oftwominds-Charles Hugh Smith

Empire of Debt I: The Great Unraveling Begins

Some readers have been concerned that my recent posts have been overly bleak or strident. Perhaps; but I sense the Great Unraveling of the Empire of Debt is finally upon us, and breathtaking losses could be revealed any day now.

You cannot properly anticipate the coming wealth destruction unless you understand that the entire model rests on financial instruments (derivatives) which mask and distort risk. Thanks to readers Cheryl A. and U. Doran, I read the best description of how derivatives are written and sold--and how they blow up: Fiasco: The Inside Story of a Wall Street Trader.

Here is an analogy. Let's say you are offered a chance to play roulette, a very risky game of chance, but with an option for insurance which guarantees you will suffer no more than a tiny loss.

Let's say you place a $10 bet, in the hopes of winning $100. Your "insurance"--what we call a hedge, as in "hedging your bets"--costs only $1. Thus you can gamble $10, with a chance of winning as much as $100, and your loss is limited to a mere $1--the cost of your hedge. If you lose the $10, the other side of the hedge trade--whoever took your $1--will give you $10. Life is good, n'est pas?

Note what this hedge does: it makes you believe a high-risk game can be played at almost no risk. But alas, the game is inherently risky, and the reduction of risk is ultimately illusory: you can't change roulette into a low-risk gamble.

Since this is such a low-risk bet, you are soon gambling, say $100 billion. And why not? The hedges are so cheap! Abd everything goes swimmingly until the day you lose the $100 billion. Ah, bad luck, Mate; but no worries, you turn to the other side of your hedge and politely request your $100 billion.

Oops--that guy just lost his bets, too, and can't pay you. Now the risk of the underlying game is fully revealed; the entire hedge which made it all so "safe" is revealed as a house of cards which depends on all the other players being able to pay off their bets. Once they can't, well, as the saying goes, all bets are off.

To hide your immense losses, you continue to claim your bet is still worth $100 billion. Since you aren't required to "mark to market," i.e. reveal the market value of your bet, you stash the $100 billion loss in "Level 3" of your assets--a dark place where you can temporarily hide your worthless bets.

Astute correspondent Peter sent in two links which explain Level 3 and the coming failure of portfolio insurance:

The Bear’s Lair: Level 3 Decimation?

The Next Worry: Bond Insurers
Wall Street is fretting that the subprime carnage could spread to bond insurance firms. A key concern is CDO exposure (NOTE: a CDO is a bond derivative--"collateralized debt obligation")

Frequent contributor U. Doran added this link:

Bernanke Eats a Large Helping of Crow.

Correspondent J.F.B. sent in this link on the global losses incurred by banks which bought U.S. debt with the question: "who will be buying our future debt?" Who, indeed:

Subprime crisis affects banks worldwide.

In other words, you bought an insurance policy to protect your risky bet on mortgage-backed securities and derivatives and now you find the insurer is belly-up and can't pay you.

If their bad bets were marked to market, Citicorp and Merrill Lynch would be declared insolvent. Why? Because they are insolvent--right now. The meaning of insolvency is straightforward: their losses exceed their capital. Recall that these firms list assets of $100 billion (or whatever) but their actual net capital is on the order of 2.5% - 5% --a mere sliver of their stated assets. In other words: a 5% loss of their stated assets wipes them out.

And once those leviathans fall, what other dominoes will they strike down?

The financial catastrophe which will unfold within the next few weeks is fundamentally a gross mispricing of risk. Inherently risky bets were encouraged because they were "hedged." That's what Hedge funds do: place bets on both sides so they collect gains whether the markets go up or down. But the risks of the gamble didn't really change; the introduction of low risk to a high-risk bet was an illusion.

The whole risk-management model depends on somebody being able to pay off the hedge. If they can't-- the game is over. the game is now over, and the players shuffling losses can only last a few more days or weeks.

The game is over for other fundamental reasons, too. The U.S. "prosperity" of the past five years has depended on one thing and one thing alone: cheap, easy borrowing, by consumers, home buyers, businesses, gamblers/bankers and government--cheap easy credit for everyone.

This was funded by capital inflows of billions each and every day. Foreigners poured trillions into U.S. markets, buying up risky mortgage-backed securities, supposedly "safe" U.S. Treasuries, and U.S. stocks, bonds and derivatives.

Now as the Fed and the Treasury destroy the dollar's value, foreign owners of dollar-denominated assets are seeing their wealth decimated. That "safe" Treasury you bought in 2002? It's down 30% as the dollar has been depreciated. You're underwater so deep you'll never make that money back.

And how about all those Yankee CDOs, MBS, interest-swaps and other exotic derivatives which Yankee ingenuity invented and sold to you as low-risk, high yield investments? They're mostly worthless now. You lost most of your money in a "safe investment." How anxious are you now to buy more Yankee "investments" denominated in the sinking dollar?

There goes the capital inflows which have funded our profligacy. They're gone, and not coming back. Mr. Bernanke and Mr. Paulson are busy destroying the dollar with interest-rate cuts, fueling runaway inflation as they flail mightily to save their banking buddies--but they can't succeed. Making more debt available to bankrupt entities, be they investment bankers or homeowners, solves nothing. It's called "putting good money after bad," and it simply guarantees ever-larger losses.

Allow me to sum it up: the money's lost, folks. You can't borrow more and pretend you made the money back. All those trillions in bad debt and derivatives are already lost. The Ministry of Propaganda is in a tizzy, trying to mask the meltdown and offer up a facade of normalcy. But the money's already lost.

Will it be contained to the U.S.? Why should it? The bad debt is everywhere. And the spending spree all that borrowing unleashed washed over the entire globe. Now that Americans can't borrow any more, the spending dries up--and so does the global "prosperity" built on an Empire of Debt.

Here are a few predictions:

1. The Dow Jones Industrials will drop hundreds of points in a day, very soon, losing at least 3,000 points within the next few weeks.

2. The Shanghai stock market will lose half its value, dropping from 5,800 to under 3,000.

3. Major banks will be declared insolvent.

4. Major lay-offs will occur as U.S. retail, auto and house sales plummet.

5. The tech high-fliers (RIMM, GOOG and AAPL) fall will precipitously

As I have noted here last week, trading curbs (and the uptick rule on shorting) have both been abolished. There are no constraints on the market falling; a free-fall of several thousand points in a single day is now possible. I also ran a chart of the VIX volatility chart which suggested a breakout up (i.e. a sharply declining market) was probable.

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

Maybe I'm off by a few weeks, but I think not. The Empire of Debt is crashing, and it won't take months for the global financial markets to react. For alas, the money's already lost.

Not that the mainstream media will be willing to state this inconvenient truth....


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