500 trilliion dollars in derivitives...sit atop world GDP of 60 trillion.



Its fragiil


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quoting:

Lisa Lisa View profile
More options Jan 27, 3:08 pm

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From: Lisa Lisa <mando...@xxxxxxxxxxx>
Date: Sun, 27 Jan 2008 15:08:52 -0800 (PST)
Local: Sun, Jan 27 2008 3:08 pm
Subject: The World Economy is Dwarfed by a Vastly Larger "Shadow
Economy" That Threatens Us All
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From the ideas section of today's Boston Globe:

***********************************************************************


The black box economy


Behind the recent bad news lurks a much deeper concern: The world
economy is now being driven by a vast, secretive web of investments
that might be out of anyone's control.


[link to www.boston.com]


By Stephen Mihm | January 27, 2008


THE PAST YEAR has been a harrowing one for the world's financial
markets, shaken by subprime crises, credit crunches, and other ills.
Things have only gotten stranger in the past week, with stock prices
swinging wildly in every major market - drastically down, then back
up.


Last week the Federal Reserve announced the biggest cut in overnight
lending rates in more than two decades. Congress, not to be outdone,
is slapping together a massive deficit spending package aimed at
giving the economy an emergency booster shot.


Despite the anxiety, nobody is stockpiling canned goods just yet. The
prevailing assumption in today's economy is that recessions and bear
markets come and go, and that things will work out in the end, much
as
they have since the Great Depression. That's because there's a
collective confidence that the market is strong enough to correct
itself, and that experts in charge of the financial system will
understand how to mount a vigorous defense.


Should we be so confident this time? A handful of financial theorists
and thinkers are now saying we shouldn't. The drumbeat of bad news
over the past year, they say, is only a symptom of something new and
unsettling - a deeper change in the financial system that may leave
regulators, and even Congress, powerless when they try to wield their
usual tools.


That something is the immense shadow economy of novel and poorly
understood financial instruments created by hedge funds and
investment
banks over the past decade - a web of extraordinarily complex
securities and wagers that has made the world's financial system so
opaque and entangled that even many experts confess that they no
longer understand how it works.


Unlike the building blocks of the conventional economy - factories
and
firms, widgets and workers, stocks and bonds - these new financial
arrangements are difficult to value, much less analyze. The money
caught up in this web is now many times larger than the world's gross
domestic product, and much of it exists outside the purview of
regulators.


Some of these new-generation investments have been in the news, such
as the securities implicated in the mortgage crisis that is still
shaking the housing market. Others, involving auto loans, credit card
debt, and corporate debt, are lurking in the shadows.


The scale and complexity of these new investments means that they
don't just defy traditional economic rules, they may change the
rules.
So much of the world's capital is now tied up in this shadow economy
that the traditional tools for fixing an economic downturn - moves
that have averted serious disasters in the recent past - may not work
as expected.


In tell-all books, financial blogs, and small-circulation
newsletters,
a handful of insiders have begun to sound the alarm, warning that
governments and top bankers may simply no longer understand the
financial system well enough to do anything about it.


"Central banks have only two tools," says Satyajit Das, author of
"Traders, Guns and Money: Knowns and Unknowns in the Dazzling World
of
Derivatives," who has emerged as a voice of concern. "They can cut
interest rates or they can regulate banks. But these are very old-
fashioned tools, and are completely inadequate to the problems now
confronting them."


Since the last financial crisis that genuinely threatened the fabric
of our society, the Great Depression, the United States has built a
system of regulatory checks and balances that has, for the most part,
worked. The system has worked because the new regulations enforced
some semblance of transparency. Companies abide by an extensive set
of
rules and file information on their profits, losses, and assets.


Obviously, there are limits to transparency: Without withholding some
information from public view, it would be hard for companies to take
advantage of opportunities in the marketplace. But a modicum of
transparency can go a long way, enabling both regulators and
investors
to make informed decisions. The advantages of the system are many;
the
costs of even a single case of nontransparency, as with Enron, can be
high.


But when the mortgage crisis broke last summer, it opened a window on
something else: The existence of a huge wilderness of investments in
the financial sector that are nearly impossible to track or measure,
and which operate out of the view of both investors and regulators.
It
emerged that investment banks, hedge funds, and other financial
players had issued, bought, and sold hundreds of billions of dollars'
worth of esoteric securities backed in part by other securities,
which
in turn were backed by payments on high-risk mortgages.


When borrowers began defaulting on their loans, two things happened.
One, banks, pension funds, and other institutional investors began
revealing that they owned huge quantities of these unusual new
securities, called collateralized debt obligations, or CDOs. The
banks
began writing them off, causing the massive losses that have buffeted
the country's best-known financial companies. And two, without a
market for these securities, brokers stopped wanting to issue risky
mortgages to new home buyers. Home values began their plunge.


In other words, a staggeringly complex financial instrument that most
Americans had never heard of, and which many financial writers still
don't fully understand, became in a matter of months the most
important influence on home values in America. That's not how the
economy is supposed to work - or at least that's not what they teach
students in Economics 101.


The reason this had been happening totally out of sight is not
difficult to understand. Banks of all stripes chafe against the
restraints that federal and state regulators place on their ability
to
make money. By cleverly exploiting regulatory loopholes, investment
banks created new types of high-risk investments that did not appear
on their balance sheets. Safe from the prying eyes of regulators,
they
allowed banks to dodge the requirement that they keep a certain
amount
of money in reserve. These reserves are a crucial safety net, but
also
began to seem like a drag to financiers, money that was just sitting
on the sidelines.


"A lot of financial innovation is designed to get around regulation,"
says Richard Sylla, professor of economics and financial history at
NYU's Stern School of Business. "The goal is to make more money, and
you can make more money if you don't have to keep capital to back up
your investments."


The hiding places for these financial instruments are called
conduits.
They go by various names - the SIV, or structured investment vehicle,
is one that's been in the news a great deal the past few months.
These
conduits and the various esoteric investments they harbor constitute
what Bill Gross, manager of the world's largest bond mutual fund,
called a "Frankensteinian levered body of shadow banks" in his
January
newsletter.


"Our modern shadow banking system," Gross writes, "craftily dodges
the
reserve requirements of traditional institutions and promotes a chain
letter, pyramid scheme of leverage, based in many cases on no reserve
cushion whatsoever."


The mortgage-driven securities that have been making headlines are
but
the tip of a much larger iceberg. Far larger categories of investment
have sprung up, with just as much secrecy, and even less clarity into
who holds them and how much they are truly worth.


Many of these began as conventional instruments of finance. For
instance, derivatives - the broad category of investments whose value
is somehow based on other assets, whether a stock, commodity, debt,
or
currency - have been traded for more than a century as a form of
insurance, helping stabilize otherwise volatile markets.


But today, increasingly, a new generation of derivatives doesn't
trade
on markets at all. These so-called over-the-counter derivatives are
highly customized agreements struck in private between two parties.
No
one else necessarily knows about such investments because they exist
off the books, and don't show up in the reports or balance sheets of
the parties who signed them.


As the derivatives business has grown more complex, it has also
ballooned in scale. Broadly speaking, Das - author of a leading
textbook on derivatives and complex securities - estimates that
investors worldwide hold more than $500 trillion worth of
derivatives.
This number now dwarfs the global GDP, which tops out around $60
trillion.


Essentially unregulated and all but invisible, over-the-counter
derivatives comprise a huge web of bets, touching every sector of the
world economy, that entangles a massive amount of money. If they
start
to look shaky - or if investors need to start selling them to cover
other losses - that value could vanish, with catastrophic results to
the owner and unpredictable effects on financial markets.


Derivatives can ripple through the market and link players that might
not otherwise be connected. With some types of new investments, that
fusion takes place within the security itself.


For instance, some financial instruments are built of two or more
different types of assets, linking together sectors of the economy
that aren't supposed to move in tandem. In the name of transferring
risk - and in the interest of creating an appealing new product to
sell to aggressive investors seeking higher returns - a bank could
create a CDO, for instance, that packaged subprime mortgages together
with corporate bonds. An economist would expect those to move
independently, but thanks to a large - and unseen - investment in
such
a linked package, problems with one could drive down the other. A bad
apple can ruin an entire barrel of fruit.


Again, it's not as though anyone necessarily knows the composition of
these structured securities. Nor do they know who has invested in
them, thanks to the fact that they have not, until recently, counted
as conventional assets subject to the normal rules of accounting. And
because they don't trade on open markets, their values are
essentially
guesses, calculated by computer algorithms.


Das disparages much of this as the product of bankers creating
"complexity for the sake of complexity," trying to wow their clients
by inventing more sophisticated-seeming investments. "Financial
innovation is a magical catch phrase," he explains. "It's very
sophisticated and chi-chi."


"Investment bankers want to make them more complex, so that they
won't
be copied, and so that their clients won't understand them," he says.
"When they ask whether they're paying the right amount, they won't
know."


But when reality comes home to roost, things can get ugly pretty
quickly: If an investor is forced to sell a CDO, the onetime price
realized on the open market may bear no relationship to the
theoretical value generated by a computer formula. That means that
everyone holding CDOs can no longer sleep well at night: the same
thing can happen to them.


T


hese risks are magnified, as they were during the stock bubble of the
1920s, by the fact that many of these assets are owned by investors
who borrowed money to make the investments in the first place. When a
market shock like the subprime crisis hits, it can send tremors
through the system with incredible speed.


If the contagion spreads, the conventional wisdom holds that the
Federal Reserve and other central banks around the world can step
into
the breach caused when consumers and investors start to lose their
confidence. But what happens when all these complicated financial
arrangements and instruments start to unravel? The market for one
product alone - the credit default swap, or CDS - dwarfs this
country's economy. The Fed has an uphill battle, made harder by the
fact that it is grappling, to a large extent, with unseen forces.


In theory, additional regulation may help with this. The Financial
Accounting Standards Board, which establishes corporate accounting
procedures and guidelines, took a first step in that direction this
past November, ordering investment banks and anyone else holding
complicated securities to assign market values to so-called Level 3
assets - a fancy name for assets for which there is no prevailing
market price. This meant assigning a market value to all those CDOs.


Banks promptly began writing down tens of billions of dollars of
assets, and their investors are still trying to sort through the
results. It's still too early to tell whether or not the effort will
work, or whether the "market prices" that get reported are anything
more than figments of in-house accountants' imaginations. For his
part, Das is skeptical. "It will help that people will know the
poison
they're drinking," he says. "Whether it will help stabilize the
system
is another question."


It would be ideal if the financial markets became a bit less opaque
and intelligible before that happens. That would be the job of
regulators, but Das isn't sure that regulators have the intellectual
horsepower to figure out what they need to do. "If you're bright and
you can make $5 million a year on Wall Street," he asks, "why would
you settle for making 50K as a regulator?"


And in any case, transparency isn't really what the denizens of Wall
Street want, Das observes. "The regulators keep espousing things like
clarity and transparency, but it's in the investment bankers'
interest
to keep things opaque." Das pauses for a moment.


"It's like a butcher. He doesn't want the buyer to know what goes
into
making the sausage." He chuckles, noting that it's the same with
financiers. "That's what they're all about and always have been."


Stephen Mihm is an assistant professor of American history at the
University of Georgia and the author of "A Nation of Counterfeiters."
**** end quote****


Phil Scott
.