Numbers

It isn’t even close to Halloween but this post should spook you.

Why would I try to scare you? Can’t it wait until the end of October? No. I’m funny that way.

Just saying the word economics causes most people’s eyes to glaze over. Actually finding out what is going on in the economy has the opposite effect. It is called the dismal science with good reason.

Stay with me here. I can assure you that you will not be as happy as you are at this moment.

All of these figures are beyond the experience of real people, so let’s start with something we can use as a baseline; something with which to compare all of the other numbers. It has been published that the Gross Domestic Product (GDP) of this country for 2009 was $14.2 trillion.

That number tells us the total amount we had available for everything that year. To me it sounds pretty impressive. It’s greater than my allowance. Take that number to heart, so that it can provide some perspective for all of these other numbers.

Commercial banks are holding $13 trillion in CDSs. Let me qualify that. Deposits at those banks are guaranteed by the government; by you. Also, the overwhelming percentage of CDSs are private arrangements. They are not known to any government agency because there are no regulations that pertain to them. Several of these banks have been designated “too big to fail.” A fair translation of that is, “pays too much in bribes to fail.”

So, if $13 trillion is known, how much is unknown? That is difficult to answer, as it is unknown. We do have estimates though. The one I feel approaches reality puts it at $595 trillion worldwide. Perspective? Our economy, at $14.2 trillion is the world’s largest. Japan’s is second largest. It is approximately one-third the size of ours. That puts the estimated amount at a multiple of the entire Earth’s annual product. Remember, this number is only for CDSs. It does not include loans, credit card debt, mortgages and other such normal debt instruments

It’s probably time for us to make certain that we know what a derivative or Credit Default Swap is. A derivative is an artificial financial construct based on something else; supposedly something of value. A CDS is one type of derivative.

Some have called them insurance. This has led some in Washington to call for them to be regulated as insurance is. There is just one problem. They are not really insurance.

You likely have purchased insurance for your automobile, perhaps your home or apartment or any number of other items. Why did you do that? You, presumably, don’t want to wreck your car or watch your house burn down. Insurance may replace a portion of your loss but you will still have a loss and probably some significant inconvenience.

If I bought an insurance policy on your car, I would only benefit if your car was damaged or destroyed. How comfortable would you feel if you knew I owned a policy on your home or car? Don’t be too thankful that I haven’t. There is a good chance that someone else already has. A CDS is a bet that a financial contract will fail. It can be, and is, bought by people who don’t live in your house. It is either a break-even deal or more beneficial if the deal fails. Can we all say foreclosure?

AIG has been the biggest player in this field. AIG just glossed over one aspect of these “insurance” policies. They didn’t bother to back them up with the ability to pay if the “insured” properties went down the tubes.

Further complicating this picture is that the people putting these CDSs together combined good and bad mortgages into a single instrument. Then they sliced and diced these packages. What does that mean? It means that a mortgage that, on its own, is solid can be part of a package that turns sour. Someone who makes all of his payments, in full and on time, can find his home being in danger of foreclosure.

The damage done to the real estate market has caused market values to decrease significantly. Many are caught in the resulting vice. They can’t afford to sell their house, even were they to find a buyer. I have seen estimates that as many as 40% of all mortgages are under water; meaning you owe more than the market value of the house. Remember, you are giving these felons the money they need for all this at an interest rate of zero.

Not all CDSs are tied to home or even commercial real estate. People have bought them based on the potential for a business to fail. Some of these people own the involved business. Some do not. Either way, they may benefit if the business fails. Could someone lose their job because their employer benefits more from a business failure than from success? Youbetcha.

You and I are forbidden buying insurance policies on assets we do not own. It is strictly illegal, and rightly so. Inherent in these instruments is the logic of burning down someone else’s house for your profit.

You may be vaguely aware that the European Union and its monetary unit, the Euro, are in a precarious position. This is based primarily on the situation in Greece. That country’s leadership has made a few economic missteps. Those missteps were so serious that the entire European Union is in deep doodoo.

It turns out that our largest Wall Street institutions have been helping the Greek politicians. For close to ten years they have been using CDSs to help them cover up the problems.

Now the speculators are ready to use these very CDSs to bring down the economy of Greece. Not only does this harm Greece, it brings a degree of instability. That instability brings other economies to the brink. Ireland, Italy, Spain and Portugal appear to be next dominoes in line.

If you think, “Well, it serves them right. Their loss is our gain.” think again. The potential damage to the EU is not limited to the EU. They, as the U.S., are to too big to fail – maybe. We may have to tighten our belts, once again, if we still have belts.

The UK and US are in jeopardy in two ways. First, they are so tied into the EU that the resulting harm from the fall of these dominoes is unavoidable. That alone might deal the UK and US serious but absorbable blows. The problem is the second part. The UK and US are still in economic ICU on their on hooks.

Since writing the above I finished reading one more economist urging the need for treating CDSs as insurance and putting those selling them under the jurisdiction of the insurance regulators. Do you think that will work as well as it has in the past?

As it is illegal for you and me to purchase insurance on someone else’s assets, all it would take is a ruling, by the SEC, the DoJ, or any of several Federal agencies that they are not legal for the banks either. Just make a declaration that all such contracts are void. That would save AIG some of our money, as it would have no obligation to pay those who purchased CDSs.