I sincerely believe… that banking establishments are more dangerous than standing armies, and that the principle of spending money to be paid by posterity under the name of funding is but swindling futurity on a large scale. — Thomas Jefferson
This is a lengthy and somewhat technical article. It is not as important to understand the specific statistics as it is to get a perspective of the downward economic spiral that plagues the current economic system. The numbers are large and history has shown that those in authority soon forget what previous generations learned. The Great Depression was preceded by the Roaring 20’s. The current environment has many parallel themes occurring. The super-charged egos of those in charge believe that they can defy the compression aspect of economic cycles. Compression is good. Delayed compression can be life threatening. We are currently at risk of an economic depression in the 2009-2010 time frame. Read on…
The financial industry operates on leverage. It loans other people’s money and collects interest income. For instance, if you are paid 5% on your bank certificate of deposit (CD), the bank will use that money to loan out at a rate typically at least 2% higher. The bank makes its money on the "spread" of 2%+. Only the best customers receive the bank’s prime rate. A standard savings account may receive 2-3% interest whereas the bank is loaning money at 7-12% interest. The financial industry is inherently structured to make money. The assumption of this model is that the lending and investment practices adhere to strict guidelines to insure minimal loan/investment losses. Regulators closely monitor loan loss ratios. They are also expected to closely review investment portfolio valuations. This is currently where the problem lies.
SIVs are investment companies that use short-term borrowings to buy a higher-yielding asset. When I was in banking in the 1970’s, I discovered an opportunity- borrow at 7% for 36 months and invest in 30 year Treasury Bonds at 8%. I would simply pocket the 1% profit. I would use the Bond as collateral. All is good. However I had a couple of problems. First, I did not have the capacity to borrow much. 1% on $10,000 would only yield $100 per year, hardly worth the effort. I would need to be able to borrow $1,000,000 to create a notable return. Since I knew that my balance sheet would not support that kind of loan, I dismissed the opportunity. Things have changed in the financial industry. Hedge funds raised large amounts of money and were able to leverage their investing by 20 to 30 times. Additionally, they could justify their investments by buying "insurance" on the asset or its stated interest rate. What a complex arrangement! In simple terms, the risk was spread among multiple players. The problem is that the investment was only as good as the weakest player. If the security was devalued, there were problems. If the insurer became weak, there were problems. If the bank lost money and was required to reduce its lending and thus "call" the note, there were problems. As you can see there are many things that could go wrong in these complex transactions that base "leverage" as the underlying fuel to high returns. If the SIV invested in subprime mortgage backed securities, all of the participants would be severely impacted if the valuation of the underlying asset (houses) substantially dropped.
The housing bubble is bursting in the developed countries. Speculators were allowed to borrow money outside the normal, historical lending criteria. The participating banks were not innocent in this fiasco. The mortgage lenders (equivalent to bank loan officers) were also complicit in this fraudulent activity. Technology has provided the lending institutions with plenty of "no brainer", "fill in the blank" loan/credit analysis tools to insure safe lending practices. Credit reporting agencies provide an easy means to verify payment history. Once again, corporate greed has raised its ugly head and will severely impact the global financial system. There will be many to lose their home and any savings they have accumulated. Those marginal families will be at risk of bankruptcy.
Another bubble of equal concern is the upcoming baby boomer retirement bubble in the U.S. The unfunded liabilities on the U.S. Government’s Balance Sheet dwarfs any potential source of revenue. How will the U.S. be able to survive this liability? The Federal Reserve will cut down all the trees in the country to print money. This will be hyperinflationary. The elderly who saved their entire lives will suffer with reduced purchasing power of their savings. Those who are marginally surviving will become welfare recipients. The 2007 Medicare/Medicaid insurance trust fund report reveals an unfunded liability of $40.9 Trillion on Page 190 of their latest report. See the following link: http://www.cms.hhs.gov/ReportsTrustFunds/downloads/tr2007.pdf. In USA Today, the overall unfunded liability to the taxpayer was $59 Trillion. http://www.usatoday.com/news/washington/2007-05-28-federal-budget_N.htm
The third bubble is peak oil. The globe is not out oil, it is just more difficult to extract with the current, available resources. "Peak oil" suggests that production from new discoveries no longer exceeds the production decline in output of existing fields. The largest discovered fields around the world are in decline. No new fields of a similar size/output have been found in decades. The world’s largest field Ghawar in Saudi Arabia was discovered in 1948 and put on stream in 1951. With all of the technology available, oil companies have not found a larger field in the last 70 years.
The Derivative Crisis is the fourth bubble. There are many other derivatives not tied to the subprime mortgage crisis. In 2003, Warren Buffett warned that derivative securities were a "mega-catastrophe" and "financial weapons of mass destruction" in the annual letter to shareholders of Berkshire Hathaway, published in the Fortune Magazine:
[T]hese instruments call for money to change hands at some future date, with the amount to be determined by one or more reference items, such as interest rates, stock prices, or currency values. If, for example, you are either long or short an S&P 500 futures contract, you are a party to a very simple derivatives transaction–with your gain or loss derived from movements in the index…
…Large amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers, who in addition trade extensively with one another. The troubles of one could quickly infect the others. On top of that, these dealers are owed huge amounts by nondealer counterparties. Some of these counterparties, as I’ve mentioned, are linked in ways that could cause them to contemporaneously run into a problem because of a single event (such as the implosion of the telecom industry or the precipitous decline in the value of merchant power projects). Linkage, when it suddenly surfaces, can trigger serious systemic problems.
This derivative industry has grown into the trillions of dollars. The Bank of International Settlements (BIS) report:
Data from the BIS Statistical Report Q4 2006
• OTC Notional Amount of Derivatives is over $414 Trillion
• 70% of Notional are Interest Rate Contracts
• Credit Default Swaps are the fastest growing product
– Over $28 Trillion
– 65% Single Name Instruments
– 35% Multi – Name Instruments
As of June, 2007 the Derivatives total stood at $516 Trillion. see: http://www.bis.org/statistics/otcder/dt1920a.pdf
Why would I put all of this information in this writing? The average person will never hear about all of these global risks in a summary similar to the above. The average person would not comprehend the inherent risk to his or her future that these bubbles represent.
These four bubbles combine to represent a perfect storm. Tax hikes or other changes to the current global economy can affect the outcome, the timing, and the severity of the expected compression. What should one do to prepare? Reduce your leverage and borrowings. Protect your assets from the financial institutions that may fail. Take possession of your stock certificates (if you are fortunate to own stock). Keep cash on hand. Invest in gold and/or silver (hard money). Tangible assets will ride out the storm. People need a place to live, food to eat, and energy for heating, cooling, and transportation. Will the severe compression take place? A good businessman hopes for the best but plans for the worst.