Sunday, March 08, 2009

The Elephant in the Room

The truth is rarely pure and never simple.
-- Oscar Wilde (1854 - 1900)

While everyone is busy trying to point the finger at what happened to cause not only our economy, but also the world’s economy, to implode – consider this?
The total value of the U.S. stock market is under $15 Trillion, the total value of all real estate in this country is under $25 Trillion, and our total GDP stands at about $14 Trillion. The value of the entire world’s stock markets currently stands at under $50 Trillion.

But, what most people do not know is that it is nearly impossible to correctly value the number of derivatives , which are outstanding. These “bets” or contracts that hedge credit obligations – which include bonds, mortgage securities and corporate debts, including credit default swaps – amount to about $700 Trillion. Or, nearly three quarters of a quadrillion dollars. Others believe the amount is larger.

This Wall Street phenomenon is the real story in our economy. It is one problem that years ago Warren Buffet warned us all about and it is one which he recently mentioned when he said he hoped to be out of any derivative positions in “a few years.” Good luck.
So, as most consumers and many banks look askance at the muddled real estate market as well as the non-existent credit markets (insofar as ability to borrow), all are missing the boat as to the source and degree of the problem. We have an inconceivable amount of money (or, rather, the fantasy of such an amount of money actually existing) floating about in the Ether as mutually balanced obligations -- that will never be able to be paid in the event of default. Those defaults are now happening. And, as the defaults wind down deflation (reduction in value) accompanies the entropy.

This, in fact, is what we are grappling with in this economic disaster: The prospect of economic Armageddon. The world does not contain the amount of money or physical assets to balance out both ends of these bets in the event of default. If the buyer of a derivative defaults, having purchased the insurance to cover that “bet” -- and the guarantor (counterparty) of that insurance does not have the resources to cover that defaulted debt – what is there to be done?
Those are the questions being asked about AIG, Citigroup, Bank of America, Lehman Brothers, Bear Sterns, Merrill Lynch and thousands of companies that are defaulting on debts covered by derivative contracts. All $700 Trillion of them.

The Elephant in the room is restless and wants to eat.
And, until he does, there will be no new loans, no expansion of credit for the economy, no new jobs, no food, and certainly no housing. That means the end of the Hamptons economy and a severely diminished Manhattan economy. Expansion and building as we know it is done. A sign of these times is one new phenomenon: vacant lots in Manhattan with "For Rent" signs on them. There is no money to build.

Mortgages imploded due to the phony securities that Wall Street created in order to collect fees and create securities that NEVER had the value ascribed to them. In fact, the subprime situation was only a pimple on the elephant's tail. And, now all of us are paying that price.
It was the derivatives market that spawned the disaster we are now entering. As Thomas Kostigan of Marketwatch reports,

“It isn't the housing market devaluation, or the sub-prime mortgage market defaults that have us in real trouble. Those are nice fakes to sway attention away from the place where greed truly flourished -- trading phony instruments to the tune of $700 trillion.”

Interesting notes: Poland’s mortgage market was mostly written in Swiss francs. Nearly 60% of all mortgages are pegged to the value of the polish currency to the Swiss franc.
The polish currency, the zloty, has dropped nearly 50% in relation to the franc. One can only imagine what lies ahead in that situation.

UBS is just the tip of the iceberg with regard to the Swiss banking crisis – spawned by the IRS insistence that all 52,000 foreign (mostly American) accounts be divulged so that taxes and, no doubt, prosecutions, can begin for not paying taxes on these numbered accounts.
It is likely that Swiss banking, the country’s main industry, could be destroyed by this American move. No account secrecy, no deposits.

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