Julian Gough

Look, I've got to talk about what's happening in the financial markets or I'll burst. Feel free to ignore it, I know  almost none of you care, but I'm incredibly excited. And if you ARE into economic meltdowns,  this is going to be the World Cup Final of economic meltdowns, and Brazil are about to walk out onto the pitch...

Well, anyway, for the few of you still reading... You might remember, I made a big, fat general prediction back in February 2007. I said, in this blog:

"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."

I also said:

"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."

Bear in mind, this was six months before August 2007, when the current credit crisis started.

I also said, (as I outlined the historical process that leads to these things):

"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."

That was the theory for the past insane decade, and a very sweet and charming theory it was. But it was bullshit, and here's why...

Somebody has to be on the other end of that bet. Someone has to sell you that credit default derivative (let's call it an insurance policy). And if the bond does default, if General Motors does go bust... That someone who sold you the insurance has to have the money to pay you. And if that someone has mispriced the risk... has sold everybody around the world cheap, cheap, cheap insurance, firmly believing the policies will never have to pay up... And suddenly has to pay up... The money isn't there. The premiums were not enough to cover the risk.

The ultra-cheap insurance made everybody (banks, companies, hedge funds, private equity firms, individual investors, your mamma) happy to take on too much risk. Taking on too much risk, they eventually collapse. Collapsing, they trigger the insurance. Which bankrupts the insurance companies.

Which wipes out everyone's insurance, which causes banks, companies, everybody, to default, collapse, implode, as they get downgraded by the ratings agencies, and investors run like rabbits for the hills.

Well it's happening, right now. There are only a few big companies who insure all the bonds issued by everyone from IBM to your local town council. They are called monolines. And, in my opinion, they have been technically insolvent (or broke, as we used to call it) for months. But the ratings agencies haven't had the guts to downgrade the monolines' ratings, for fear of the consequences. This cannot last forever: the monolines ARE broke, and they WILL go bust (unless some generous soul from outside intervenes and bails them out), and the ratings agencies cannot pretend they're OK indefinitely...

Ah, enough for tonight. (It's not like anyone reads my economics stuff anyhow.)