is now more than twenty years ago, I published a book with James Dale Davidson. Some people still remember it for its title, Blood in the Streets, taken from a remark of Nathan Rothschild in 1815, at the time of Napoleon’s hundred-day gamble that ended in his defeat at Waterloo. “The time to buy,” said Rothschild, “is when blood is running in the streets.” The book arose out of our commentary in Strategic Investment.

The book attracted a good deal of attention at the time because it forecast the 1987 crash, which is still the largest fall in one day’s trading on Wall Street. I was in New York when the 1987 crash occurred. I remember an Australian broker observing that he had fought in a foxhole in Vietnam and that he found the 1987 crash more frightening.

Certainly we are experiencing a time of panic now, but there have been panics before. Some of them, like 1987, have had a benign outcome, with a recovery in the months following the panic. James Davidson and I did not forecast the post-1987 recovery; we expected a recession. The recession of the early 1990s duly came, but it was only a recession, not a crash. Even the ending of the dotcom bubble in 2000 did not produce a crash and certainly did not produce a depression.

The collapse of the U.S. housing and mortgage bubble has proved much more worrying and has already destroyed the independence of Bear Stearns, Merrill Lynch (NYSE:MER), A.I.G. (NYSE:AIG), Lehman Bros (NYSE:LEH), Fannie Mae (NYSE:FNM), Freddie Mac (NYSE:FRE), and, in London, Northern Rock and HBOS, with various levels of loss for the shareholders.

When we were writing Blood in the Streets, we did foresee the significance of the housing market. There is a section, in the book titled The Coming Real Estate Crash. Indeed we were able to identify in 1987 several of the weaknesses of the world’s political economy. It is not much help forecasting a crash twenty years ahead of its happening, but there are elements in the analysis we then made which turned out to be valid when the crash occurred. The 2008 crash comes as a natural consequence of long-term systemic failures.

Blood in the Streets was written fourteen years before 9/11. We did specifically refer to the threat to the twin towers in a subsequent book, The Sovereign Citizen. There is also a paragraph in Blood in the Streets in which I think we can take some legitimate pride:

“No V-day over terrorism. Disorder today is far more threatening because of the collapsing scale. As the margins of American power recede at the periphery, the raw power of these groups rises. So does their ability to disrupt arrangements they do not like. They cannot be stopped, as World War II was stopped, by forcing the surrender of a large-scale network of command. There is no single chain of command that has the authority to stop terrorism. Nor can anyone negotiate a compromise to meet demands of many of the small groups now wielding military force.”

We did foresee the significance of real estate and terrorism as factors that might undermine the stability of global finance. We also expressed concern about the reliability of the interbank market. “The danger of rapid deflation is more acute than it was in 1929. Why? Look no further than the geometric growth of the $700 billion interbank lending market. Each day U.S. banks are involved in interlocking transactions that total as much as $700 billion. This is the banking equivalent of having hundreds of trapeze artists swinging through the air — to what everyone hopes will be a safe landing. If even one bank failed to make good on its commitments, the whole criss-crossing show could come tumbling to the ground. This means that a liquidity crisis and a loss of confidence could contract credit almost instantly — on a far wider reach than in the past.” That is a fair description of what has been happening in the last thirteen months.

We correctly foresaw the bail-out of weakened banks, and the losses for their shareholders. “Remember that a bail-out of the banking system, which the authorities will surely attempt in the event of a debt collapse, does not necessarily mean a bail-out of bank holding companies or shareholders. Depending upon the political climate and administration at the time the music stops, there might even be a de facto nationalisation of major American banks — an outcome less far-fetched than it might seem. In a time of crisis, the government may be the only entity large enough to save the vulnerable banks.” Only the Federal Government was big enough to rescue A.I.G.

The U.S. real estate market, terrorism, debt, interbank lending and nationalisation of U.S. banks have all figured in the development of the present crisis. We did not get every issue right, but we did identify in 1987 the underlying insecurity of the global financial system. What we failed to foresee was the timing of the crisis. We saw its vulnerability, and pointed accurately to its weaknesses, but we did not see that so unstable a system could survive for twenty years of rapid economic and technological change. Will the Central Banks now be able to restore confidence after the events of last week? It will be some months, perhaps years, before we know the answer to that question.

Regards,
Lord William Rees-Mogg

Source: Forecasting the Crash

The United States is incomparably the stronger defense power; indeed the U.S. is now the only defense superpower in the world. As Britain found at the height of imperial power, it is not always easy to convert defense capacity into financial strength. Nevertheless, it was the sails of the British navy that maintained world peace in the nineteenth century and made the gold standard possible.

In 1797 the Napoleonic War led to the suspension of gold convertibility, which was not resumed until after the Battle of Waterloo in 1815. Gold convertibility was again suspended in 1914, on the outbreak of the First World War. Britain was able to maintain gold convertibility for the hundred years of relative peace, which allowed the industrial revolution to spread around the world. In the 1860s, the United States had to suspend gold convertibility, during and immediately after the Civil War. The euro is now protected by U.S. defense capacity.

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A more immediate concern is the growing divergence of European economies. Two big European economies, Italy and Spain, are perceived as more risky than the two core members of the Eurozone, Germany and France.

The traditional indicators of risk in debt markets, as reported in The Financial Times, are Credit Default Swaps (CDS) and 10-year bond yields. The 10-year bonds are particularly interesting as they are Eurobonds for which the different Euro countries are separately responsible. Currently the Italian 10-year bond yields about 60 basis points more than the German, which is the benchmark bond. Greek bonds also have high yields.

Financially, Europe can be divided into two zones. The Southern zone includes Italy, Spain, Greece and Portugal, of which only Portugal is not a Mediterranean country. Ireland is also financially overexposed, but Ireland is a small economy, and has separate problems over the Lisbon Treaty.

The Northern group of the Eurozone countries are the Franco-German alliance, which includes the adjoining three core countries of the original six nations of the Rome Treaty — Belgium, the Netherlands and Luxembourg. On present financial trends, there are three Europes, a Mediterranean Europe, led by Italy, a core Franco-German Europe and a peripheral Europe, in which Britain is the largest economy. The peripheral Europe includes Scandinavia, the Central European group and potentially, a Balkan group.

In American history, the original division was between North and South. That would now include the West as a separate economic zone. Europe is already divided in three ways. The risk is that North and South Europe will diverge in economic capacity. Can Italy or Spain maintain a fixed exchange relationship with Germany? The stronger the euro becomes, the greater the internal strains on the Eurozone are likely to become.

Source: You’re on Eurown

If you study economics from a mathematical view, the credit crisis must have come as something of a shock, says Lord Rees-Mogg.

But if you’re an economic historian, recent events won’t surprise you at all. Historical economists don’t see timing as any more predictable for economic shocks than for earthquakes. But they recognize a cycle of debt when they see on. And they know that the liquidation of debt has a deflationary effect…

There are two ways of studying economic theory. One approach is mathematical, and has been much enhanced by the computing power available to the individual economist. The other is historical and relies on the accumulated understanding of economic theory and practice.

The events of 2007 and 2008 have shown the limitations of the mathematical method. The credit crunch was not foreseen by anyone that I read, but it came as a shock to the number crunchers – it took them completely by surprise.

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It did not come as a shock to the economic historians, who happily settled down to discuss the resemblances between this credit crisis and earlier ones, going back to the South Sea Scheme in 1720 or the Wall Street Panic of 1907. The economic historians know that similar events had happened before, and had also learned, often by painful experience, that such events are quite common.

Neither group foresaw the actual events of August 2007, but the historians were quite able to put the credit crisis in a context of other crises. Even though both groups were taken by surprise, it was the mathematicians whose previous forecasts were stood on their heads.

By and large, historical economists, who follow the example of major English economists such as Maynard Keynes or W.S. Jevons, do not regard timing as any more predictable for economic shocks than for earthquakes.

One can say that there is a build up of stress in the system that will eventually have to be released. One cannot say that the release of pressure will occur next Tuesday or next August or even next century.

Some say the big earthquake will happen along the San Andreas Fault in California. It may come tomorrow; it may come before 2050; it may not happen for 500 years. We can usefully predict what and where, but we can very seldom predict when. This makes expectation difficult to quantify, though all markets are based on expectations

What we do know from economic history is that there is a cycle of debt that has to be relieved. In twentieth century history the war debts of the first war played their malign part in the European depression of the 1920s and eventually in the Great Depression of the 1930s. The Austrian School of Economics, and particularly Friedrich von Hayek, developed the Debt-Deflation theory of the business cycles. Hayek indeed foresaw the risk of a deflationary crisis as early as 1927.

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Keynesian economics, as expounded in his General Theory, 1936, were criticised at the time for an inadequate appreciation of the negative aspects of excessive debt. Bankers of the Gold Standard era attached great importance to the balance sheet rather than the profit and loss account. I get the impression nowadays that people read the current account much more carefully than they do the capital account — partly because they think that off balance sheet financing has reduced the transparency of the balance sheet itself.

As a result, government balance sheets, bank balance sheets, corporate balance sheets and personal balance sheets have all deteriorated. Finance ultimately depends on the security of capital, and weak balance sheets, at any level, are exposed to risk and to problems of opportunity cost.

An old-fashioned banker would now be calling for strengthening of balance sheets at every level. But the liquidation of debt takes years to accomplish and diverts fund from current consumption. The 2007 credit crunch calls for liquidation of debt, but that is bound to have a deflationary effect.

Source: Two Schools of Thought

As we reported earlier this morning, economists surveyed by Bloomberg estimate US growth will slow to 0.5 percent from October to December.

The US economy is not yet officially a recession. But most commentators are treating it as such, including Lord William Rees-Mogg, former editor of The Times and regular contributor to The Daily Reckoning UK. Lord Rees-Mogg says there won’t be a recovery until the first half of 2009…

The downturn in the global economy is now 11 months old, if one takes the subprime crisis of August 2007 as the starting point. It has spread like the forest fires in California, establishing itself in one area after another, putting out tongues of fire that extend the area of the fires, always a step ahead of the firefighters.

The housing and mortgage crisis is far from having burnt itself out. The oil price crisis also started in August 2007, when the oil price was only $70 per barrel, half what it now is. The price of other commodities, particularly foodstuffs, has moved with the price of oil. Equity markets behaved as though they were immune from the recession. That pretense lasted until last October.

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Since that time, the U.S. stock market has fallen by 20%. Only the art market seems to be exempt, with billionaires buying conceptual art at speculative prices. This may reflect the sheer weight of billionaire money, or it may follow the precedent of the art market being the lagging indicator among all asset classes.

Everyone would like to know how long — and, implicitly, how deep — the 2007 recession is going to be. There are always commentators who think that the end of recession is about six months away. In 2007, there were those who expected a recovery in the second half of 2008; that expectation has now shifted back into 2009, with the recovery starting in the second half of next year and persisting through 2010. Hardly anybody now expects even the first signs of a recovery to appear before the November presidential election in the United States, the fist big political date. If the American voters follow precedent, they will elect a Democrat as president; since the classic case of Herbert Hoover in 1932, economic depression has usually led to the incumbent party being turned out.

Source: Still Burning