Capitol Hill Blue Forums Political Issues Finance, the economy & Economics Banks in trouble?

British Prime Minister Gordon Brown told Parliament: "While our economy is resilient and the fundamentals strong, we will . . . continue to take whatever action is necessary to maintain economic stability."

The City -- London's equivalent of Wall Street -- has been hard hit by the U.S. subprime crisis. The Centre for Economic Business Research in London estimates the financial market turmoil will lead to the loss of 10,000 jobs in the City this year.

"The major players in the U.K. financial market are essentially American banks. And it's not just American banks -- we've seen a number of big European banks that have been exposed to the [credit crunch]. And what's happened to Bear Stearns has just raised investors' doubts about the liquidity risks that banks have," said Jonathan Said, senior economist at the research group.

[snip]

In China, meanwhile, investors are wondering whether the government will intercede to stop the decline of markets. Shanghai's composite index has fallen from a peak of over 6,000 in October to 3,820 today.

As the mortgage blow-up has shown, many of the "modern finance" techniques that have been designed in the last 30 years have shown themselves fatally flawed. Of all such innovations, probably the one posing most current danger for the world’s financial system is the credit derivatives market.

Like most modern finance products, credit derivatives were marketed as hedges. A bank could reduce its credit exposure to a particular borrower by entering into a contract whereby another bank would make payments to it if the borrower fell into bankruptcy.

Needless to say, once Wall Street's trading desks got hold of credit derivatives, all thought of hedging was lost. Instead of selling a credit exposure once, banks sold it 10 times, or even 20. Instead of selling credit exposure to another bank or an insurance company, which would be able to handle the credit exposure and could be relied upon to pay up in case of trouble, credit derivatives traders sold credit derivatives to hedge funds, private equity funds and any riff-raff that walked in off the street.

As a result, the credit derivatives market is a time-bomb waiting to explode. It will remain quiescent while credit losses on the underlying loans are low or moderate, but at some point rising credit losses on the underlying loans will be multiplied by the credit default swap mechanism to produce a payment requirement that is several times the size of the underlying defaulted loans.

Theoretically, that mega-payment requirement would be offset by mega-profits in other corners of the web of counterparties. In practice, the losses are likely to be large enough to cause counterparties to default, particularly if they are "men of straw" such as hedge funds, so the profits will prove ephemeral while the losses prove all too real. Losses of even a modest fraction of a $50 trillion principal amount would bring down most of the banking system.