Money: A Mere Bag of Shells

June 1, 2008

The latest word out of Wall Street is: “there’s a lot of money sitting on the sidelines.” Actually, its money they (Wall Street) printed by assigning unrealistic market values to arcane investment instruments such as derivatives. As a result, more than $1 trillion of potentially worthless paper is padding the balance sheets of the nation’s banks and, could also be contaminating the huge pensions and annuities that support millions of Americans.  What are derivatives?

A derivative is essentially a contract which has its value derived as a function of some underlying variable.  It’s a generic term for a variety of financial instruments unlike stocks and bonds; a derivative is an electronic contract rather than an asset.  Essentially, this means you buy a promise to convey ownership of the asset, rather than the asset itself and this leads to speculation which is more commonly used by hedge funds or traders who aim to generate profits with only a marginal investment by essentially placing a bet on the movement of an asset.  Although speculation can produce a high return on investment, the downside risks are equally as prominent as demonstrated by the collapse of Long Term Capital Management in September of 1998 and now, the collapse of the housing market.  Because of the high degree of leverage one can take in speculative contracts, an adverse change in prices can result in rapidly increasing debt and a portfolio worth billions could fall to almost zero with the space of a few hours.

The bad news …The banking system is “over-extended” in the derivatives market. For example, according to the latest figures from the Office of the Comptroller of the Currency, JP Morgan Chase has the most exposure to derivatives with $80 trillion outstanding vs. total assets of just $1.46 trillion in assets to back up the potential risk.  Citigroup has $34.9 trillion in derivative exposure vs. total assets of $2.2 trillion.  Many of these securities are parked in subsidiaries of banks or at other entities, and are comprised of bundled mortgages, car loans, credit card payments and leveraged buyout loans all of which are almost impossible to value on a day to day basis.  World-wide, the underlying value of these contracts exceeds $500 trillion. When all is said and done, the losses could approach $500 billion. This in hindsight asks the question: Where’s the oversight?

A lot of funny money on the sidelines … yes there’s plenty of it just waiting to be plowed into another scam. Think about it.  It’s not “real” money such as the funds on deposit at the Federal Reserve. That’s only about $7trillion or as Ralph Kramden would say “a mere bag of shells” but it is and this is something to think about backed by the good faith of the United States of America. In other words, $500 trillion in derivative contracts is backed by a mere (bag of shells) $7 trillion on deposit.  What's frightening here is that in the financial markets, its business as usual.

Those of us who live in the real world will be facing a severe case of inflation in the not too distant future. Accelerating prices and a slow or no-growth economy is a killer combo called "stagflation." Those old enough to remember can recall the stagflation which dominated the US economy in the 1970s. It was a gloomy time when energy prices (and gasoline lines) dominated the news; when whole industries slumped at the same time, and when job losses and price hikes seemed to travel in tandem. Now, we could be facing it again.  It's easy to see where the concerns come from. On the recession side, there's the housing slump, the worsening mortgage market, the continued loss of jobs to lower-paid workers in developing countries. If you're looking for inflation signs, you need look no further than the accelerating price of manufacturing supplies or just check what you're paying for healthcare, college tuition, gasoline, food and your monthly mortgage. Add to that, the political instability in the Middle East and I for one am leaning toward a short term economic “brownout” as I see no light at the end of the tunnel. 

As we move forward in 2008, our over leveraged economy will struggle. Here are some pointers: Worry about yourself first. For the short term at least, keep purchases to a minimum. Reign in spending and start paying off credit card balances and other bills in the biggest chunks possible.  Organize your debts. Stagflation, the last time around, saw interest rates rising to usurious levels. Use the time you have now to lock in decent fixed-rate mortgages, transfer balances to low-rate cards, or use other loan products on the market to keep your debts manageable and stable.  Even if bad times come, spreading your money around will moderate the impact.  Invest in yourself. Finally, SAVE MONEY. The worst part of stagflation is that it makes it harder and harder to save any money. The more cash you have to call upon in an emergency, the less desperate or destitute you'll be.