ome 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.
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
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
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
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
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
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:
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
2. The Shanghai stock market will lose half its value, dropping
from 5,800 to under 3,000.
3. Major banks will be declared insolvent.
4. Major lay-offs will occur as U.S. retail, auto and house
5. The tech high-fliers (RIMM, GOOG and AAPL) fall will
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. I also ran a
chart of the VIX volatility chart which suggested a breakout up
(i.e. a sharply declining market) was probable.
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
Not that the mainstream media will be willing to state this
Empire or Debt II: The Dollar (November 06, 2007)
Wes Penre is the owner of the domain
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