System Instability, Redundancy and the Domino Effect (February 13, 2008)


The potential for a systemic collapse of the global financial system is finally hitting the mainstream. For instance, this from the Wall Street Journal: New Hitches In Markets May Widen Credit Woes

A widening array of financial-market problems threatens to trigger a new phase in the global credit crunch, extending it beyond the risky mortgages that have cost banks and investors more than $100 billion in losses and helped push the U.S. economy toward recession.

In the past few days, low-rated corporate loans -- the kind that fueled the buyout boom of recent years -- have plummeted in value. As a result, banks are expected to try to unload some of those loans this week at fire-sale prices.

Nervous buyers also have retreated in recent days from the market for securities backed by student loans and municipal bonds, roiling some corners of the short-term money markets. Similarly, investors have recoiled from debt backed by commercial real estate, such as office buildings.

In the blogosphere, many analysts have warned of this possibility. For example, Nouriel Roubini posted this on rgemonitor.com: The Rising Risk of a Systemic Financial Meltdown: The Twelve Steps to Financial Disaster. Michael Panzner over at Financial Armageddon has written a sobering book on the topic and provides blog updates on the meltdown's progress.

Even your amateurish correspondent here at OTM could see it coming a few years ago:

As we discussed yesterday, the entire system is built on a series of incentives to obfuscate or hide risk and then pass the risky asset on to the next player.

The borrower lies about income and creditworthiness, hiding the true risk.

The broker happily goes along, otherwise the loan won't fund and he won't get paid.

The lender goes along in order to reap a fat profit from selling the loan to Wall Street.

The ratings agencies go along in order to earn their fat fees for masking risk-laden debt with a AAA rating.

Wall Street goes along to sell the bundled loans and derivatives constructed from the loans to investors seeking a "safe, AAA investment."

Traders and sales reps distribute the asset as "safe" around the globe in order to reap huge commissions/trading profits.

Politicians look the other way as Wall Street ponies up big-bucks contributions.

The Mainstream Media gloss over the layers of risk so as not to offend their big-bucks real estate/banking advertisers.

These incentives to cloak the true risks of loans aren't just built into the home mortgage market--they're built into all loans which have been bundled and sold as "low-risk": student, auto, commercial real estate, corporate buy-outs, you name it.

Consider a spacecraft as a metaphor for a system which is designed not to fail. There are two basic ways the spacecraft can fail: a single essential component can fail, or a single failure can trigger a domino-like cascade which leads to the entire craft failing.

If the craft's single oxygen tank ruptures, the crew dies. 99% of the spacecraft is still working perfectly, but the system failed in its primary purpose: keeping the crew alive.

If an electrical failure causes a cascade of subsystem failures, you end up with the same result: a powerless craft and a dead crew.

Redundant systems--as in Nature, two eyes, etc.--are one safeguard against catastrophic system failure. Thus having the oxygen in two separate tanks minimizes the risk that a tank leak could kill the crew.

Inserting breaks in dependent systems, e.g. "spacing the dominoes far apart" also works to stop a subsystem failure from cascading into others. Thus an electrical breaker will stop a short circuit from bringing down the entire electrical system.

In a way, this is the idea behind the "checks and balances" of modern republics. A bicameral legislature provides a kind of "breaker:" if one legislative body passes some harebrained scheme, hopefully the other house will kill it or at least water it down. Similarly, the President can veto the lamebrained idea. If he/she fails to do so, then as a final "breaker" the Supreme Court is supposed to step in and protect the Constitution and the Republic by striking down the law. (The Patriot Act shows how even this system can fail.)

So where is the redundancy in the global financial debt machine? Where are the checks and balances, or breakers? There are none. Here and there, you find a bit of redundancy, but nothing on a global scale.

For instance, there are still small local banks and credit unions in the U.S. which fund and service their own home mortgages. (Yes, they do exist.) But the number of mortgages funded and serviced by such responsible lenders is small compared to the trillions in risky mortgage debt dumped on the world markets.

Theoretically, there are government regulators who are supposed to act as checks or breakers against abuses or fraud in the system. But in the past seven years we have seen a wholesale surrender of responsibility by the Federal Reserve, the SEC, the FDIC, etc. Individuals within each agency issued clarion calls of concern, but their political masters didn't want to rock the boat. The breakers failed to go off, insuring systemic failure.

There is little or no regulation which requires transparency of risk or even the market valuation of loan-based assets such as CDOs. The ratings agencies were supposed to objectively assess risk, but with their fees dependent on issuing AAA ratings to 90% of all debt instruments, this supposed "check" failed catastrophically.

Here then is a system close to the perfection of instability: the risks are cloaked, and there is no redundancy or breakers in place to stop the dominoes once the first one falls. The subprime domino fell last year, and now other dominoes are falling rapidly, as described in the above quote from the Wall Street Journal article.

Roubini's article describes 12 dominoes; you can choose whatever number you prefer, but they're all falling, and there is nothing to stop them except more attempts at masking the risks of default or masking the defaults themselves.

All such attempts will of course eventually fail.

It would be better for all of us if the whole rotten structure collapsed in a month: Moody's, Fitch, et. al. confessed their liability and declared bankruptcy, investment and money-center banks admitted their insolvency by marking all the "off-balance sheet" assets they've been hiding to actual market, 10 million homeowners who can't afford their mortgages demanded market valuations on their houses and lower rates from lenders, monoline bond insurers gave up the delusion they will ever be solvent and declared bankruptcy, etc.

Yes, trillions would be lost/written off. But the trillions have already been lost. All we're doing is stretching out the pain. Such a confession of reality by all players would clear the decks of bad debt and allow regulators to start from scratch. No more appraisers paid by those whose only interest is a falsely high appraisal; another model would be put in place.

No more ratings agencies paid by investment banks for masking the real risks of debt being packaged. A new rating system could be put in place, perhaps based on the subscription model which worked well until the SEC abolished it. No more CDOs, CLOs, etc. No more hiding of assets off-balance sheet, "marked to myth"; all assets will have to be stated and marked to market at the end of each trading day.

Such reforms are just common sense; nothing fancy or arcane is required.

Will it happen? No. There are too many powerful players hoping the trillions can be restored with some fancy footwork, i.e. "restoring faith in the system." They will continue to obfuscate the risk and mask the bad debt, for years if necessary. Only when the entire system finally implodes will a reckoning take place.

When will that occur? Nobody knows. Some think it might happen soon, in a matter of months. My best guess is four or five years hence, for it will take that long for the "crew" to try twirling every useless knob in the hopes of staving off system failure.

You can't restore stability to an inherently unstable system.

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I TOLD YOU SO! Charles Hugh Smith, another person, explains what I already TRIED to explain on here. Again, it isn't JUST the media with no gutz and no glory, but the corporate culture absolutely mitigates that things get much, much, much, much worse as they cannot bail themselves out at ALL, and there is NO way we will ever know the extent of the losses. What a great PONZI run this was, eh, folks??


Empire of Debt I: The Great Unraveling Begins (November 5, 2007)


Some readers have been concerned that my recent posts have been overly bleak or strident. Perhaps; but I sense the Great Unraveling of the Empire of Debt is finally upon us, and breathtaking losses could be revealed any day now.

You cannot properly anticipate the coming wealth destruction unless you understand that the entire model rests on financial instruments (derivatives) which mask and distort risk. Thanks to readers Cheryl A. and U. Doran, I read the best description of how derivatives are written and sold--and how they blow up: Fiasco: The Inside Story of a Wall Street Trader.

Here is an analogy. Let's say you are offered a chance to play roulette, a very risky game of chance, but with an option for insurance which guarantees you will suffer no more than a tiny loss.

Let's say you place a $10 bet, in the hopes of winning $100. Your "insurance"--what we call a hedge, as in "hedging your bets"--costs only $1. Thus you can gamble $10, with a chance of winning as much as $100, and your loss is limited to a mere $1--the cost of your hedge. If you lose the $10, the other side of the hedge trade--whoever took your $1--will give you $10. Life is good, n'est pas?

Note what this hedge does: it makes you believe a high-risk game can be played at almost no risk. But alas, the game is inherently risky, and the reduction of risk is ultimately illusory: you can't change roulette into a low-risk gamble.

Since this is such a low-risk bet, you are soon gambling, say $100 billion. And why not? The hedges are so cheap! Abd everything goes swimmingly until the day you lose the $100 billion. Ah, bad luck, Mate; but no worries, you turn to the other side of your hedge and politely request your $100 billion.

Oops--that guy just lost his bets, too, and can't pay you. Now the risk of the underlying game is fully revealed; the entire hedge which made it all so "safe" is revealed as a house of cards which depends on all the other players being able to pay off their bets. Once they can't, well, as the saying goes, all bets are off.

To hide your immense losses, you continue to claim your bet is still worth $100 billion. Since you aren't required to "mark to market," i.e. reveal the market value of your bet, you stash the $100 billion loss in "Level 3" of your assets--a dark place where you can temporarily hide your worthless bets.

Astute correspondent Peter sent in two links which explain Level 3 and the coming failure of portfolio insurance:

The Bear’s Lair: Level 3 Decimation?

The Next Worry: Bond Insurers
Wall Street is fretting that the subprime carnage could spread to bond insurance firms. A key concern is CDO exposure (NOTE: a CDO is a bond derivative--"collateralized debt obligation")

Frequent contributor U. Doran added this link:

Bernanke Eats a Large Helping of Crow

In other words, you bought an insurance policy to protect your risky bet on mortgage-backed securities and derivatives and now you find the insurer is belly-up and can't pay you.

If their bad bets were marked to market, Citicorp and Merrill Lynch would be declared insolvent. Why? Because they are insolvent--right now. The meaning of insolvency is straightforward: their losses exceed their capital. Recall that these firms list assets of $100 billion (or whatever) but their actual net capital is on the order of 2.5% - 5% --a mere sliver of their stated assets. In other words: a 5% loss of their stated assets wipes them out.

And once those leviathans fall, what other dominoes will they strike down?

The financial catastrophe which will unfold within the next few weeks is fundamentally a gross mispricing of risk. Inherently risky bets were encouraged because they were "hedged." That's what Hedge funds do: place bets on both sides so they collect gains whether the markets go up or down. But the risks of the gamble didn't really change; the introduction of low risk to a high-risk bet was an illusion.

The whole risk-management model depends on somebody being able to pay off the hedge. If they can't-- the game is over. the game is now over, and the players shuffling losses can only last a few more days or weeks.

The game is over for other fundamental reasons, too. The U.S. "prosperity" of the past five years has depended on one thing and one thing alone: cheap, easy borrowing, by consumers, home buyers, businesses, gamblers/bankers and government--cheap easy credit for everyone.

This was funded by capital inflows of billions each and every day. Foreigners poured trillions into U.S. markets, buying up risky mortgage-backed securities, supposedly "safe" U.S. Treasuries, and U.S. stocks, bonds and derivatives.

Now as the Fed and the Treasury destroy the dollar's value, foreign owners of dollar-denominated assets are seeing their wealth decimated. That "safe" Treasury you bought in 2002? It's down 30% as the dollar has been depreciated. You're underwater so deep you'll never make that money back.

And how about all those Yankee CDOs, MBS, interest-swaps and other exotic derivatives which Yankee ingenuity invented and sold to you as low-risk, high yield investments? They're mostly worthless now. You lost most of your money in a "safe investment." How anxious are you now to buy more Yankee "investments" denominated in the sinking dollar?

There goes the capital inflows which have funded our profligacy. They're gone, and not coming back. Mr. Bernanke and Mr. Paulson are busy destroying the dollar with interest-rate cuts, fueling runaway inflation as they flail mightily to save their banking buddies--but they can't succeed. Making more debt available to bankrupt entities, be they investment bankers or homeowners, solves nothing. It's called "putting good money after bad," and it simply guarantees ever-larger losses.

Allow me to sum it up: the money's lost, folks. You can't borrow more and pretend you made the money back. All those trillions in bad debt and derivatives are already lost. The Ministry of Propaganda is in a tizzy, trying to mask the meltdown and offer up a facade of normalcy. But the money's already lost.

Will it be contained to the U.S.? Why should it? The bad debt is everywhere. And the spending spree all that borrowing unleashed washed over the entire globe. Now that Americans can't borrow any more, the spending dries up--and so does the global "prosperity" built on an Empire of Debt.

Here are a few predictions: [remember what I said! This will all happen VERY VERY VERY fast. ALL of it! and MORE!! surprise to come GALORE! It's a global financial meltdown. No one gets "out" unhurt by this one.]

1. The Dow Jones Industrials will drop hundreds of points in a day, very soon, losing at least 3,000 points within the next few weeks. [WATCH for the first 700 point drop and if you still have money in stocks by then, you are CRAZY. You've been repeatedly been warned HERE.]

2. The Shanghai stock market will lose half its value, dropping from 5,800 to under 3,000. [I am not SO sure about this - they aren't as stoopid as it may first appear. But they were remarkably slow to respond although they had been warned AND they can't seem to see how the US debt is TOTALLY unmanageable as the gambling, Ponzi-schemed hedge funders just kept approving the US empire of debt wars .. why DID they suppport that??]

3. Major banks will be declared insolvent. [Ah, but that' s already true! Just not DECLARED.]

4. Major lay-offs will occur as U.S. retail, auto and house sales plummet. [oh, yeah. Last hired, first fired? NOT this time! Whoever will work cheapest stays .. but the layoffs will be more than MAJOR, they will be catastrophic accompanied by TRAGIC home losses for people who could not see themselves as the working class persons they actually were all along. Such is the problem with over-education into Western capitalist mindset produced in US and English schools, for example.]

5. The tech high-fliers (RIMM, GOOG and AAPL) fall will precipitously. [ Yeah. so WHAT??]

As I have noted here last week, trading curbs (and the uptick rule on shorting) have both been abolished. There are no constraints on the market falling; a free-fall of several thousand points in a single day is now possible. [Hey! I agreed with that starting on 28 June!] I also ran a chart of the VIX volatility chart which suggested a breakout up (i.e. a sharply declining market) was probable. [GREAT CHARTS, if you understand what he is on about.]



Maybe I'm off by a few weeks, but I think not. The Empire of Debt is crashing, and it won't take months for the global financial markets to react. For alas, the money's already lost.

Not that the mainstream media will be willing to state this inconvenient truth....


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