Systemic Threat

by | Jun 18, 2017 | Economy, Keith | 0 comments

Let us make a few connections on China, Greece, Europe and Puerto Rico: the common thread on all of these is defaulting on debt. Each debt is a credit to another party. Each of those credits has, in all likelihood, been used as collateral on a derivative of some sort. Due to hypothecation and re-hypothecation it is probable that each of these credits presented as collateral has been used for multiple derivatives.

Grasp that chain. That is the key to understanding what happens from this point forward. This is key to understanding why these different events in far off places matter to your life.

The Chinese markets are highly leveraged, that is that many people and institutions borrowed money to invest in these markets. If these markets dive in value then paying back the borrowed money becomes even more difficult. China in the recent past has prevented people from selling. Each share may have a number associated with it on a board somewhere but if you are not allowed to sell that share then the effective value becomes zero. The inability to pay back these loans will daisy chain into other markets, both in and out of China. Go back to the model, each of those debts taken on to buy stocks is a credit to someone else and that credit has probably been used as collateral.

As I have mentioned before, banks are no longer a bank as we traditionally know them to be. They are now effectively hedge funds and they monetize this credit, not by having you pay back the loan, but by collateralizing that credit. This is the systemic threat. The same model goes for Puerto Rican and Greek bonds.

No single person or entity in the world knows where the trail of counter parties, collateralizing, hypothecation, and re-hypothecation leads. This is a problem that central banks and governments have in trying to react to this problem.

Another problem is that, due to our electronic trading and communication ability, this can theoretically melt down worldwide in milliseconds. It is on cruise control.

Yet another problem is that, due to the ability to hypothecate and re-hypothecate, the same credit collateral has been used over and over again to secure more debt. For example there are nearly $700 trillion in the notional value of derivatives the world over. This is secured by about $70trillion in collateral. To make it worse, due to be able to use the same collateral over and over, the actual base value of the collateral securing all of that $700trillion is estimated at $7-10trillion.

As debts are defaulted on there is a scramble for the ‘quality’ collateral. As you can see from the numbers above, there is not a seat for everyone when the music stops. In fact there will be a seat for hardly anyone.

To summarize: each debt represents a credit that has been collateralized many times over. In a default situation, if that credit has been collateralized ten times, nine of those counter parties will not be made whole. Because those nine would of used that derivative which is now in failure as collateral for even more derivatives you end up with a cascading failure.

This is the systemic threat to the world that China, Europe and Puerto Rico represent today.