Humpty Dumpty Had a Great Fall!
Mr. Dumpty Pre- Lehman Collapse
How Do You Unscramble an Omelette?
Want to know why this credit crunch may be intractible and last for a decade? Here's how to best understand the arcane world of CDO's, credit default swaps and structured finance in general. When markets are moving along at normal earthly speeds (let's say up to 500 mph- the speed of jet) we can think in terms of the laws of Newtonian physics. But when markets seize up things instantaneously start to fall apart as the loss of confidence in market mechanisms moves at roughly the the speed of light. Welcome to "Einstein-ville" a world of quantum physics. When markets collapse we move from a Newtonian paradigm to a quantum realm where really strange things start to happen: rulers shrink, time becomes different for different observers, black holes and worms appear in the universe. Matter is both a wave and a particle at the same time. The act of observation changes the outcome. (George Soros's "Quantum Fund" and his Theory of Reflexivity are no coincidence). Check out this 5 minute video from Dr. Quantum. Then ask yourself, do we really want a financial system predicated on rocket scientists running models?
In the Newtonian world, otherwise complex yet intellectually digestable securities encounter a bit of flatulence here and there. Passing wind generally relieves the pressure: a predictable and sustainable number of defaults, restructurings, bankruptcies, write-offs and the like. When markets collapse however things become come undone. Isaac Newton is thoroughly discredited and we go into global geothermal nuclear finance mode. Fas 157 becomes the mother of black holes. The weight of gravity, time and space folding upon each other. There is not enough capital in the system to clear the market without wiping out civilization. The self-fulfilling prophecy becomes the group-fulfilled immolation. Imagine playing musical chairs with no seats! Capital is a global proxy for market confidence. When market confidence fails, governmental response is massive liquidity injections which either quickly restore confidence or if unsuccessful begin to completely undermine it.
So here's an instructive visualization: Wall Street created a several trillion dollar ham and cheese omelette and was paid billions in profits. Treasury's job is to put the eggs back into the shell, the ham back onto the pig and the cheese back into the cow. Not to mention putting the homefries back into the potato skins and onions. Noooo problem!
Ham and Cheese Omelette with Homefries
If all this sounds confusing welcome to the world of structured finance. Want to know why we are in such a pickle in the first place? Wall Street was a game of IQ arbitrage where complex cash flow models can only be understood by people who can decipher Gaussian cupola multivariant analysis in their sleep.
Hmmmmm. So what if only a handful of members of congress understand structured finance? Traffickers in tragedy will reap hundreds of billions of dollars in profits as the DOT tries desperately to put Humpty Dumpty back together again. All those sliced and diced securities-- 64,000 of which were originally rated "AAA" by our wonderful rating agencies who only deemed 12 U.S. companies worthy of the same "AAA" rating. Nice work boys!