Anatomy Of A Panic

The global financial markets have just begun to recover from a financial panic that has driven some 43 stock markets around the world down over 20 percent a piece from their most recent all-time highs. In the parlance of the financial world, that means that there are 43 "bear markets" in stocks occurring simultaneously around the planet, including a bear market that's mauling Wall Street.

The financial market pressure was so intense over the last 48 hours that the Federal Reserve, our nation's famous central bank, took the nearly unprecedented step of slashing short-term interest rates by three-quarters of a percent, the largest single one-day cut in over 20 years, with a promise of more rate cuts to come ... possibly as early as next week.

Equally dramatic and surprising is that the cut came just 10 days before the Fed was scheduled to meet in Washington, where and when it was expected to make those cuts anyway.

The plunge in the global markets reflected a very real and palpable fear that our real estate recession and associated "credit crunch" will drive us into a deep and lasting recession, if one hasn't started already.

The story of the financial crisis we are witnessing is mind-numbingly complex, if told in the words of Wall Street. The global credit crisis, that erupted from the collapse of the U.S. sub-prime mortgage market, takes an extraordinarily circuitous route from Main Street to Wall Street and back again, and then on to the rest of the world's financial markets. Unlike the virtuous circle of prosperity that we have seemed to enjoy, the world over, in the last seven years, it appears that a vicious cycle of calamity be unfolding before our very eyes.

It began with the bursting of the bubble in residential real estate here in the United States. It quickly spread to other hot real estate markets around the world. Complex debt instruments that were linked to sub-prime mortgages, both here and abroad, imploded in value. The credit collapse spread by waves of delinquencies, defaults and foreclosures in sub-prime real estate, caused a contagion effect in other highly complex credit derivatives that were sold by Wall Street as safe bets to presumably savvy institutional investors around the world.

If your eyes are glazing over, it is entirely understandable. Many of the financial engineers who created these highly complex, and highly levered, investments didn't fully understand how the structures would behave, themselves, particularly when stressed in unanticipated ways.

But that never stopped them from creating more and more financial products with complicated names like "Collateralized Debt Obligations," (CDOs), or "Credit Default Swaps," (CDS) or "Asset-Backed Commercial Paper Programs," (ABCPP), that were built around highly risky sub-prime mortgage securities or other flaky investments, and then leveraging them to the hilt.

By the way, there is no more dangerous or incendiary combination on Wall Street than taking newly engineered financial instruments and using loads of borrowed money to boost their returns. These highly leveraged bets make investors tons of money when times are good. But, when times go bad, it's look out below!

Billionaire investor, Warren Buffet, very famously referred to these derivative products as "financial weapons of mass destruction." As always, the "Oracle of Omaha" was right. Unlike our experience in Iraq, we found our WMDs on Wall Street, or more accurately, they found us, with potentially grave consequences for the global economy.

There are some $750 trillion worth of credit derivatives trading on global markets. That compares, rather unfavorably, to the $50 trillion of global economic output, or GDP. As we enter a phase where these financial WMD's implode in value, they imperil the health of the global financial system and threaten to bring, not only our economic activity, but the vibrancy of the world's economy to a crashing halt.

Hence, the Federal Reserve, which has come very late to the rescue, slashed interest rates by a record amount on Tuesday. The Fed, and other central banks around the world, however, need to do much, much more to create an environment of calm and eliminate the possibility of further catastrophic "WMD" events, some of which may be getting ready to explode as I write.

The Fed let far too much time pass watching this crisis unfold over the last 11 months. The Fed fiddled while our homes burned. They can still put out the fire, but they need to use every tool at their disposal and get their counterparts around the world to do the same.

While their efforts to stave off crisis Tuesday were virtually unprecedented, they were not unwanted nor unwarranted. We can only hope they will finish the job they started so sheepishly, so those sheep who, in great herds, bought overvalued homes and followed the markets blindly over the last several years, won't be led to the slaughter.

Comments

[GregNewYork]

Hey Ron, glad to see you are making a comeback.

I always enjoyed CNBC at 3pm when you were the host of that hour... it was and is the best hour of the day and you made it all the more interesting and insightful.

You know, back in 2000, I believe on April 15th the then current Energy Secretary of the USA, Bill Richardson did an interview with CNBC. He had just returned from Saudi Arabia. His mission was to ask Saudi Arabia to cut back Oil Production because Oil was trading at a level of around $15 dollars a barrel and he, along with the USA and the World Bank wanted the price to get up to $25 a barrel. Why? Because the extra $10 a barrel would be used by Venezuala to pay back their debt to the world bank. I remember Richardson's answer when asked 'what was the Saudi's first reaction' when asked to cut back Oil Production and his answer was , 'well they were surprised... especially after what they had done to the USA back in the early 70's when they cut off oil production after the USA supported Israel after Israel's neighbors attacked Israel.

Well here we are today, 8 years later and oil is trading at 6x the price it was back when Richardson was Energy Secretary, and Clinton was President.... and all of what we are paying today is out of pure greedy profit and nothing to do with Oil Shortages.

There is no Oil Shortage... it is a big lie.. and I'm waiting for a real hero to make this fact public, along with exposing Bill Richardson / Bill Clinton & World Bank policy which is now shanking the US / World Economy.

[rugbyliz]

Let's review the facts:
1) Greenspan (the so-called maestro) warned markets the cost of money (bond spreads) was too low in an August 2005 speech at Jackson Hole. He said long periods of low risk premiums don't end well.
2) The subprime mortgage crisis has been around since at least a year ago.
3) There is a difference between a credit crunch and a repricing of risk. Borrowers don't like the latter because it makes the cost of leveraged buyouts prohibitive.
4) The so-called credit crunch started with BNPParibas's Aug. 9 announcement of its writedown due to subprime exposure. Suddenly investors realized wow! this is bigger than the US. There were only 2 junk bonds sold in Europe during the 4th quarter and only 1 in the 3rd (on July 23) and nothing this year. By comparison, there were 56 junk bonds issued in the US in the fourth quarter and about 5 this year.
5) The Fed has been the only central bank actively injecting cash into the markets. The ECB has been stingy. The BoE has been a bit better. The European market is getting killed, so Europe's companies are flocking to the US to borrow, driving up borrowing costs. The US has the biggest, deepest, most liquid and transparent capital markets in the world -- guess why everyone comes here to borrow?
6) Derivatives are unregulated. No credit derivatives have imploded. Hedge funds, also unregulated, made a fortune using derivatives. Because they don't have to report, hedge fund managers can talk the markets down without ever disclosing their positions.
7) Now the Fed is supposed to keep the inevitable from happening? Business cycles mean that things slow. GE's numbers were amazing. Yet, the stock market guys are demanding the Fed bail them out.
8) Lower interest rates will prolong this bubble, they won't fix it.
9) The problem stems from the structured products engineered to provide better returns (higher yields) for ``no additional risk.'' Hello! You don't get something for nothing. Buyer beware: if you can't model or explain it, you probably shouldn't buy it.

[realitytrumpsbull]

No reason to panic...after you sell the Lexus,
and get booted out of your McMansion 'cause you can't afford the mortgage anymore, you can put on your McDonald's hat and come to work. Now, repeat after me: "Hi, welcome to McDonalds, can I take your order, please?"

'Al' is waiting...limo fuel's not cheap...well, not for US anyway...he gets a 'special deal'...
when your dad owns half the proven oil reserves or whatever...america's your bitch.

[mmckinl]

And just what measures should the Fed take Ron ? I guess you believe that rate cuts will help, but help what exactly ?

According to you the world is up to it's eyes in debt and needs another large shot of debt to stabilize it ?

The party of fractional debt banking may stumble on but it's fate is certain, a disastrous end.

[yappnmutt]

the markets have just begun to recover????? this is the first recession that has been declared over before it has started. that is what really makes bernanke's fed measures so unprecedented. ben is in the process of saving the fed's ownership group from itself. the fed is obviously willing to sacrifice everyone and everything to this end. we could argue this point all night but i will still call your opinion wrong.

[Idytme]

"There are some $750 trillion worth of credit derivatives trading on global markets. That compares, rather unfavorably, to the $50 trillion of global economic output."
That is the most frightening thing you wrote. I try to tell people how big this is, but I haven't always been successful. I told friends and family six months ago that it was time to shore up and get very conservative. It is different than anything that has happened to us in quite a while.
I imagine the worst and I hope we can avoid it - but Congress is responding to a normal recession and this is not normal, it is way bigger than the last few downturns.

[BillZBubb]

Probably the biggest bubble of all time has been the Republican "deficits don't matter" borrow and spend economy. Your "virtuous circle of prosperity" has been purchased by literally mortgaging away our future. Even then the prosperity has been mainly for the top quintile.

The Fed can, in the short term, soften the coming blow. Longer term, this will not end well.

[realitytrumpsbull]

Whatever, as long as when you guys are all finished, I don't end up paying rent to some guy on a boat...

[horseface]

I'm a total idiot and I saw this coming: Fatuous Republicans no longer patting themselves on the back - almost worth it.

[Jane]

So, what you're saying it that not so many people make anything anymore, and most money is spent gambling (that would be what you call the "financial markets"). Various types of chips are used, and most of the time all the players agree on what the chips are worth, but now they don't, so everyone is nervous, since everyone has been keeping a few chips up their sleeves, along with some aces and some loaded dice. It's not that hard to understand. Deregulation means that cheaters prosper, at least until their cheats get so outrageous that no one wants to be at the table. All of this ha been coming for a long time. The globalizers made sure that no one would escape, too.

[wldnswmmr]

Dear Mr. Insana,
I think you're casting more heat than light with this "analysis." The Fed is in no position to stabilize the world markets with a decrease in the discount rate or any other lending maneuver. Please see Hale Stewart's columns here on the HuffPost for a more thorough discussion of why the problem is not "liquidity" but debt that is causing the US economy to freeze up. Excessive lending is how we got into this predicament. The US, the workhorse consumer of the world economy, is about to be put out to pasture. That will bring on a deep recession as retail sales and importing begin to decline, leading to a big increase in unemployment and foreclosures. The derivative problem is something separate from these crises, but again, the Fed is not going to be able to solve the problems caused by the fatal interplay among all these exotic instruments.