To start this months post I would first like to make a mention of a great blog I read every week that I consider to be well worth a look;
It’s written by Alice Cook and is called UK Bubble
The second artice I would like to recommend is from Alex Ritson (14/07/08), a reporter with the BBC’s Newsnight program. The contents of his article are so powerful and awe-inspiring that this is one situation that would never be allowed to play out. Titled ‘The US Economy’s Next Bad Thing?‘ it is essential viewing.
Even the most conservative of approaches to market intervention would still be put aside to prevent this meltdown from taking place. The scary part is that this is not some doomsday scenario, but is in fact a very real situation that will take some skillful and careful economic management from all western governments to avoid it becoming the worst economic collapse ever.
To prevent the situation identified by Alex in the above article, no bank will be allowed to fail, especially the two most precarious of giants, Freddie Mac and Fannie Mae. If you wanted to know what the gun being held to the US Treasury’s head looks like, the Credit Default Swap market is that gun. The US Treasury looks like being handed a choice between nationalising Freddie & Fannie and taking the US national debt from around $3 Trillion to $9 Trillion, or allowing them to collapse and starting the cascade effect of Credit Default Swaps being paid out by the banks that issued them.
The problem is that these banks can’t cover the payments they are meant to make and will therefore collapse. The big problem with banks collapsing is that these Credit Default Swaps are in fact insurance policies, and, to ensure they will never have to be paid out by any bank, they secured most of them on the safest assets they could find – big banks mortgage products.
When the two biggest banks in the market fail, and all the policies are paid out by the surrounding banks, then those banks paying out may also collapse. Then, the next wave of CDS’s (Credit Default Swaps) pay out on the next set of banks to fail, and, before you know it, you’ve got a cascade effect going right though the system ripping $62 Trillion out of banking.
In the UK the exposure of British banks to this problem was mentioned in Alex’s article as being unknown due to it being hidden amongst a package of credit derivatives. Notably however, the two banks that have recently been inexplicably trying to raise shareholder finance, Barclay’s and RBS, have the biggest exposure of any UK banks at £2.5 & £2.4 Trillion respectively. Is it any wonder then that they are desperately trying to raise their capital holdings?
One further notable problem connected to Fannie & Freddie is the fact that one of the biggest takers of their sub-prime related bonds are the Chinese government. If, in avoiding a Credit Default Swap situation, the US government does have to nationalise Freddie & Fannie and bankrupt its investors, this will wipe out any holdings by China.
This would really represent a Bush administration encouraging China into investing in the US economy, only to find that the US government has taken their cash and run. It’s not like the US government will have much choice, but that will still be a hard pill for the Chinese to swallow, and may discourage them from fueling any similar fires in US housing in future.
Posted by ullrakesh 