Disclaimer: I am not an economist. An accountant. Or Business man. So take this with many huge grains of salt
So I got a wild hair up my ass and thought I’d share what I know of the cyclical Boom/”OMG THE SKY IS FALLING” cycle we seem to be set in. Specifically focusing on 2008 and the next one that is looming overhead.
Culprits:
2008: Bad debt being sold fraudulently
TBA: Derivatives, derivatives are like insurance on inflation. Kind of like a future you aren’t obligated to buy if the price is under the agreed upon terms. Essentially say you make sundaes, and you need banana. Now you know the price right now is $60 a unit. If however the price doubles to $120 per unit, you are up shit creek without a paddle, you can’t do business and you will have to fold (bit of an exaggeration but you get the point.) what a derivative is, is a financial product that says you pay $2, and if the price of banana’s goes about $80, you only pay $80, but if the price remains under $80 you pay the market value plus the fee. Simple, and actually helpful, especially helpful at combating inflation, so the market is actually fairly self-stabilizing to some degree. Oh and 30 day lending might play a role, maybe.
How:
2008: In 2008, the problem was that people were basically selling spoiled goods. In laymans terms what happened was Bob bought a $200,000 house from Jack on credit, promising to pay $250,000 by the end. (often times Bob couldn’t really afford the house but was persuaded to by jacks silver tounge, I.E. Predatory lending). Now, Jack, looking to make a quick buck want to sell something, what does he sell? He sell’s the debt that bob owes jack to Rufus for $220,000. However, Jack knows Bob isn’t doing well, and has a high likelihood of going into default, paying only $10,000 leaving Rufus with $10,000 and a house that is really only worth $150,000. Now, rufus would have been fine had he known the risks, and the price was under $160,000 for the $220,000 Debt but Jack had promised Rufus that Bob would be able to pay at least $30,000 and that the house was worth $200,000.
Now, you have to understand that a house and debt are assets and that assets don’t obey the law of supply and demand, in fact, as price increases, demand increases, and as demand increases price increases. Now obviously what drives this is speculation as to increasing value and how much you can get out of it, however, once it goes too far it won’t go up any more because since it’s an actual product the price can’t rise forever. So the “market” was telling people the house was worth vastly more than what it really was, or at least what you could build one for. As you can expect, this was a perfect storm of stupid. You had bad, or outright fraudulent claims made about assets in the form of debt. And the two components of the income on those assets were, well shall we say, shaky at best due to predatory lending and the inflated prices. Now, the inflated prices were market value so those were “fine” it was when you had the fraudulent claims about the risk of the debt that made things bad. Basically once the cat was out of the bag, the shadow banking system collapsed and with it the demand in housing assets and thus their price, which compounded the problem. By the end the largest banks had been assisted with over 7.7 trillion dollars, yes 7.7 trillion, mostly by the FED. That’s half the GDP. So 2008 was a crisis that lost us one half GDP
TBA: Now the derivatives markets are fairly stable, as far as I know there is no fraudulent claims. They aren’t based on something that can just up and poof out of existence, the risks are calculated by very smart people, and important to note is that the seller of these is the one that loses if the math is done incorrectly and risk is not assessed correctly. However, the size of the markets is over 630 trillion dollars. To my knowledge that is the total of what the derivatives are worth (the $80 in my previous example, someone correct me if I’m wrong. Which is good because that’s the biggest number you have, if that 630 trillion is the summation of all those $2, start prepping, and I ain’t kidding, full out bomb shelter)What does this mean? If for some unpredictable reason, prices on average rise above the value of the derivatives terms the issuers are going to be taking a loss. Now what does this mean… well the largest banks are on average worth about 1-2.5 trillion dollars. Notice the differences there 630 trillion…2.5 trillion. Luckily that’s shared by a fair number of banks. However for example, JP Morgan Chase, total assets worth around 2.3 Trillion
http://en.wikipedia.org/wiki/JP_Morgan_Chase, how much do they have in derivatives? 72 trillion
http://www.youtube.com/watch?v=PDprXKn8oTU. These are the same people that just lost a few billion a few months back. That means if prices rise unexpectedly 3.5% past the agreed upon terms in their derivatives for some reason (or they were just fucking wrong about the risks) they get wiped out. 10% and you’re talking about them alone creating a financial disaster like 2008, 20% and that would equal a loss of the entire American GDP. These price increases, they’d affect all of the banks and anyone holding a derivative, and the derivatives markets total 630 trillion, meaning an increase over expected of just 2% would wipe the equivalent of the US economy. 11%, would wipe out the Gross World product. Oh and remember that 30 day lending, without the banks these companies go broke temporarily. Meaning when the house comes crashing down, not only is the erasure of every private bank account possible without some miracle of intervention, something the Government would not be able to accomplish without immediately being downgraded to a null credit rating, but businesses would halt, workers wouldn’t be paid.
On the flipside: derivatives ARE fairly straightforward and I know of no fraud or incentive for fraud, and they are looked over by some very smart people. So getting to that 3% increase would be monumentally hard (remember that’s over the agreed upon price which is usually somewhat higher and standard inflation is taken into account). So panic time? No. but you’d have to be a fool not to keep an eye on it.
Long story short, pray that smart people looking after the derivatives markets are as smart as they say they are, and a metor or some shit doesn't hit us.
