(This is Part 7 in a series. Go back to Part 6.)
A second potential trigger is the great derivatives bubble, one of the daughters of the Great Global Credit Bubble.
What are derivatives? They are instruments that "derive from" primary markets such as stocks, bonds and futures. An example is the listed options on various stocks.
But the derivatives we're talking about here are mostly private contracts between companies, such as contracts between banks, insurance companies and government-sponsored enterprises (GSE's).
The best-known GSE is Ginnie Mae, the gigantic U.S. mortgage packager. Ginnie Mae's debt has surged 130% in six years to now almost $2 trillion, supported by a sliver of equity. It is the world's 4th largest borrower, after only the U.S., Britain and France, and its derivative positions leaped 58% last year.
Huge derivative positions are undertaken for hedging, arbitrage and trading purposes, but they can easily get out of hand. The leverage can be so enormous that a slight miscalculation can bring down the entire company, as Long Term Capital Management discovered in 1998 and Britain's Barings Bank discovered a few years later.
These private derivatives markets have now reached staggering proportions. How staggering? Consider that derivatives outstanding at U.S. banks have gone from
$7 trillion in 1991 to $71.1 trillion today—against total deposits at U.S. banks of about $2.7 trillion.
But wait, it gets better. Since bank reserves are now at an historic low of about 1%, it means that the reserves in back of this $70 trillion of derivatives contracts are now
less than one part in a thousand. Leverage, anyone?
U.S. derivatives leaped 57% in the last 2 years. Total worldwide exposure to derivatives is now estimated to be $170 trillion, approximately 3 1/2 times world GDP. U.S. derivatives are about 5 times GDP and about 6 times the entire capitalization of the stock market.
When the deleveraging of this unfathomable mountain of leverage occurs the fallout will be catastrophic. It's with good reason that Warren Buffett, perhaps the greatest investment mind on the planet, has called them ticking "time bombs" & "financial weapons of mass destruction."
A third potential trigger that could precipitate the bust of the Great Credit Bubble is the stock market.
The dividend rate on the S&P index is now below 2%,
rivaling the lowest level in history which was reached in early 2000 at the peak. Sentiment ratios—a contrary indicator—are now at the highest level in history, higher than the peaks of 1929, 1987 and March of 2000. That's the kind of sentiment that shows up at historic tops.
Meanwhile, as the public is busily gobbling up stocks,
corporate insiders are bailing out at the fastest rate in history. Of course there could be lots of reasons why they are selling so passionately—but a belief that their stocks are going up probably isn't one of them.
Could the market go up from here? Sure; markets can do anything they like. But whether the market goes up a bit from here or not, I believe that it's near a historic juncture which will begin the next and major leg down in a secular bear market that started in early 2000.
If history is a guide, such a continuing fall in the stock market could be the trigger that precipitates the collapse of the Great Global Credit Bubble, particularly since I expect the market averages to eventually fall 90% from their peaks.
As covered previously, the resulting depression would be triggered but not caused by the fall in the stock market. Though the stock market could be the trigger, the cause would be the excesses of the credit bubble itself.
A fourth potential trigger would be a precipitous fall in the value of the dollar.
The United States is running a current account deficit (our "income statement" with the rest of the world) of over $500 bilion a year now, almost 6% of GDP (compared with 3% just 15 years ago). In just a few decades the U.S. has gone from being the world's largest creditor to the world's greatest debtor.
The numbers are staggering. The federal government is borrowing $2 billion every business day from abroad to sustain itself. Foreign investors and central banks are now holding $11 trillion in U.S. assets, $2 trillion in U.S. treasury paper alone, and are financing almost 60% of
the mammoth U.S. budget deficit.
In short, dollars are flooding the world like confetti at a wedding. How long will foreign investors and central banks want to hold onto all these dollars as more and more U.S. debt piles up? Your guess is as good as mine, but they must be worried. I don't see how this unstable situation can go on much longer.
The dollar has been falling steadily since 2002, though not precipitously yet. If investors and central banks begin a panic flight out of the dollar and the dollar begins a real collapse, that would certainly trigger a piercing of the Great Global Credit Bubble.
We'll just have to wait and see. The triggering event could be one of the four events discussed above or it could be something completely unexpected. The point is that once a bubble has grown too large it is exceedingly fragile and thus vulnerable to almost any triggering event.
The collapse of the Great Global Credit Bubble, when it comes, will lead into a depression. Since I believe we are at the tail end of a thousand-year financial and economic expansion, the resulting depression will almost certainly be of historic degree and last well beyond our lifetimes.
(This is the end of Part 7. Go to Part 8.)
—jim sloman, 3.31.04 for Aug 29
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