Massive Debt Default by Mike Whitney

Bearly Alive, Wall Street Investment Giant Rushed to “Intensive Care” by Panicky Fed-Chief

On Friday, Bear Stearns blew up. It was the worst possible news at the worst possible time. A day earlier, the politically-connected Carlyle Capital hedge fund defaulted on $16.6 billion of its debt. Carlyle boasted a $21.7 billion portfolio of AAA-rated residential mortgage-backed securities, but was unable to make a margin call of just $400 million. (Where did the $21.7 billion go?) The news on Bear was the last straw. The stock market started reeling immediately; shedding 300 points in less than an hour. Then, miraculously, the tide shifted and the market began to rebound. If there was ever a time for Paulson’s Plunge Protection Team to come to the rescue; this was it. For weeks, the markets have been battered with bad news. Retail sales are down, unemployment is up, consumer confidence is in the tank, inflation is rising, the dollar is on the ropes, and the credit crunch has spread to even the safest corners of the market. Facing fierce headwinds, Washington mandarins and financial heavyweights had to decide whether to sit back and let one small investment bank take down the whole equities market in an afternoon or stealthily buy a few futures and live to fight another day? Tough choice, eh?

We’ll never know for sure, but that’s probably what happened.

We’ll also never know if Bernanke’s real purpose in setting up his new $200 billion auction facility was to provide the cash-strapped banks with a place where they could off-load the mortgage-backed junk that Carlyle dumped on the market when they went belly-up. That worked out well, didn’t it? Now the banks can trade these worthless MBS bonds with the Fed for US Treasuries at nearly full value. What a deal! That must have been the plan from the get-go.

The Bear Stearns bailout has ignited a firestorm of controversy about moral hazard and whether the Fed should be in the business of spreading its largess to profligate investment banks. But the Fed had no choice. This isn’t about one bank caving in from its bad bets. The entire financial system is teetering and a failure at Bear would have taken a wrecking ball to the equities market and sent stocks around the world into a violent death-spiral. The New York Times summed it up like this in Saturday’s edition:

“If the Fed hadn’t acted this morning and Bear did default on its obligations, then that could have triggered a widespread panic and potentially a collapse of the financial system”.

Bingo.

So, what makes Bear so special? How is it that one of the smallest investment banks can pose such a threat to the whole system?

That’s the question that will be addressed in the next couple weeks and people are not going to like the answer. For the last decade or so the markets have been reconfigured according to a new “structured finance” model which has transformed the interactions between institutions and investors. The focus has been on maximizing profit by creating a vast galaxy of exotic debt-instruments which increase overall risk and volatility in slumping market conditions. Derivatives trading which, according to the Bank of International Settlements, now exceeds $500 trillion, has sewn together the various lending and investment institutions in a way that one failure can set the derivatives dominoes in motion and bring down the entire financial scaffolding in a heap. That’s why the Fed got involved and (I believe) approached Congress in a closed-door session (which was supposed to be about FISA legislation) to inform lawmakers about the growing possibly of a major economic meltdown if conditions in the credit markets were not stabilized quickly.

http://dandelionsalad.wordpress.com/2008/03/16/massive-debt-default-by-mike-whitney/

500 trillion in outstanding derivatives? WOW

I've been bad-mouthing the BS bailout as an example of government helping the big guys and ignoring the financial problems the rest of us are facing. Now I'm not sure. This article suggests that if BS had been allowed to crash, it would have taken all financial markets with it. I assume this means the stock market and the bond markets? Since that's where most people have parked their money this is not good news for us. Am I right on this? Does the little guy ultimately "own the risk"?

The derivatives market receives its underpinning from all familiar investment options: stocks, bonds, currency markets (Forex), etc. It includes almost anything you can think of. Derivatives are best described, for me, as a contract with the fore-mentioned investment tools as collateral.

The most dangerous aspect of the derivatives market is its character of outright speculation on the future price of a commodity. This is Vegas stakes increased logarithmically.

How are they planning to cover even 10% of that amount if they're called in?

Full-scale liquidation of assets is the first step.

enough with how these things work to understand it but it seems to me that if no one knows what the value of these things are, then ultimately they are bound to go under. Are they trying to have it be an orderly failure? Certainly they cannot continue to prop them up. There is not enough money to do it.

Only the word 'failure' shall not be used. Look for the words 'rescue' or 'reorganization' or 'merger'. With a merger - BS will get eaten. JP Morgan will get a huge tax write-off for assuming Stearns' debt load. Tax attorneys love these kinds of deals.

but we're half way there.:scared:

:rofl: Quadrillion?

econ meltdown.