The underpinnings of the financial world are extremely complicated. It’s as complicated as maybe the space shuttle. The difference is the space shuttle comes with all kinds of manuals on how to fix every system in the thing. No such manual exists for the world financial system.
Greed drove the complexity. Make things so complex that auditors don’t know how to audit and you get by with a lot book value that has no value. Moreover, the big accounting firms have been complicit in faulty reporting of financial condition (Enron and Arthur Andersen).
Billie Sol Estes’s scheme was simple. Get loans on fertilizer tanks that didn’t exist. Maybe buy one or two and move them around to show the banker the same tank at several locations.
The idea is the same with the big-time financial scam. Dream up contracts (derivatives) that reference any financial parameter and assign a functionally arbitrary notational value to it. Then sell or use it for collateral at its notational value.
As collateral leveraged 12 to 1 based on notational value, the true leverage would be 60 to 1 if the fair market value is 20 percent of notational. Or it would be infinity if the market value is zero.
I used the term “functionally arbitrary” to describe notational value. Math types create algorithms to arrive at the notational value of a lot of the $1 quadrillion of derivatives sitting on computers around the world These algorithms include assumptions that may not be valid in the future even if they were valid taking into account market conditions at the time they were created.
The subconscious mindset of the people creating the algorithms subjectively produces code that will justify the notational value. They use assumptions that are not realistic. I got caught in this trap a few years back by making projections based on historical data that I would have concluded were not representative of the future if only I had been honest with myself.
So now there’s all kinds of derivative contracts sitting on the books of banks at unrealistically high values. If you think this fact is not true, please read Section 132 of both the Senate and House versions of the Emergency Economic Stabilization Act (EESA). It gives the SEC the power to suspend mark to market valuation of just about any type of asset held by a financial institution, including derivatives.
Which brings us to LIBOR. It’s financial jargon for London InterBank Offered Rate. This standard came about in 1984 in part because banks were increasingly trading in certain types of derivatives. The increase in the LIBOR rate in this current crisis is an indicator of the unwillingness of banks to make loans to each other.
Gold bug Jim Sinclair today posted a warning that if the LIBOR rate doesn’t drop sharply, we’re looking in the near future at a Weimar-Republic-like world wide financial crisis. If I were a bank that had lending power, I’d want to know the true financial condition of any other bank I might make a loan to. If a prospect is holding a bunch of derivatives, I would have to assume they are worthless in making a decision to make the loan.
So here comes EESE and the US treasury buys bad assets from a bank, but at what value? Mark to the market or at notational value? If the House passes EESA, the treasury must pay a lot more than five percent of the notational value for bad assets of a bank in trouble, in order to give a sound bank an incentive to loan to money to the troubled bank.
This evening on PBS’s Nightly News, three university economic profs (U of Chicago, George Washington and Harvard) were relating their views on the merits of EESA. The U of Chicago guy was against it. The other two were for it only because it would bolster confidence on main street, and maybe Wall Street, that the fed was taking action. That’s not a strong endorsement for EESA itself solving the problem.
Last night, Warren Buffett on Charley Rose made it clear that he’s all for its passage. George Soros is not.
We are certainly in for a ride. It’s going to last a lot longer and cost a lot more than the roller coaster at Six Flags.