The financial crisis of 2008-2009 crumbled the U.S. economy to a degree not seen since the great depression. Now another economic problem is emerging—a problem 46 times bigger than the gross domestic product (GDP) of the U.S. economy.
It’s the financial crisis involving derivatives markets.
Starting next year, to “prevent” another financial crisis, traders need to back up their derivatives by top-rated collateral such as U.S. Treasuries. (Source: Bloomberg, September 11, 2012.) The current value of the derivatives markets stands at about $648 trillion!
This collateral rule was the result of the Dodd-Frank Act, which was passed in the midst of the financial crisis of 2008. Companies like American International Group Inc (NYSE/AIG) did not have their derivatives backed up by enough capital; American International ended up needing a $182.3-billion bailout to protect itself from collapse.
It has been said that the worst financial crisis since the Great Depression was caused by derivatives backed by insufficient collateral. Hence, one would think raising the collateral requirement by which derivatives are backed should avert another financial crisis. It sounds like a great idea, in a perfect world. But it’s not the case in this current U.S. economy.
Two important points here:
The U.S. Treasury market is worth about $11.0 trillion. But the derivatives market is worth $648 trillion. The demand for U.S. Treasuries will surge next year, as derivative players rush to back their derivatives with U.S. Treasuries. Doesn’t this almost guarantee the yields on U.S. Treasuries will fall even lower?
Bank of America Corporation (NYSE/BAC) and JP Morgan & Chase Co (NYSE/JPM) have the biggest derivative components on their balance sheets. Together, they hold $140 trillion of derivatives instruments! If the collateral requirement to hold derivatives is increased, then banks will have to hoard more cash in the case their derivatives position goes against them.
But backing derivatives with liquid collateral causes a cascading effect—lending could be curtailed as cash requirements increase. But if we have no lending, we have no growth, and the lingering effects of the financial crisis continue.
As I have been writing, the U.S. economy is at a critical point. The derivative collateral issue is just going to be another red light. These regulations are being implemented at a time when banks are still struggling to fix their balance sheets and lending is soft. Sure, we do not want another financial crisis in our economy, so more regulation is important, but the U.S. economy is still battling the previous financial crisis.
Originally, to save its collapsing economy, the Spanish government decided it would access the credit markets itself. But as interest rates on Spanish government debt skyrocketed, Spain realized it needed the help of its eurozone neighbors and the European Central Bank (ECB) to stay afloat.
Spain then moved on to create a “bad bank”—a government-owned bank that would purchase all the bad assets currently held by country’s banks with proceeds from a eurozone bailout fund.
But now the Spanish government has flip-flopped on its position about accepting any bailout funds from eurozone countries to avert the debt crisis it faces. The Spanish government now wants to avoid any bailout from the eurozone countries. (Source: The Guardian, September 11, 2012.)
The main reason for this change of heart: the Spanish government believes that it has reformed its financial system too many times already and doing any more reforms would further weaken its economy.
The ECB is insisting it will only intervene to help Spain once the country has accepted “strict conditionality” of the eurozone, which means more austerity measures. (Source: BBC News, September 11, 2012.)
It is interesting to see the situation unfold here. The Spanish government is facing a debt crisis like no other. The Spanish economy has the ingredients mixing for all sorts of trouble, including higher skyrocketing unemployment and a housing bust.
From the looks of it, the Spanish government does not want to look needy to the eurozone, so it isn’t forced to accept bailout terms similar to Greece’s. The ECB and other eurozone countries are calling for stricter controls over Spain’s financial system and Spain is resisting tougher financial responsibility.
I remember when Ireland was the first eurozone country to face extreme financial pressures because of the eurozone debt crisis. The Irish government put forth the same resistance. It was election time in Ireland and the government did not want to look needy. Eventually, the financial crisis deepened and a bailout was suddenly needed by Ireland.
Spain will need bailout money from the other eurozone countries. It can deny that it urgently needs the money, but in the end it will be desperate for, and will take, the funds. A collapse of Spain’s economy would cripple the eurozone and send the world deeper into a global recession. That’s why it will get bailed out.
Where the Market Stands; Where it’s Headed:
All eyes are on the Federal Reserve Open Market Committee today. Will it announce a third round of quantitative easing (QE3) today or not? We’ll know in a few hours. In the meantime, the stock market has rallied to recognize the fact QE3 is a done deal. Let’s hope Ben Bernanke doesn’t disappoint.
What He Said:
“When I look around today, I see falling stock prices…I see falling house prices…and prices for retail goods stores declining. The media has it all wrong blaming (worrying about) inflation. In my opinion, the single biggest threat to the U.S. economy and to the Fed in 2008 is deflation. You can bet the Fed will expand the money supply and drop interest rates aggressively as deflation starts to rear its ugly head.” Michael Lombardi in Profit Confidential, December 17, 2007. Michael was one of the first to warn of deflation. By late 2008, world economies were embedded in their worst state of deflation since the Great Depression.