That storm has now struck. The house of cards has fallen down, and revealed a hole of derivatives-based debt that could not be filled, literally, by all the money in the world, much less by the mere trillions that national governments are frantically throwing at it today.
Yes, "mere" trillions. As Will Hutton explains in the Observer:
...the dark heart of the global financial system [is] the $55 trillion market in credit derivatives and, in particular, credit default swaps, the mechanisms routinely used to insure banks against losses on risky investments. This is a market more than twice the size of the combined GDP of the US, Japan and the EU. Until it is cleaned up and the toxic threat it poses is removed, the pandemic will continue. Even nationalised banks, and the countries standing behind them, could be overwhelmed by the scale of the losses now emerging.
Try to imagine that: a $55 trillion market now at risk of complete destruction. Even the derivative debt owed by individual institutions stands at nation-wrecking levels. For example, a single bank in Britain, Barclays again, holds more than $2.4 trillion in credit default swaps, the tradable "insurance" mechanism against securities default. This is more than the entire GDP of Great Britain. If all this paper goes bad, there are not enough assets in the entire country to pay it off. And that's just one bank, in one country.
Hutton gives the details:
This market in credit derivatives has grown explosively over the last decade largely in response to the $10 trillion market in securitised assets - the packaging up of income from a huge variety of sources (office rents, port charges, mortgage payments, sport stadiums) and its subsequent sale as a 'security' to be traded between banks.
Plainly, these securities are risky, so the markets invented a system of insurance. A buyer of a securitised bond can purchase what is in effect an insurance contract that will protect him or her against default - a credit default swap (CDS). But unlike the comprehensive insurance contract on your car which you have with one insurance company, these credit default contracts can be freely bought and sold. Complex mathematical models are continually assessing the risk and comparing it to market prices. If the risk falls, the CDSs are cheap; if the risk rises - because, say, a credit rating agency declares the issuing company is less solid - the price rises. Hedge funds speculate in them wildly.
This is the ultra-dangerous downward vortex in which the system is locked. It is why share prices are plummeting. As recession deepens, there will be defaults on securitised bonds and the potential collapse of more banks outside the G7 ring-fence. Nobody knows what proportion of the $55 trillion of credit default contracts that have actually been written will be honoured and who might bear losses running into trillions of dollars.
Their purpose was a market solution to make securitisation less risky; in fact, they make it more risky, as we are now witnessing. The collapse of Lehman Brothers - the refusal to bail it out has had cataclysmic consequences - means that it can no longer honour $110bn of bonds, nor $440bn of CDSs it had written. On Friday, the dud contracts were auctioned, with buyers paying a paltry eight cents for every dollar. Put another way, there is now a $414bn hole which somebody holding these contracts has to honour. And if your head is spinning now, add the three bust Icelandic banks. They can no longer honour more than $50bn of bonds, nor a mind-boggling $200bn of CDSs....
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 beast in the dark that is haunting the feckless leaders of the developed world: $55 trillion of unaccountable debt, and no way of knowing how much of it is even now being flushed down the toilet, taking the global economy with it.
The massive interventions we are seeing might stabilize the markets temporarily, or at least arrest their free fall long enough to come up with some kind of massive restructuring of the global financial system. Or they might not. For it is by no means certain that the wisdom, and the political courage, to come up with a more viable system can be found among the world's political leaders -- all of whom, as we noted here the other day, have risen within the present system and, to one degree or another, owe their own power and privilege to the "malefactors of great wealth" and the extremist cult of market fundamentalism. There is no indication anywhere that the circle of collusion and corruption between governments and Big Money has even lessened, much less been broken, by the economic catastrophe. All of the various bailout plans and "coordinated actions" still have as their chief aim the preservation of the malefactors in their current state of wealth, privilege and domination.
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