It’s perfectly understandable why so few people are paying attention to the crisis that is threatening the global financial system, even though the professionals are biting their nails like little children about to embark upon their first rollercoaster ride. In addition to all the confusing and esoteric terminology being thrown around more freely than medical terms on a hospital show – before being introduced to “House,” I didn’t realize that all medical conditions, no matter how rare, are treated with either surgery or steroids – it is hard to distinguish between the gravity of a Dubai corporation asking for a loan extension and the Italian government collapsing for the 343rd time since Mussolini fled Rome.
There is a certain amount of crisis fatigue now, even among those of us who pay close attention to the ups and downs of the global markets and the economic statistics. One can only anticipate disaster so many times before being tempted to throw up one’s hands and assume that the global economy is going to muddle through somehow, all apparent reason and evidence to the contrary.
But the fact of the matter is that things have changed considerably since 2007, when the first material credit events, which I and various others had been expecting since 2002, began to take place. Some of them are well known, others much less so. But two of the more significant occurred in the last month. I won’t bother to go into the details of MF Global’s legally stealing $1.2 billion from the accounts of its clients, as the negative implications of this sort of activity on investor confidence in the system should be obvious. But very few people understand the potential implications of the steadfast refusal of the European Union to permit the default of countries that every observer knows to be mathematically incapable of paying back their debts.
While the amount of credit default swaps has shrunk considerably from the $62.7 trillion that existed in 2007, the amount has been growing again and presently stood at $32.4 trillion at the end of June 2011. These can be best understood as insurance taken out against the possibility of a default by a corporation or a nation whose debt is being held. For example, if the Chinese, who presently hold $1.1 trillion in U.S. Treasury bonds, were worried about a U.S. default on its debt in light of the failure of the congressional supercommittee to reach an agreement on reducing the deficit, they could take out insurance against that failure by utilizing a credit default swap against that $1.1 trillion in U.S. debt.
The problem is that insurance is a good business for a financial institution, so long as the events against which it is insuring only occur to the extent that the insurance company is expecting. And since sovereign debt, which is a fancy name for the debt incurred by national governments, is considered to be completely safe, the parties insuring bond-holders against sovereign default didn’t bother to maintain the funds necessary to pay off any claims. Since their inability to pay off on the default insurance they sold would not only take down the insurers but also many of the institutions holding the worthless debt, the European Commission, the European Central Bank and the International Monetary Fund have decided that the solution is to pretend that defaulting countries are not in default.
The reason this is a disastrous solution in which the cure is actually worse than the disease can be explained by a simple analogy. Let us suppose that you are considering a purchase of life insurance to support your family in case something happens to you. Let us also suppose that the life insurance companies, having failed to take into account an unfortunate reoccurrence of the lethal Spanish flu of 1917, cannot afford to pay out all of the insurance claims now owed to the survivors. And finally, let us suppose that the various governments of the world decide to save the insurance companies and prevent them from going bankrupt by declaring that none of the recently deceased are, in fact, dead.
Are you going to buy a life insurance policy that doesn’t pay out in the event of your death? Is anyone?
In refusing to admit that Greece is in default and attempting to hide behind verbal gymnastics (by which I mean the “voluntary” “hair cut” on Greek bond-holders intended to reduce the amount of outstanding Greek debt by 75 percent without calling it a “credit event” that would trigger the debt insurance payouts), the various financial authorities have not only rendered the $32.4 trillion in credit default insurance worthless, but they have effectively destroyed the very concept of default insurance. Moreover, by limiting the ability of investors to protect themselves against the risk of default, they have necessarily increased the amount of risk involved in loaning money and, therefore, increased the amount of return that must be offered to investors to make taking those risks worthwhile.
This refusal to call time of death on an obvious corpse is why bond yields have skyrocketed in the last two weeks. The Italian five-year bond is at 7.827 percent, more than twice as high as one year ago and over the seven percent figure assumed to trigger the death spiral. The Spanish five-year is creeping every closer to it, having hit 6.156 percent, Portugal’s five-year is at a lethal 16.214 percent, higher than Greece was one year ago. While Greek yields are no longer available at the Wall Street Journal’s Market Data Center, they exceeded 100 percent last week.
I can’t say with any certainty that the game is up yet. The Federal Reserve, the European Central Bank and the International Monetary Fund have managed to play “Weekend at Bernanke’s” with the global financial system, and the global economy, for longer than I ever imagined possible. They have instituted extra-democratic regime change in Greece and Italy already, and will probably not hesitate to do so in France, Germany and the United States if it is necessary to maintain the illusion of a functional status quo.
But eventually, the corpse of the global economy is going to start stinking strongly enough that its morbid state can no longer be denied. We already have been witness to economic growth that is not economic growth, foreclosures that are not foreclosures, sovereign defaults that are not defaults and democracies that are not democracies. It would appear to be only a matter of time before we learn that our money is no longer money.