Debt & Derivatives: A Prediction.

Warning: This is solid economics all the way to the end, and it's long. So, please, skip it if this kind of thing doesn't interest you.  I will totally understand.

Sigh. OK.  For the last week, I've been meaning to predict a global economic disaster, but never got round to it. And now there's this big 9% Chinese stock market fall today, which has jolted the US markets down 3%, so if I post now I'll look like Chicken Little, hit by an acorn and screaming "The sky is falling! The sky is falling!"

But, sheesh, I'll do it anyway.  Here's my prediction, based a little on economics and a lot on history and human nature. At some point in the next five years (but my gut feeling is much sooner, within the next two years) there will be almost simultaneous collapses in the valuations of many unrelated asset classes across much of the world.

 OK, why? Because almost every major unregulated financial innovation starts out being used for its intended purpose, gets misused by more and more mainstream financial institutions to make free money, and is pushed to grotesque excess, leading to the unexpected collapse and disgrace of often venerable institutions, followed by reform and regulation.

 The new derivatives (especially some of the credit default ones, and some of the very, very weird and complex derivatives-of-derivatives) are classic examples of this.

Step one: A great idea. You can hedge risk by buying a derivative: for example, if you own General Motors bonds, you can insure against the risk that General Motors will go bust by buying a credit default derivative for those bonds. The derivative will pay out if General Motors goes bust. Voila! You now have no risk. Ultimately, either the bonds will pay up, or the derivative will pay up. Banks also get excited, because they can shift risk off their books by packaging debt (say a bundle of mortgages) and selling it as a product. Risks can be spread more widely. This should lead to greater stability in the markets, and safer banks.  And it would, if human nature didn't lead inevitably to...

Step two: Misuse.  People and institutions start to get really, really interested in the derivatives themselves, and not the underlying asset, as the derivatives themselves become tradable assets. At first it's just people buying and selling derivatives they don't need. Someone with no General Motors bonds buys a credit default derivative for those bonds, because he figures it's better value than the bonds. Now debt, and risk, start to change meaning: Instead of being locked in place between a lender and a borrower, debt and the debt's risk can be moved, separated, repriced, sold, resold, shuffled, combined with something else, repackaged, renamed, rebranded, remarketed, in derivatives of derivatives of the original thing, whatever the hell that was.

Step three: Grotesque excess. The relationship between derivatives and the underlying assets becomes totally meaningless. The value of outstanding derivative contracts becomes massively greater than the value of all the assets on earth. Many derivatives are now pure and simple speculation (or "bets" as they used to be known.) But there is a feedback mechanism now exaggerating the situation and pushing it to its limit (and crisis). The removal of risk from the lending institutions leads to far more lending than would otherwise be the case. The removal of risk from the borrower means that companies and institutions are far more keen to borrow than they would otherwise be. Much of the lending and borrowing is to buy unanchored assets which only exist because of the extraordinary liquidity of the financial markets. Real-world debt is now an asset in high demand: therefore, there is immense pressure to supply it.

An example: Banks which once made their money slowly, from mortgage borrowers slowly paying back their mortgages, now make much more money, much faster, by slicing-and-dicing the mortgage debt into complex derivative products and selling it to hedge funds. So the bank's primary customer becomes the hedge fund, not the guy buying a house. The product the bank is selling has changed: it's no longer selling money to people who need money: it's selling debt, to institutions that need to buy debt. And almost any mortgage to almost any individual becomes profitable, because the supply of real world debt is the only bottleneck, in a world awash with liquidity.
 

 Step four: Unexpected collapse. The global house price bubble is largely explained by this hunger for real debt to repackage. A lot of other assets are now at silly prices because the illusion of no risk has led to vast over-lending into a limited pool of real-world assets. The consequent pumping up of real-world asset prices keeps the whole game going. But risk hasn't been eliminated: it's merely been moved around (and, I believe, mispriced).
There is also, in total, a lot more of it than there was before. A crash has become less likely, on a day-to-day basis; but it will be larger and spread across more territory and asset classes when it does.

By definition, an unexpected collapse will be unexpected. It's impossible to predict the trigger, and foolish to predict the timing. But if it pops, the feedback loop which pumped it up will reverse and act to deflate it. There will be a horrible drying up of liquidity, a credit crunch, and a fairly general asset crash.

But, to end on an up note, the underlying real-world economy is in fact in excellent nick (on its own terms, but that's a different debate). It is also, now, a system of such tremendous complexity that it is in fact quite stable. (The mathematics of large complex systems are very interesting and often counterintuitive). It will bounce back surprisingly quickly. And once derivatives and hedge funds are properly regulated, they will indeed bring greater stability to the  financial system. Until the next major innovation.

OK, that's it. Glad I got it off my chest. And don't worry, it's just my pet theory. I could also be quite wrong. Nobody really knows what the hell is going on in the financial markets these days. They're now just too vast and complex to model. And they involve the one factor that can totally screw up any prediction: lots and lots and lots of people, living their lives, and making their decisions, and reacting to events while creating new events in a real world that exists on a plane that transcends any theory.

If you made it all the way to the end of that, my God, you're a hero. Thanks for sticking with it. Buy yourself a cup of coffee. Have a biscuit too, you deserve one.