Econapocalypse

The current econapocalypse has at its root two  intertwined parts, one a first cause and the other its unintended amplifier.  The government must attack both if it wishes to have any hope of halting this catastrophe.  Unfortunately, it currently is doing a dismal job by failing to either breathe life into the securitization markets or expeditiously wiping out the toxic derivatives paralyzing these markets.  And it is simultaneously failing to expeditiously contain the bonfire of credit default swaps copiously sold as insurance on these toxic derivatives of questionable value and the debt predicated on them.

  

The first cause is the meltdown in the subprime market and what it did to the value of securitized derivatives consisting of bundles of mortgages and other hyper inflated assets. There has been a near total collapse of these securitization markets since subprime mortgage defaults began to surge.  Unfortunately these securitization markets are what most major financial institutions had and have large positions in.  Some of these positions were on-balance sheet but also quite often not.  Thus you are seeing large on-balance sheet losses and the market panic caused by the spectre of even more massive off-balance sheet liabilities at many, if not all, major financial institutions.  

 

No one really knows what these toxic derivatives are worth.  Thus this first cause  turns on finding a way to value (price) these derivatives that a gun shy market can trust. No faith in value equals no sale, no matter how many Nobel Prize winning equations you have on your side.  In the meantime in the face of these paralyzed markets the government simply needs to seize the institutions that are illiquid due to their huge unrealized  losses on their derivative holdings. 

 

The second amplifying part of the econapocalypse is the inability of the sellers of insurance (read AIG) upon debt and derivatives  to meet what are essentially margin calls on their positions. As the value of the debt and/or derivatives  AIG was and is insuring plunges, AIG is contractually obligated to post cash collateral to its counterparties based on factors such as the risk of default and loss in value. 

Worse, AIG CDS contracts are the parchment barrier between liquidity and illiquidity for many financial institutions.  If AIG cannot make its contractual payments on these policies many of these institutions will no longer be able to keep their derivative losses off there books, leading to illiquidity and defaults (that AIG insured) and margin calls because of the change in credit risk.  The formerly lucrative CDS echo chamber thus grows into a roar that no one has been able to quell.  The administration's action on this front has been weak and is cause for concern.

   

Or Maybe Not

Hard to tell what is going on in the credit default market. Some argue that there is no significant risk of things spinning out of control because the parties that insured Lehman's bonds were forced to pony up collateral as Lehman's bonds precipitously fell in price (CDS contracts have margin call clauses activated by price drops) and that this payment of collateral has already been written down on the parties balance sheets. Sounds plausible. Others are not so sure. But what scares me about those who say this is no big deal is that they are prefacing their statements with words like "probably" or phrases like "no one really knows." Which brings us back to the central fact that no ones knows WTF is going on in the markets right now. I doubt our wild ride is over.

Whistling Past the Graveyard

Is this the final financial derivative wave crashing down on Wall Street?  Will all now be washed clean again?  Or are we on the verge of financial catastrophe?  Maybe I'm just scared because I know more about Wall Street now than when I was younger, but banks are going under right and left and major companies are struggling to shore up their capital.  It's going to be an interesting week. Adios Lehman Brothers, Merrill, we hardly knew ye.  AIG, you're not looking too good there, fella. You look like you need some more capital.  Best of luck at the Fed money spigot.  There's no consequences to the Fed extending all this credit, right?