[Trusties] Fw: Financial Monsters

Sat Oct 27 16:12:14 EST 2007

For those you who are interested in the looming global financial crisis, 
another great find by Trust member, Ben Burke. Thanks Ben.

Tim

Here is the full article

      Financial Monsters
      Written by Alice Friedemann

      We are entering the Money/Energy Transition. (The term was coined by 
Tom Robertson, moderator of the energyresources listserve.) This is when 
people will realize they can't fuel their cars with dollar bills -- that 
money is meaningless and all that really matters is energy. M. King Hubbert, 
the original peak-oil visionary, proposed an energy currency half a century 
ago so that people would understand how critical a role it plays in our 
survival. But it isn't practical to carry tanks of gas around or bits of 
uranium in your pocket.
      So we spent our energy foolishly, plundering and poisoning the planet 
for a blip-in-time of pleasure, and now the "Limits to Growth" boas of peak 
oil, climate change, and natural resource shortages are tightening around 
us.

      But most people don't see the world ecologically. Nearly everyone is 
brainwashed to see the world through economic and political filters. As we 
sink into depression -- both individual and economic -- brought on by 
increasing population, pollution, and decreasing energy and natural 
resources, most people will blame politicians, the Federal Reserve, and 
"evil" foreign governments for our woes. So we should start recognizing our 
personal, national and global financial monsters.

      It appears the United States is succumbing to what all governments 
have been tempted to do over time: run the money printing presses overtime 
to pay for wars, debts, and corporate welfare. In anticipation of completely 
worthless money, we ought to at least design it in colors and shapes to make 
origami and something to do, since most of us will be out of work (you can 
start practicing at members.cox.net/crandall11/money).

      The subprime market is just the first tremblor bursting out of the 
ground to suck the life-blood out of your bank account and "disappear" your 
job.

      Other Economic Monsters

      Derivatives. Originally used to hedge risks, then as leverage, i.e., 
"swaps," derivatives allowed hedge funds to get around the leveraged limits 
the SEC instituted after the 1929 crash.

      Warren Buffett has been warning for years that derivatives are 
endangering the financial system. He believes that the widespread use of 
swaps makes the leverage that preceded the 1929 crash "look like a Sunday 
school picnic." (Smith 2007). He warns that derivatives are financial 
weapons of mass destruction (BBC 2003):

      . An explosion in derivatives contracts could create serious systemic 
risks; derivatives are like time bombs waiting to explode the economic 
system. Large amounts of risk have become concentrated in the hands of 
relatively few derivatives dealers.
      . Outstanding derivatives contracts -- excluding those traded on 
exchanges such as the International Petroleum Exchange -- are worth close to 
$85 trillion.
      . Some derivatives contracts appear to have been devised by "madmen." 
Buffett warns that derivatives can push companies onto a "spiral that can 
lead to a corporate meltdown," like the demise of the notorious hedge fund 
Long-Term Capital Management in 1998.
      . Derivatives also pose a dangerous incentive for false accounting. 
The profits and losses from derivatives deals are booked straight away, even 
though no actual money changes hands. In many cases the real costs hit 
companies many years later. This can result in nasty accounting errors. Some 
of them spring from "honest" optimism. But others are the result of 
"huge-scale fraud," for example, with the US energy market, which relied for 
most of its deals on derivatives trading and resulted in the collapse of 
Enron.

      Many derivatives don't trade often, making it hard to value them 
accurately. Institutions don't trust each other because no one knows who's 
got the most skeletons to hide. It's hard to make financial instruments like 
leveraged loans transparent if the asset has never traded, or no one's 
buying. Institutions tend to put as much gloss on their numbers as possible, 
and investors, lenders, and shareholders are very suspicious. (Davies 2007)

      If hedge funds ever have to put an accurate price on what they own, 
the outcome could be scary -- that's why the Bear Stearns subprime debacle 
caused such concern, because it could start a chain reaction of other hedge 
funds forced to truly discover their asset values and adjust them sharply 
downward. Banks have about 375 billion dollars in leveraged loans. Bank, 
private equity, brokerages, and hedge fund failures are likely as assets 
continue to decline in value. Hedge funds have used derivatives to dampen 
volatility, and act like shock absorbers against market risk. But if the 
real value of derivatives has been exaggerated, then when these "shock 
absorbers" break down, there could be a hard landing (Patterson 2007).

      The Great Unwind: Leveraged Debt. Not since the Great Depression has 
there been so much leverage in the stock market. Hedge funds, private equity 
firms, and Wall Street have found ways to work around the legal limits of 
leverage via derivatives and other complex financial instruments. Part of 
the reason we got into this mess was that banks, which are regulated and 
supposed to be transparent, don't control credit or money anymore.

      Hedge funds and private equity firms are not regulated. If there's a 
serious market downturn, leverage can create a snowball effect, as stocks 
are dumped to raise cash, spiraling prices ever downwards. Wall Street 
analysts call this "The Great Unwind." The Wall Street Journal summarized 
this risk by saying, "No one is sure what will happen with this complex web 
of borrowing and derivatives in the event of a serious market downturn."

      Larry Fink of BlackRock, says that lenders to highly indebted 
companies are making the same mistake as the subprime mortgage market, and 
will become "tomorrow's problem" as leveraged buy-out and junk-rated lending 
grows. The Bank of England also warned that cheap corporate lending with 
loose credit standards "has increased the vulnerability of the global 
financial system", and cautioned against weak standards of risk assessment 
for repackaged bank loans that are sold to the rest of the financial system 
(Beales 2007).

      In the Economist magazine (June 21, 2007), Daniel Arbess, of Xerion 
Capital Partners, said that "perhaps the most worrying thing for financial 
institutions holding mortgage-backed paper is not the subprime market, but 
the unnerving parallels with an even bigger one to which they are also 
exposed: leveraged loans to companies". Subprime might well be "a dress 
rehearsal for something bigger and scarier."

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