The Wandering Economist

Those giants of giants in the banking community, the JP Morgans, Bank of Americas and all of the other Too Big To Fail banks and investment houses have crossed the Rubicon. The have ventured so far past the point of no return that the Obama administration doesn’t even realize that they are already at the city gates and unable to turn back. No reasonable amount of economic stimulus is going to allow these banks to recover, not now, not ever. And by “reasonable amount” I am even taking into consideration the ludicrous 2,3,4 trillion dollar amounts of money that some analysts are calling for.

Lets look at the problem from the simple mans perspective, the one that most people in congress are using. According to the Investment Company Institute (www.ici.org) the total value of global stock markets was approximately $62 trillion in December 2007 and has since shrunk by almost half to around $30 trillion. That loss in value alone has been spread amongst shareholders, issuing banks and bank holding companies. Banks and those investment houses now scrambling to become banks shouldered approximately $2.5 trillion dollars of that burden.

Taken along, that single burden, while huge, is not enough to cripple the banks. The slowdown in the real estate market commenced along with the global slowdown however and its affects, when added to stock holding losses produced a sizeable chink in the banks armor. Housing became the visible scapegoat for the banking industry. People understood housing, even those who didn’t own stocks. They saw the value of their own houses decline and understood that the value of banks’ portfolios of houses also declined. Oh, those poor poor banks who loaned out trillions of dollars to customers who could no longer afford to pay. There losses on these house would be huge, right?

Well, maybe? First I would like to remind you that the banks began to cry uncle long before the houses came home to roost so to speak. Banks were beginning to fail before those poor people were being foreclosed upon. Banks were under huge stress before homeowner #1 failed to pay his mortgage. How is this possible?

Here is where the dirty little secret in the world of REAL money comes into play. According to figures released in the December 2007 quarterly review by the Bank of International Settlements (www.bis.org) the total notional amount of outstanding derivatives in all categories was a mind boggling $596 TRILLION.

Derivative? What the heck is a derivative? The short and simple answer is this…there has been so much freaking money created by banks over the past 50 years that there is no longer enough actual stuff for that money to buy. So, instead of buying actual stuff, like a stock certificate for General Electric, that money is spent to by a derivative against the movement of General Electric stock. Essentially, it is a bet between 2 people, one betting the stock will go up and the other betting it will go down.

Derivatives are also commonly highly leveraged. Lets say for example that a company uses a large quantity of Natural Gas in its equipment production, so much so that a big swing in the price of gas would hurt the company badly. They might fear that the price of NG would go up and wager $100,000 on a short term (3 month) contract that the price of Natural Gas would go up. If this was a straight bet, it would pay 1:1 up or down and would provide no real benefit versus just “taking their changes” on the gas price. So, instead they use this $100,000 as collateral on a $2million loan and use that loan to purchase the derivative contract.

In normal times when fluctuations are small, they may lose their initial investment, or double it. In the case that they doubled it, the proceeds are used to purchase the now pricier commodity for their daily production and operations continue. If they lose, the losses were a calculated risk and already assumed in the cost of production. But this past year was NOT NORMAL TIMES.

Price fluctuations over the past year were dramatic to say the least. Fluctuations in currencies, commodities, stock prices, real estate, corporate debt, everything that derivative junkies gamble on.

Due to the speed of the decline we could have more than a third of the total derivatives pool underwater. My best guess puts the number at about 35% upside down with the average bet losing more than 15%. That means that $208 Trillion dollars of derivatives are now being held off book by firms that are hoping and praying to be able to foist any or all of them on some government entity or otherwise stupid fool. The losses look to be somewhere in the $30-32 trillion dollar range. The problems that we are seeing and will continue to see with investments that have real assets attached to them may be able to be fixed. It will take upwards of $5-8 trillion dollars by the time its all over, and inflation will kills us when its done, but we could fix that. That $30 trillion dollar derivative monster? Now you go and figure out a way to fix THAT!

Tags: Economy, Banking //