Some Facts – all in US dollars
54.62 Trillion: the size of the world Gross Domestic Product (GDP)
51-55 Trillion: Estimated peak size of Credit default Swaps Market
36.90 Trillion: World stock market value as of 31 December 07
1.4 Trillion : IMF estimate of total total probable losses from credit crises
700 Billion: US Bailout package
This is the financial story of our lifetime. It can be difficult to get your mind around the complexity of the problem. Here is my take:
Issuing mortgage debt to people who cannot pay is the source of the problem. It became everyone’s problem once it passed through to the corporate debt market. Lehman Brothers went bankrupt and a couple of money market funds in the US lost investor capital. “Breaking the buck” is a big issue since the only stipulation investors give to money market managers is – do not lose any money.
These money market fund managers turned a dollar into 97 or 98 cents. The industry took notice and either sold or did not roll into new corporate debt. They were, and are, afraid to lend money to the corporate world since size and debt ratings don’t seem to predict solvency. As a group, money market managers went safe and bought government debt only. The net result is now there is no access to capital for worldwide capitalism. New issuance of corporate debt market in the US is worth many billions each day. If companies can’t get a ready source of capital they can’t expand, reinvest, hire people or perhaps pay employees. This de-leveraging is devastating to world wide economies. The money didn’t disappear. Governments have the cash. That’s why we need government intervention to fix the problem.
Credit default swaps (CDS) are insurance policies. Banks issue them and holders pay a premium which historically amounted to a couple of percent per year. If the debt issuer defaulted on the debt the premium holder received money from the issuer to make up the loss. Buyers of CDS reduced risk and passed it on to issuers. Think of them like life insurance policies. You buy a policy to reduce the risk to your family after your death. The insurance company collects the premium and pays out at death the benefit to your family. Banks like premiums and here is where it gets weird. A decision was made that it was OK to collect premiums on the bond many times over. People who held the bond got coverage and many people who didn’t hold the bond got coverage and paid a premium. One bond, many premiums works well for the bank since earnings are juiced. The probability of default is calculated as a small reserve. Profits go up without bound. Until a catastrophic small probable event occurs (see black swan). The reserves are many times smaller than the benefit owed. Goodbye Iceland.
Just read your blog but got lost half-way through: “a group of money managers went safe and bought government debt only.” Can you elaborate more on what this means?
Were the money investors hurt by the sub-prime mortgage defaults?
I understand the problem of cutting off the corporate world from credit but lost the connections: who did what to whom?
why Goodbye Iceland?
Looking forward to learning more. Cathy
Money market funds are very low risk. Investors understand they get little in the way of return but their money is safe. Lehman Brothers bankruptcy was a shock. Individual investors and money managers as a group sold existing corporate debt and replaced it with government debt. This is a change in confidence but as we have seen in the past few weeks, this change has far reaching implications to companies all over the world as well as the investment markets everywhere.
Iceland had a gross domestic product of about 20 billion in 2007. The three largest banks in Iceland have debts of about 60 billion – a direct result of losses in credit default swaps. It appears that the banking system is to be nationalized.
Patrick
Hi Patrick,
Great explanation, but I have further questions about the crisis and the fallout.
The following Reuters article reports how much money the Fed lent (printed) to banks this past week. It is an insane amount…2 trillion in one week alone!!!
http://www.reuters.com/article/newsOne/idUSTRE49F97920081017
I am confused…..
I have heard many pundits recently state that we are in a deflationary period…destruction of a lot wealth in equities, crash of commodities, etc … Is the Fed trying to re-inflate the economy with all this liquidity?
But, all this liquidity HAS to create inflation sooner or later- correct?
Also, what mechanism or who will force the banks to loan all that money they are receiving from the “bailout” to businesses (individuals, etc …) ?
As I understand it, the point of the “bailout” was to unthaw credit. Is it lending between banks or lending to the common folk that must be “thawed”? Does the first have to happen before “main street” starts to benefit from this so called “bailout” ?
It seems to me that the banks will hoard their new found cash to pay down further losses they know are coming down the line . ie. CDS losses, etc… The following stories illustrate my worry about this happening.
http://www.washingtonpost.com/wp-dyn/content/article/2008/10/15/AR2008101503233_pf.html
http://www.ft.com/cms/s/1a596038-9408-11dd-b277-0000779fd18c,Authorised=false.html?_i_location=http%3A%2F%2Fwww.ft.com%2Fcms%2Fs%2F0%2F1a596038-9408-11dd-b277-0000779fd18c.html&_i_referer=http%3A%2F%2Fwww.godlikeproductions.com%2Fforum1%2Fmessage628535%2Fpg1
Patrick, can you explain what is happening?
Cheers,
Rocco
My take is that the money supply is shrinking without fed intervention. Inflation is a secondary effect but there is a lot of pricing pressure the other way. See oil price and the price of just about everything else. The fed isn’t really crowding out as much as replacing a disappearing flow of funds from the public to corporations. The interim step is through the fed. Eventually, as confidence in the banking system improves there should be a move to equilibrium. I am waiting and watching the TED spread to see evidence of this beginning.
The TED spread has improved 136 basis points to 3.36%. It was 4.65% on October 10th. This is sign that the government action is having an affect and liquidity is improving.