Quadrillion Dollar Problem

The S&P500 resumed its furious snap-back rally from 12 year lows reached only three weeks ago.  The hope rally, long overdue, has materialized, and is now in danger of pushing the markets into an overbought condition.

Amazingly, precious little has changed over these last three weeks, certainly not enough to explain, unambiguously, the violent swing up.  This week, the Treasury Department did flesh out its toxic asset removal scheme–to nobody’s great surprise, it centered around the taxpayer subsidizing private capital to bid higher than market prices for toxic assets held by mismanaged banks.

Both liberal and conservative critics have already pounced on the obvious flaw:  buyers, even with taxpayer incentives, will probably not bid enough to meet the banks’ asking prices.  This means that banks might not sell their toxic assets (because a sale below the asking price would force them to realize huge losses and further deplete capital, pushing many closer to official insolvency).  But the equity markets, unlike the credit markets, rallied anyway.

The economic data continued to point to an economy in deep recession:  prices for existing homes dropped 16% yoy; existing home inventories climbed to 3.8 million units; initial claims jumped up to 652,000 and continuous claims, at 5.56 million, hit another all-time record high.  Personal income fell 0.2% and the personal savings rate remained at an elevated 4.2%.

Technically, the S&P is still in an uptrend from a daily perspective.  But this rally is getting long in the tooth.  Many traders are preparing for a pullback that’s now becoming almost as overdue as a rally was three weeks ago.  On a monthly basis, the bear market is nowhere near violating the downtrend that was first established in December 2007.

Let’s not forget that we’re suffering from a recession that cannot be compared to most of the other recessions in the U.S. over the last 50 years.  The more recent recessions were of the inflation control type; this one is rooted in the bursting of an asset and credit bubble.  The best U.S. analogy is the Great Depression. 

And unfortunately, this time we’re suffering from several harmful forces that didn’t even come into play during the Great Depression.  One major force is the derivatives market.   Hernando de Soto in the WSJ reminded us that today’s global crisis is growing because the world has created an estimated one quadrillion (a thousand trillion) dollars worth of derivatives that are not regulated or properly recorded by our financial markets.  This massive overhang of MBS’s, CDO’s, and CDS’s is paralyzing the world’s credit markets, exaggerating the speed and magnitude of the deleveraging already taking place because of the above-normal ratios of debt to GDP worldwide.

Given that the U.S. GDP is about $15 trillion, is it any wonder that the global markets are worried about the risk from derivatives (described as financial weapons of mass destruction by Warren Buffett) where a mere 1.5% gross loss would equal the entire GDP of this country?

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