Now for the real abyss into which our economies stare

[Banquo's Ghost]

Amongst the current panics and draining of trust, there looms an even bigger disaster. The derivatives market.

Derivatives (essentially a gambling scam) are in danger of revealing an enormous loss to the financial system that no one can really quantify (save that it is likely to be trillions) because these instruments are entirely unregulated.

I don't pretend to understand their workings myself, except to be very wary of anything that has no intrinsic value. I offer two articles that certainly frighten me, and I am beginning to revise my earlier assertion that the fundamentals, being strong, will see the West move out of recession reasonably soon. Unfortunately, it seems that fundamentals - being measurable and real - may be swamped by the tsunami of bad debt and financial panic generated by a derivatives failure.

Since markets are still in meltdown even after huge bail-outs, maybe there really is a good reason for panic - that the moneylenders know something we don't?

A £516 trillion derivatives 'time bomb'. The Independent

The complex and opaque derivatives markets in which these hedge funds played has been dubbed the world's biggest black hole because they operate outside of the grasp of governments, tax inspectors and regulators. They operate in a parallel, shadow world to the rest of the banking system. They are private contracts between two companies or institutions which can't be controlled or properly assessed. In themselves derivative contracts are not dangerous, but if one of them should go wrong – the bad 2 per cent as it's been called – then it is the domino effect which could be so enormous and scary.

Without real leadership, we face disaster. Will Hutton, The Guardian

While every bank tries to pass the toxic parcel on to somebody else, the system has to find the money. So will compensation for the near valueless contracts and thus now uninsured debt ultimately be made - and by whom? And because nobody knows - not the regulators, banks or governments - who owns the swaps and whether they are credit-worthy, nobody can answer the question. Maybe holders of insurance policies will get the cash due to them, but will that weaken somebody else? The result - panic.

This is the ultra-dangerous downward vortex in which the system is locked. It is why share prices are plummeting.

One faces Monday with some trepidation.

[gaelic cowboy]

I posted this allready in the Euro bank thread but it still holds true for this thread.

https://www.youtube.com/watch?v=hXBcmqwTV9s

This entire financial debacle is going to hump up everything for a decade at least until someone comes up with a new wheeze to magic away this problem and of course create a new one fo someone else.

[InsaneApache]

I wanted to say cheer up chaps but I fear this is just the beginning. I'm off to the bank in the morning to draw out my pension in full. Let's hope it's still there.

[Gregoshi]

My wife works for The Vanguard Group (2nd largest mutual fund company in the US) and the employees are pulling their hair out because they don't have $10,000 or $100,000 to invest in this down market. It is driving my wife crazy at the moment. Funny how perspective differs.

[Oleander Ardens]

@Gregoshi: True. The market can still go down even 20% or more, but there are great opportunites. Lucky is the one which has liquidated most of his stocks a year ago. Now it becomes time to feel like an oversexed guy in a whorehous, and get rich to quote Buffet.

The derivatives are actual excellent instrument to spread risk. Sadly the huge volume ot them (xxx trillions) and the large scale of "value-at-risk" have created something counterintuitive to classical financial theory. Usually vast liquidity and models able to capture risk up to certain point (95%) should flatten volatility and increase ability to forecast trends and also allow effective hedging. Sadly "the false sense of precisness" which is even featured in the textbook "Value-at-Risk" by Jorion, Philippe, Value at Risk: The New Benchmark for Managing Financial Risk, 3rd ed., McGraw-Hill, 2006, 600 pages. ISBN 0-071-46495-6. has allowed a great deal of investors all over the world, but especially on Wall Street to circumvent the limitations set by risk management and to huge levers to profit from small margins in many markets, but especially in the derivative one. Blind trust in precise number created by this models has blinded the management for risk in general. It is a bit like to navigate just with GPS - what happens if your expensive Garmin breaks down in the wilderness, and you just kept looking on its screen instead of studying the environment?

OA

[Louis VI the Fat]

Amateurs. The lot of you.

All my money's safely stored in art and wine.


So I don't even beging to sweat no matter how much the markets collapse.
Not, unless I shred my reproduction of 'Gypsy Boy with Tear' for cigarette paper and drink those two bottles of wine.

[Gregoshi]

All my money's safely stored in art and wine.

Yeah, but try to buy a loaf of bread with that. "Excuse me, but do you have change for a Renoir?" At least the wine gives you some liquidity.

[ICantSpellDawg]

I like financial crises - they add humility to otherwise out of control societies. It could go either way and that's what makes life interesting.

[Incongruous]

I like financial crises - they add humility to otherwise out of control societies. It could go either way and that's what makes life interesting.

I like financial crises - they add an ever greater amount of burden upon those already in need, indeed, this aspect of capitalism is what one can really base all its strengths upon. The weeding out of the weak, damn empathy I say. Off with their power!

[Fragony]

Interesting times. Most of my money is in my house, prices aren't falling and it's on a tripple-A location I am not worried about that I glad I made a solid base for myselve. So far we appear to be doing good but I am still a bit worried I know no such thing as poverty it's a completily alien thing to me a meltdown is something I never even considered.

[Idaho]

I'm taking my money out of stock and moving into crack cocaine. I hear it can be quite lucrative.

[KukriKhan]

I'm taking my money out of stock and moving into crack cocaine. I hear it can be quite lucrative.

Not H? C'mon... think of all the poor farmers in Afghanistan!! Growers of the world, Untie!

[drone]

If you have capital right now, you are a happy, happy person.

[Oleander Ardens]

Well there was a huge ralley yesterday and more seems to be coming. Such volatility is usually a bad sign and the global economy is weak. Still a very sharp rally might be possible, I will use it possibly to reduce my few remaining stocks, while buying into the next fall.

[Hosakawa Tito]

My wife works for The Vanguard Group (2nd largest mutual fund company in the US) and the employees are pulling their hair out because they don't have $10,000 or $100,000 to invest in this down market. It is driving my wife crazy at the moment. Funny how perspective differs.

I have a good portion of my deferred compensation account diversified in various Vanguard Funds. They have done well for me, historically, and I really like the low fees.

Definitely take note of successful investors like Warren Buffett and others who have been hoarding cash to buy into certain other-wise solid securities that have been beaten down in the current panic. Selling now only locks in your losses. Better to stay in if you're looking long term.

Hedge Funds and derivatives are way out of my league. That Voodoo is for high-roller investors with money to burn, I'm not the Herb you're looking for...

[Oleander Ardens]

I personally would invest part of your disposible money in an ETF tracking a large index like the DJ or the DAX, possibly even in a leveraged form. Usually what matters most is the timing of the buy and the timing of the sell. So you have a highly secure tool, easy to liquidate, very transparent and with low fees which will earn you money in the long term.

Buy single stocks with low P/E and a low cashflow per price. I'm more in European stocks so I don't know solid American ones, but get some which don't rely too much on the American consumer - he is suffering greatly.

If possible go also global - but there is a big exchange risk. I would do it only with a large capital.

I have build up quite a big pile of cash and have waited for such a market for over a year.

Be well
OA

[KukriKhan]

Yesterday's 9k point run up on the NYSE, was folks buying bargains, after Friday's fire-sale of pension plans selling off stock to move into Treasuries.

I work with about 100 people; Thursday, we all awaited our quarterly TSP statements, to see what might have happened to the "C" Fund (Common Stock). The statements got released Friday, and we all took a hit; all said we'd moved out of C into the safer G-Fund (Gov't Securities). If that pattern held through the country with Fed employees and the Military, and if other pension plans did similarly, that might explain the Friday dip and Monday spike - or part of it.

Of course, our politicians and bureaucrats say it's because 'the market' trusts 'the plan', which hasn't spent a dime so far, after telling us to hurry up and approve $700Mil, or we'd never retire and lose our house and car.

[Lemur]

Of course, our politicians and bureaucrats say it's because 'the market' trusts 'the plan', which hasn't spent a dime so far, after telling us to hurry up and approve $700Mil, or we'd never retire and lose our house and car.

That would $800Bil, pal, or thereabouts. And my understanding is that the total mortgage market is valued somewhere around $760Tril, so let's not talk irresponsibly about the government buying up all of the bad mortgages. That way madness lies.

In case you weren't completely, utterly depressed, the latest Nobel Laureate has a column out today:

October 14, 2008
Op-Ed Columnist

Big Government Ahead
By DAVID BROOKS

We’re in the middle of a financial crisis, but most economists say there is a broader economic crisis still to come. The unemployment rate will shoot upward. Companies will go bankrupt. Commercial real estate values will decline. Credit card defaults will rise. The nonprofit sector will be hammered.

By the time the recession is in full force, Democrats will probably be running the government. Barack Obama will probably be in the White House. Democrats will have a comfortable majority in the House and will control between 56 and 60 seats in the Senate.

The party will inherit big deficits. David Leonhardt, my colleague at The Times, estimates that the deficit will sit at around $750 billion next year, or five percent of G.D.P. Democrats had promised to pay for new spending with compensatory cuts, but the economic crisis will dissolve pay-as-you-go vows. New federal spending will come in four streams.

First, there will be the bailouts. Once upon a time, there were concerns about moral hazard. But resistance to corporate bailouts is gone. If Bear Stearns and A.I.G. can get bailouts, then so can car companies, airlines and other corporations with direct links to Main Street.

Second, there will be more stimulus packages. The first stimulus package, passed early this year, was a failure because people spent only 10 percent to 20 percent of the rebate dollars and saved the rest. Martin Feldstein of Harvard calculates the package added $80 billion to the national debt while producing less than $20 billion in consumer spending.

Nonetheless, House Speaker Nancy Pelosi promises another package, and it will pass.

Third, we’re in for a Keynesian renaissance. The Fed has little room to stimulate the economy, so Democrats will use government outlays to boost consumption. Nouriel Roubini of New York University argues that the economy will need a $300 billion fiscal stimulus.

Obama has already promised a clean energy/jobs program that would cost $150 billion over 10 years. He’s vowed $60 billion in infrastructure spending over the same period. He promises a range of tax credits — $4,000 a year for college tuition, up to $3,000 for child care, $7,000 for a clean car, a mortgage tax credit.

Fourth, there will be tax cuts. On Monday, Obama promised new tax subsidies to small business, which could cost tens of billions. That’s on top of his promise to cut taxes for 95 percent of American households. His tax plans aren’t as irresponsible as John McCain’s, but the Tax Policy Center still says they would reduce revenues by $2.8 trillion over the next decade.

Finally, there will be a health care plan. In 1960, health care consumed 5 percent of G.D.P. By 2025, it will consume 25 percent. In the face of these rising costs, Obama will spend billions more to widen coverage. Obama’s plan has many virtues, but the cost-saving measures are chimerical.

When you add it all up, we’re not talking about a deficit that is 5 percent of G.D.P., but something much, much, much larger.

The new situation will reopen old rifts in the Democratic Party. One the one side, liberals will argue (are already arguing) that it was deregulation and trickle-down economic policies that led us to this crisis. Fears of fiscal insolvency are overblown. Democrats should use their control of government and the economic crisis as a once-in-a-lifetime chance to make some overdue changes. Liberals will make a full-bore push for European-style economic policies.

On the other hand, the remaining moderates will argue that it was excess and debt that created this economic crisis. They will argue (are arguing) that it is perfectly legitimate to increase the deficit with stimulus programs during a recession, but that these programs need to be carefully targeted and should sunset as the crisis passes. The moderates will stress that the country still faces a ruinous insolvency crisis caused by entitlement burdens.

Obama will try to straddle the two camps — he seems to sympathize with both sides — but the liberals will win. Over the past decade, liberals have mounted a campaign against Robert Rubin-style economic policies, and they control the Congressional power centers. Even if he’s so inclined, it’s difficult for a president to overrule the committee chairmen of his own party. It is more difficult to do that when the president is a Washington novice and the chairmen are skilled political hands. It is most difficult when the president has no record of confronting his own party elders. It’s completely impossible when the economy is in a steep recession, and an air of economic crisis pervades the nation.

What we’re going to see, in short, is the Gingrich revolution in reverse and on steroids. There will be a big increase in spending and deficits. In normal times, moderates could have restrained the zeal on the left. In an economic crisis, not a chance. The over-reach is coming. The backlash is next.

[KukriKhan]

That would $800Bil, pal, or thereabouts. And my understanding is that the total mortgage market is valued somewhere around $760Tril,

Hehe. I hadn't trained my left fore-finger to go for the B or T yet, when talking money. Right fore-finger still thinks he has a lock on Million. :)

Davey got a Nobel? I shudda known, but didn't.

[Lemur]

Davey got a Nobel? I shudda known, but didn't.

Nope, I am an idiot; it was Paul Krugman, not David Brooks. Entirely my bad. I blame insufficient caffeine syndrome.