Opinion: The fatal flaw in the markets

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What really hit the markets harder than anything was sheer volume. A tsunami of debt and defaults. Gigantic amounts of money were involved, and there was no cover. Coverage existed in theory but not in practice. The credit crunch gutted the markets. America has done things Houdini would envy with credit. It’s been a big driver, with a lot of actual grunt. Even in the recent past, with serious hits in the last 30 years, credit wasn’t particularly threatened in the macro economy.

Hence the current shock across the whole financial sector. The credit crunch was like “No brakes!” when driving on the wrong side of the express lane. People who used to be able to get lines of credit like cornflakes couldn’t put things together. Market based moves fell apart because the money just wasn’t going to be forthcoming.

The sky had fallen in.

Chicken Little, God rest his soul, was right.

The markets are big, and complex, but the things that provide the motive power are relatively simple. In a healthy credit market, people can carry debt reasonably easily. The exact opposite is now the case. Margin calls, requiring people to ante up on their borrowings, are more common than spam at the moment.

Here’s a basic equation: Volumes of money are direct measures of risk.

Debt is risk incarnate, and it's deadly. Current private debt in the US is $41 trillion. That debt funds other debt. Banks lend to other banks who lend to corporations and individuals. Defaults, on a large scale, can crash the credit system. Hence the bailout.

The global economy has been generating enormous amounts of money, and enormous amounts of debt. The US market, the biggest in the world by far, simply wasn’t geared to handle that level of debt if it went bad. That was a fatal mistake.

The subprimes crash was the first part of the house of cards to come down. It was lousy business practice, and everybody knew it, to create a massive pile of bad debt. It was insane to securitize that mass of garbage and surgically graft it into the markets.

People talk a lot about greed, but this was pure, unadulterated, stupidity. Idiocy in estrus. Add to this the interesting revelation that actual values of securities suddenly became very hard to find, and that the people actually paying their mortgages were penalized.

You can see that this isn’t the Mensa Society we’re talking about. A first year accountancy student could poke holes in the whole market. Zero credibility from day one.

Unfortunately the blame game isn’t going to fix Humpty Dumpty. Some nice, considered case law may get these guys selling used cars to dead people like they should be, but there’s a much more immediate problem: These debt levels cranked up the volume of money to staggering levels. The level of debt per dollar is said to be roughly 10-20 to 1 dollar on deposit. That debt is global.

The markets are, literally, their own greatest risk.

If anything good ever comes out of this ignominious fall from supertitans of global finance to assistant clowns at a freak show, it has to be creating some cures for this disease.

No thanks to anybody on Whatitsname Street, a How To Fix Your Crappy Overpaid Financial Sector In the 21st Century When It Can’t Handle No Brainers Manual is being slowly written by trial and error.

This was more money flying around in a week than anyone’s even heard mentioned in recorded history.

Even while all of this money was being sprayed all over the planet, six banks crashed, and several foreign governments had to bail out their own banks as they slithered into their own abysses.

The market can ignore wars, disasters, and social collapses. It can’t ignore debt when that debt can’t be covered. If there’s direct coverage, with real asset values, they’re happy.

The major discovery of this whole crisis is how scared and distrustful the markets are of themselves. Even the word "exposure" is enough to start a panic.

The US and global economies, with a bit of luck, will come out of the present train wreck bruised and scratched up, but functional, more or less.

But there's a much bigger problem.

Over time, capital volumes will grow. As the rest of the world capitalizes, takes on debt, and expands, the amounts of capital required will be gigantic, much bigger than the present.

We've just been watching how badly the markets dealt with current levels of capital and debt.

Just for the record, the "Growth Is Good" mantra from the markets isn't particularly correct. We've seen rapid growth in regions like SE Asia, which turned into nightmares. A global economy working on the current basis of growth and debt as the criteria for success would crash regularly.

In the future, it’s unlikely that any national government will be able to control major crashes. Even multiple central banks, working together, have barely managed to cap this super nova of sewage in the markets, with trillions.

Future volumes of money will be way too big. The risks will be a lot greater. If this situation occurred with volumes of quadrillions of dollars, (a quadrillion is 1,000 trillion) the global economy would crash in 24 hours.

Governments would not be able to do anything at all. They'd be destroyed, too. Their revenue would also crash, and their own debts would escalate out of control, meaning their backing would be worthless. Currencies would fall to pieces.

So ways of preventing these crashes have to be created.

The only way to really defend against huge volumes of capital is with reliable practices and limits on debt ratios. Exposure to debt has to be bearable. Lenders need to be able to lend.

Debt insurance is part of the current problem, thanks to the tangle of liabilities, but it can be part of the solution to future problems. The fix for this is a version of deposit coverage, realistically applied to debt with conservative valuations and backing of hard cash. The advantage is that it’s automatic cover. The coverage load can be spread across the market, using underwriting to minimize risk to insurers.

The markets can also protect themselves if they start introducing a series of failsafes.

One is a requirement for disclosure of information regarding anything that affects the status of lenders. That would have flushed out the subprimes a lot earlier. It’s normal practice on some stock exchanges. Either you provide the information or you don’t trade, which costs billions to investors, so the information is provided, whether they like it or not.

Another is proper market scrutiny. That's not impossible, either. Some people did know the subprimes were about to explode. Others predicted it.

Yet, the markets went like sheep to the abattoir.

Regulation isn’t the only answer, and it’s not the best answer.

It’s part of an answer, because regulation can only deal with offences after they’ve been committed. You need regulators to make the rules, so everybody knows what's supposed to happen, and to enforce them, so people can trade with some confidence in their legal rights. That's not the case now, and it's been killing investment, understandably enough.

Try this for an added string to the instrument:

If big investors don’t like the way a company is operating they can pull the plug, bail out, and that company is severely damaged, instantly. You can expect new CEOs and a new board. Funds, private equity, and hedge funds can destroy a company in the marketplace. If you’ve ever seen a corporation which is really out of favor, you’ll know how much damage that is. Credit rating agencies, when awake, can do the same thing.

This is one way the market can defend itself against the clowns. These major investors can get good quality information, when they can be bothered. They know how to analyze it, and they’re not apathetic about their investments.

They also know bad debts, bad securities, and bad practice, when they see them, because their level of scrutiny is a lot better than any regulator's is legally allowed to be.

That information can be passed on to markets in the form of complaints to exchanges, or actual law suits, or plug-pulling with press releases saying "no confidence". That's not altruism, it's common sense. It’s also very much in their interests to shut down idiots and bad risks in their markets. That’s easy to do, and there’s no bureaucracy involved. It's mutual self defence, and it does work when it's applied.

That didn’t happen during the subprimes debacle, and they and the world are now paying for it.

Next time, in a big crash, there may be nothing left of the markets but ashes.