November 2011



We in the US cannot become too smug as we watch the ongoing drama of Europe trying to keep its head above water.  Because of the linkage between our banking systems, we cannot escape the effects of their crisis.  


Our largest banks, Morgan Stanley, Citigroup and Bank of America hold $1.8 trillion in loans to Europe according to the Bank for International Settlements.  They also are on the hook for $1.6 trillion in credit default swaps (derivative contracts) which guarantee European debt.  Remember, these are the banks that are TOO BIG TO FAIL.  We don’t even want to think about bailing them out again but that is why this situation is so dangerous.


Another fault line is the $2.6 trillion money market industry on which I have been sending you material.  38% of the loans this industry makes with investors’ money are made to firms in Europe.


But the real 800lb. gorilla in the room is the derivative market as a whole. As we have discussed, derivative contracts are largely wagers between two entities that a certain event, such as a default of a company (now country) will happen or not. If one of the counter parties is in doubt that the other party can deliver if he loses, he may require collateral. Currently sovereign (national governments) have been considered risk free and have never had to post collateral against possible losses.


According to Manmohan Singh, an economist at the International Monetary Fund, this anomaly has helped create a severe under-collateralization worth $1.2 to $2 trillion for the 10 largest banks alone.  If “true” counter party risk were ever recognized in derivatives the implications could be brutal.  There may simply not be enough decent collateral to go around.


I must add that none of these issues were really dealt with by the Financial Reform Act.


We are all weary of what we must now recognize as, not a new crisis, but simply the continuation of the one that began in 2008.  It is like watching a slow motion train wreck.  I am continually reassured that we are doing the right thing by not trying to get back on the track.


What is also a recurring theme is the folly of the worldwide banking industry‘s ability to take one dollar and leverage it 30 different ways and make another dollar each time it does.  We have already witnessed what can happen when the original dollar is pulled away; collapse!  We may have to witness a second installment of that before too long.


What we really do not want to see is what has been tried in prior financial crisis; inflation. I will be discussing this for our next seminar but for now know that one way governments deal with not creating enough revenue from taxes or economic growth is to just print money.


As for the stock market, with all its’ ups and downs, has managed a return of .3% for the S&P 500 year-to-date.