I am not sure whether the economic and monetary situation we face is just lousy due to garden variety social democracy and rampant rent seeking or catastrophic with with wild financial recklessness added to the aforesaid corruption. But in truth, I've never really crystallized in my own mind why the financial system could be in so much trouble that it would result in catastrophe. I think I now get it (I know, I'm slow, so what's your point?) and in the hopes that my simpleton explanation may have value for others I am penning this missive. If you think I've got something wrong and you're smarter than me (no great trick, admittedly) then by all means let me know.
Banks and regulators evaluate the adequacy of capital requirements, the value of incentive compensation and the acceptable level of risk taking using "Value at risk" models. VAR models take each 'position' held by a bank, estimate how much risk that position faces and how much capital is needed to back it and how that risk relates to the bank's overall portfolio of risks. Risks come in two flavors: Interest rate - if interest rates rise ceteris paribus the value of an asset will fall and Default - an asset which is composed of the present value of a stream of future cash flows loses some (but not necessarily all) of its value if the issuer of the asset defaults on his obligation. Each asset class has its own risk levels determined by historical regressions of variations relative to interest rates and credit rating. Critically, VAR can be substantially reduced by 'hedging' an exposed asset. You 'hedge' the risk of a default or interest rate change by paying some other entity to incur that risk on your behalf. AIG famously went bankrupt because it sold so many Credit Default swaps to banks to hedge the default risk of their Mortgage Backed Securities portfolios. Essentially what AIG did was 'rent' it's AAA credit rating to banks so that they could take BBB assets and call them AAA. By doing so, they could reduce the amount of capital that they held in reserve to protect against the possibility that these assets would default. Interest rate swaps achieve the same result for interest rate risk.
Now, there are two questionable assumptions that underly VAR: first, the key relationships between various interest rates, asset classes and credit ratings will not change, either on a secular basis or at different times in the business cycle. This is critical for if something is to be 'hedged' the relationship between the entities and the assets composing both sides of the hedge have to be understood and be roughly constant. If the relationships change, for example, if it turned out that because of heretofore unacknowledged losses, AIG was BBB rather than AAA then hundreds of billions of dollars of CDSs written by AIG would instantly become valueless and the VAR models at the banks would suddenly show a massive capital gap.
Which leads to the second dodgy assumption which is that there won't be a mad scramble for the exits that results in a liquidity crisis which would distort the VAR's conclusions. In our scenario, the massive capital gap would lead the banks to dump mortgage backed securities to retrieve their position which would lead to a collapse in the value of that class of assets as the bankers pile on top of each other at the exit. Which is sort of what happened.
According to the Bank for International Settlement we have a notional volume of derivative contracts in place of $693 Trillion, others estimate it at almost twice that. Now these contracts cancel out - that's their point so that the real net value of derivatives is much smaller. For example, in 2011 it was estimated that a record over 90% of notional exposure for major US banks was 'netted' against other contracts held.
Which is good news so long as nothing untoward - what Nassim Taleb calls a "black swan" - happens to muck up that netting logic. Because a rather small shift in the 'netted' percentage could mean disaster for banks. And crucially, the VAR models assume no net change. And remember, compensation is derived from the VAR models. Which makes sense because you want to pay your bankers on the risk adjusted returns that they generate with the capital they have at their disposal.
But if the VAR systematically underestimate the risk in all of this hedging/derivative activity by ignoring the unpredictable panics and if that risk only shows up periodically during massive market meltdowns and if the big banks are bailed out by the Central Bank then bank profitability is systematically overstated which means banker compensation is too high - they are taking far greater risks than admitted and being compensated as if they were earning returns on lower risks. If the models were truly accurate, they would be taking fewer risks and earning less money all the way across the industry. Now if the biggest banks were simply allowed to collapse and their investors and employees were wiped out then this imbalance of risk would not persist - it would just be tough tacos for those who believed in the flawed models. The surviving banks would then adjust their models to be much more conservative and sales of S class Mercedes would fall.
But as with much else in our society, the baleful influence of the Federal Stupor State ensures that bankers are getting filthy rich at the expense of the rest of us. A situation that is compounded by the Fed's persistence in keeping interest rates extremely low which has been an enormous boon to banks and the individuals who control them. But it isn't surprising given that the Fed is largely controlled by...bankers. Indeed it's a brave President who goes against Wall Street. And with the accession of 'plucked dove' Janet Yellin to the Greenback Throne, President Obama demonstrates that he's not that kind of President.
Incidentally, negative real interest rates also mean that high tech millionaires rapidly become billionaires because the lower the risk free rate of money, the higher the valuation of their various tech businesses and projections. It's of course not surprising that the current President has massive support from both Wall Street and the Tech Oligarchs. They don't call him President Goldman Sachs for nothing.
So how does all this result in catastrophe? Simple but not easy: First, to bail us out of the last few financial crises, the FED has used its powers to radically increase the money supply - both to keep interest rates low and to prop the value of hundreds of billions of dollars of distressed Mortgage Backed Securities by buying them. At some point all of this liquidity injection has to go into reverse to avoid massive inflation. When Bernanke hinted that it would, emerging markets tanked which is why super dove Yellin is clinging to the conn of the USS Quantitative Easing now. So we are stuck between the Scylla of a collapse due to the withdrawal of the excess liquidity and the Charybdis of uncontrolled inflation if we continue to print so much electronic money. And since economic collapse and deflation both frightens politicians and makes their debts seem bigger while uncontrolled inflation reduces government debt as a share of the economy, the politicos are not going to allow Yellin to take away the QE punchbowl.
This means that like it or not, the decision to remove the dollar from world reserve currency status has already been made. It was made in steps - starting with Greenspan and now likely to be completed by a Yellin who - forced by frightened politicos - can't reverse Bernanke's Quantitative Easing to avoid inflation. As a result, the US Dollar's reign as a world reserve currency, a reign that has had great positive economic benefits for the world and particularly for the US is over. Done. Kaalas. Finis. Killed by the bankers and politicians who wanted the gravy train to continue as long as possible, enabled by a FED that is controlled by the selfsame self seeking bankers and politicians.
The result at a minimum will be a financial crisis similar in scale to those that happened in 1914, 1939 and 1971. But back then bankers were not a big part of the economy and the idea of quadrillions of dollars of derivatives had not been conceived. And of course our derivatives exposure are even more concentrated among the eight to big to fail banks today than it was in 2009. And I sincerely doubt that their VAR models or incentives have changed much if at all. And they certainly haven't comprehended the hyperinflation that their regression models have never had the data to analyze. And aside from writing 20,000 pages of regs and flowcharts with up to 300 steps, our 'crack' regulators are no nearer to getting control of the situation than they were before. Mostly because they are trying to manage undefined market risk on an a priori basis using negative regulatory rules which is an approach that makes GOSPLAN's record in the old Soviet Union look good.
Because of this, today the potential crash is an order of magnitude greater than the past as trillions of presumed real value evaporate in a derivative supernova. And the extermination of the dollar as the world reserve currency will not result in a replacement but in a period of confusion and chaos where Yuan, SDR, SFR, Euro, GBP, USD, Yen and most saliently, Gold enter a risk blender that will produce a concoction very unlikely to please the financial palate.
So that's the pessimistic view. And I must admit, I'm becoming more pessimistic by the day. God help us every one.
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