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« Arthur Schlesinger is dead | Main | Super-black and ultra-chunky »
Tuesday
Feb272007

Debt & Derivatives: A Prediction.

Warning: This is solid economics all the way to the end, and it's long. So, please, skip it if this kind of thing doesn't interest you.  I will totally understand.

 

Sigh. OK.  For the last week, I've been meaning to predict a global economic disaster, but never got round to it. And now there's this big 9% Chinese stock market fall today, which has jolted the US markets down 3%, so if I post now I'll look like Chicken Little, hit by an acorn and screaming "The sky is falling! The sky is falling!"

But, sheesh, I'll do it anyway.  Here's my prediction, based a little on economics and a lot on history and human nature. At some point in the next five years (but my gut feeling is much sooner, within the next two years) there will be almost simultaneous collapses in the valuations of many unrelated asset classes across much of the world.

 OK, why? Because almost every major unregulated financial innovation starts out being used for its intended purpose, gets misused by more and more mainstream financial institutions to make free money, and is pushed to grotesque excess, leading to the unexpected collapse and disgrace of often venerable institutions, followed by reform and regulation.

 The new derivatives (especially some of the credit default ones, and some of the very, very weird and complex derivatives-of-derivatives) are classic examples of this.

Step one: A great idea. You can hedge risk by buying a derivative: for example, if you own General Motors bonds, you can insure against the risk that General Motors will go bust by buying a credit default derivative for those bonds. The derivative will pay out if General Motors goes bust. Voila! You now have no risk. Ultimately, either the bonds will pay up, or the derivative will pay up. Banks also get excited, because they can shift risk off their books by packaging debt (say a bundle of mortgages) and selling it as a product. Risks can be spread more widely. This should lead to greater stability in the markets, and safer banks.  And it would, if human nature didn't lead inevitably to...

 

Step two: Misuse.  People and institutions start to get really, really interested in the derivatives themselves, and not the underlying asset, as the derivatives themselves become tradable assets. At first it's just people buying and selling derivatives they don't need. Someone with no General Motors bonds buys a credit default derivative for those bonds, because he figures it's better value than the bonds. Now debt, and risk, start to change meaning: Instead of being locked in place between a lender and a borrower, debt and the debt's risk can be moved, separated, repriced, sold, resold, shuffled, combined with something else, repackaged, renamed, rebranded, remarketed, in derivatives of derivatives of the original thing, whatever the hell that was.

 

Step three: Grotesque excess. The relationship between derivatives and the underlying assets becomes totally meaningless. The value of outstanding derivative contracts becomes massively greater than the value of all the assets on earth. Many derivatives are now pure and simple speculation (or "bets" as they used to be known.) But there is a feedback mechanism now exaggerating the situation and pushing it to its limit (and crisis). The removal of risk from the lending institutions leads to far more lending than would otherwise be the case. The removal of risk from the borrower means that companies and institutions are far more keen to borrow than they would otherwise be. Much of the lending and borrowing is to buy unanchored assets which only exist because of the extraordinary liquidity of the financial markets. Real-world debt is now an asset in high demand: therefore, there is immense pressure to supply it.

 

An example: Banks which once made their money slowly, from mortgage borrowers slowly paying back their mortgages, now make much more money, much faster, by slicing-and-dicing the mortgage debt into complex derivative products and selling it to hedge funds. So the bank's primary customer becomes the hedge fund, not the guy buying a house. The product the bank is selling has changed: it's no longer selling money to people who need money: it's selling debt, to institutions that need to buy debt. And almost any mortgage to almost any individual becomes profitable, because the supply of real world debt is the only bottleneck, in a world awash with liquidity.
 

 Step four: Unexpected collapse. The global house price bubble is largely explained by this hunger for real debt to repackage. A lot of other assets are now at silly prices because the illusion of no risk has led to vast over-lending into a limited pool of real-world assets. The consequent pumping up of real-world asset prices keeps the whole game going. But risk hasn't been eliminated: it's merely been moved around (and, I believe, mispriced).
There is also, in total, a lot more of it than there was before. A crash has become less likely, on a day-to-day basis; but it will be larger and spread across more territory and asset classes when it does.

 

By definition, an unexpected collapse will be unexpected. It's impossible to predict the trigger, and foolish to predict the timing. But if it pops, the feedback loop which pumped it up will reverse and act to deflate it. There will be a horrible drying up of liquidity, a credit crunch, and a fairly general asset crash.

 

But, to end on an up note, the underlying real-world economy is in fact in excellent nick (on its own terms, but that's a different debate). It is also, now, a system of such tremendous complexity that it is in fact quite stable. (The mathematics of large complex systems are very interesting and often counterintuitive). It will bounce back surprisingly quickly. And once derivatives and hedge funds are properly regulated, they will indeed bring greater stability to the  financial system. Until the next major innovation.

 

OK, that's it. Glad I got it off my chest. And don't worry, it's just my pet theory. I could also be quite wrong. Nobody really knows what the hell is going on in the financial markets these days. They're now just too vast and complex to model. And they involve the one factor that can totally screw up any prediction: lots and lots and lots of people, living their lives, and making their decisions, and reacting to events while creating new events in a real world that exists on a plane that transcends any theory.

 

If you made it all the way to the end of that, my God, you're a hero. Thanks for sticking with it. Buy yourself a cup of coffee. Have a biscuit too, you deserve one. 

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Reader Comments (11)

Chicken Little I think not!

So, do you reckon we'll be alright then? If the financial markets have already been pre-empting (or being counterintuitive about) the collapse, they obviously know how to 'work around’ the difficult time until it stabilises... but that's the private sector you are on about, right? Us mortals below the skyline will just get taxed until tax starts coming out of every orifice!
Do you think it will bounce back soon or should I get the hell out of Ireland...?

Hello by the way! I'm Neassa. I like your books. Write some more please.x
August 7, 2008 | Unregistered Commenterneassa therese
Hiya Neassa, sorry I'm a month late responding to your comment (but then, you are a year and half late responding to my post!)

Should you get the hell out of Ireland? Oh, Ireland's banjaxed! Run!

Well, even Ireland will recover eventually... I don't know what's going to happen next in the real economy, but I grow gloomier.

Still, however bad it gets, this too will pass. And people are generally happier in a recession (there's much less status anxiety for one thing), as long as they don't lose their jobs.

Egad, I just had a look back over that post, and I'm pretty pleased with it. Not bad for February 2007:

"But if it pops, the feedback loop which pumped it up will reverse and act to deflate it. There will be a horrible drying up of liquidity, a credit crunch, and a fairly general asset crash."

Hmmm. If I could be arsed doing the Googling, I'd love to compare that with what the fecking Irish banks were saying 18 months ago. And the grossly irresponsible and culpable Irish newspapers. (The Irish Times, with its 64 page property supplement, and no journalism on the biggest bubble - and the biggest economic story - in Irish history.)
September 4, 2008 | Registered CommenterJulian Gough
...and down go Lehman Brothers, with Merrilll Lynch and AIG hanging on by the skin of their teeth. I'm beginning to think that Julian Gough is some sort of cyborg economist sent from the future, masquerading as a comic novelist.
September 15, 2008 | Unregistered CommenterRobert Cotter
Jeeeez, don't tell everyone Robert, you'll get me into trouble.
September 15, 2008 | Registered CommenterJulian Gough
Bravo,

You should be running the FED!

If not you, Who?

I am a bond trader and I have been making a ton of money betting against the how stupid these financial institutions were and are! You are the most clear thinking person I have read.

I truly believe the next shoe to drop are the currency derivatives written by foreign banks to hedge against a rise in the dollar. The dollar is dramatically up!

Only a matter of time before countries start calling in their currency derivatives to raise cash and then we will all be in a world of hurt because the dollar will rise in value more and deflation will be here and unemployment will be around 15%. 24 months give or take!

Congrats again!

Be the voice in the Night!
October 27, 2008 | Unregistered Commenterchris hogan
Chris, that's fascinating. The looming problem with those currency hedges hadn't occurred to me... Blimey, they really could cause chaos, with the dollar and yen already going up like fireworks...Yes, I agree with you, there's a lot more fun to be had from derivatives over the next year or two.

I'm also interested in seeing what happens to all those trillions in outstanding credit default obligations and credit default swaps when we actually start to get a huge wave of defaults, as debt-burdened corporations can't roll the debt over, and go under. 2009 is going to be really interesting.
October 28, 2008 | Registered CommenterJulian Gough
Even Cash is NOT KING anymore. Not with interest rates at 0.5%.
Do you foresee a Negative Intrest Rate? I mean the banks charging us for keeping our money for us in Deposit accounts.
Can you recommend a good locksmith to design for us a fail-proof and fire-proof safe that we can put under our bed?
April 6, 2009 | Unregistered CommenterEzzat Dawlatly
I truly believe the next shoe to drop are the currency derivatives written by foreign banks to hedge against a rise in the dollar.
September 1, 2010 | Unregistered Commenterfree icon editor
I am totally agreed with you. Thanks a lot for such a nice article.
Hello Julian,

I am amazed that you wrote this blog just before the housing market crash in 2008. Your ability to predict the future is impessive. How do you see things from here on out? I have read a few articles which insist that we have not seen the worst effects of the unregulated derivatives craze and that there are still trillions (or even quadrillions) of dollars of derivative debt that are ready to completely destroy the world market. What is your view?

Thanks!

Andrew
October 17, 2011 | Unregistered CommenterAndrew
Hi there! We have a friend in common -- Suzanne Munshower. She said she is having lunch with you, thi Thursday. Small world!

Well it's 2014 now, and I just met with a realtor (here in Santa Fe, NM) and the prediction here is that houses are taking 1-2 years to sell, instead of weeks like in pre-2008. :-(. Also that the real estate market is expected to remain mostly flat for the next TEN YEARS! Everyone here is increasingly scared about the bullish stock market too. I'm wondering, oh wise one -- how do you see it? Is there another, perhaps even bigger, crash heading our way? Inquiring minds want to know!

Let me know if you come through Santa Fe on your way to Area 51. I recommend you go across from Vegas (assuming you are driving, and I think you should) to the Four Corners region, to see Chaco Canyon. Then come over to Taos, down to Santa Fe, then buzz through Albuquerque, stop at the Giant Array as you head south, bath at the hot springs in Truth or Consequences, and then voila! You end up over in the Roswell area. New Mexico's motto is "The Land Of Enchantment", and it truly is enchanting. Hope you come this way! Karen
August 19, 2014 | Unregistered CommenterKaren Strickholm

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