Monday, August 27, 2007

Financial Extinctions: The Subprime Meteorite Has Hit


Here is a chart depicting the extinction of the dinosaurs. The horizontal axis is time, the vertical axis is the number of families (types) within the entire taxonomy of dinosaurs.




Now take a look at a chart of hedge funds' ascent to domination.

Please go to www.oftwominds.com/blog.html to see all the charts.

Here's a graph of home prices in California.

Our National Debt.

And U.S. household liabilities.

And here on the right is a chart of derivatives' growth, and one of real estate assets held by banks.

Do you see any parallels in all these charts? How about a spectacular ascent along an exponential (power-law) curve?

The primary feature of such an exponential curveset in species diversification is that it is periodically interrupted by extinctions
. While most of us are aware that the dinosaurs were wiped out by a 20-KM wide (12-mile wide) meteorite which struck shallow water in the Gulf of Mexico 65 million years ago, fewer of us are aware that the number of types of dinosaurs (i.e. the number of different families) was already in decline prior to the meteor strike.

(Some claim a second later meteorite strike was the coup de grace).

In other words: dominant species tend to decline from internal forces. An external shock/change of climate may provide the final push to extinction, but internal causes have already weakened the diversity and genetic innovation of the species.

Dominant species "have their moment in the sun," so to speak, when they diversify rapidly and occupy numerous ecological niches, and then decline, either rapidly as the environment changes, or slowly shrinking to "safe" habitats. Charles Darwin noted this in his book Voyage of the Beagle:
"On such grounds it does not seem a necessary conclusion that the extinction of species, more than their creation, should depend exclusively on the nature of their country (environment). All that can be said with certainty is that, as with the individual, so with the species, the hour of life has run its course, and is spent. "

In comparing the dinosaurs' passing to the exponential extremes which have proliferated in our financial realms, we have to ask: now that the subprime meteorite has struck, are all these "had their day in the sun" financial species doomed to extinction?

If all these dominant behemoths of the financial world were weakening from internal forces, perhaps the so-called "subprime meltdown" is the "event" which nudges them off the cliff to extinction.

Lest you think this impossible, consider the financial species "HELOCus Maximus," a.k.a. the home equity line of credit.



Note that this beast has already plummeted to near extinction. (A few survivors may yet exist in small pockets, but their days are numbered.)

Can hedge funds, commercial paper and consumer debt leverage be far behind? The mainstream media is chockful of stories these days on the "freeze" in new corporate debt, the "seizing up" of commercial paper, and the frenzied resuscitation of fallen giants--not just in the U.S., but worldwide:

Fed bends rules to help two big banks (Fortune; Thanks to Ken K. for this link)

Don't forget: The Federal Reserve is in crisis management at the moment. However, it doesn't want to show any signs of panic. That means no rushed cuts in interest rates. It also means that it wants banks to quickly take the big charges that will inevitably come from holding toxic debt securities. And it will do all it can behind the scenes to work with the banks to help them get through this upheaval. But waiving one of the most important banking regulations can only add nervousness to the market. And that's what the Fed did Monday in these disturbing letters to the nation's two largest banks.

Brace Yourself for the Insolvency Crunch (Telegraph-UK; Thanks to U. Doran for this link)

Global junk bond issuance has been frozen for two months. Fresh sales of collateralized debt obligations – the CDOs of subprime notoriety: a $1 trillion sold last year - have all but stopped. Banks have yet to off-load $300bn of debt from leveraged buy-out deals, forcing them to keep the liabilities on their books. They are all snake-bitten now.

Germany's Landesbank Losers (Forbes; Thanks to Albert T. for these two links)

As the European Central Bank continues to try to resuscitate the European banking system with daily injections of cash, the fate of German banks is worrying. On Tuesday the chief executive of WestLB warned that a reluctance of foreign banks to provide credit to their German peers could lead to a banking crisis in Germany.

Doesn't this indicate the inherent weaknesses hidden in seemingly "healthy" lumbering giants? The German banking market: Structural change:

The recent bank problems and closures show that the German banking industry is going through a difficult phase. Not only a few individual banks, but the industry as a whole, are affected.

This is an excellent article which details vast, profound changes in virtually every aspect of banking in Germany--corporate funding, merchant banking, investment of surplus funds, etc. These adaptations mirror those experienced by all banks in the developed and developing world.

Though the adaptations were made to survive as financial species, it is becoming obvious that the adaptations have fatally weakened the species. Despite the happy-happy murmurings of central bankers, efforts to save the dying breeds of speculations and lending are clearly failing.

Allow me to speculate on what the Leading Dinosaurs were saying just after the meteor vaporized a big chunk of the Earth's assets: (Had they possessed the gift of language)

"Dear fellow dinosaurs, the most powerful and dominant species on this planet. A dark cloud has obscured the sun, but this disruption in our dominance is a temporary phenomenon, as there are plentiful smaller creatures to catch and vast tracts of lush vegetation to consume. There is absolutely nothing to worry about. We expect the cloud to pass in a few days. So just go on enjoying your dominance."

The cloud cover obscured the sun for one or two years. Every last dinosuar had starved to death long before any light broke through the leaden haze.

Perhaps the subprime "event" which has vaporized tens of billions of assets is the financial equivalent of the meteor which wiped out the dominant land species 65 million years ago. Will we look back in 5 or 10 years and wonder how the dominance of hedge funds, derivatives and exotic mortgages and corporate debt all vanished without a trace--other than the bankrupting of millions and the loss of trillions in financial assets?

My guess is "yes." Why? I offer a short quote from the book Extinction: Evolution and the End of Man :

Change one feature in a self-organized system (CHS--i.e., a market) and you get a reaction in many other dependent parts of the whole complex machine.

If the other inter-related parts' dependencies are poorly understood/obscure (i.e. subprime MBS, credit/debt derivatives and swaps), the parts themselves untested and inherently unstable, then you get what we have today: a financial house of cards--or concentric rings of dominoes, if you prefer that metaphor. Either way, it all comes down.

Put another way: the subprime meteorite has struck, and the financial sky is darkening with a gloom which will last for years.


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