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For those that might want a simpler view of what is currently ongoing with our financial system:

Throwdown
Gilligan's Island vs. Land of the Lost
by Eric Andrews | September 25, 2008

It's been several years since our intrepid Islanders had been marooned on the savage, barren island of Gilligan. They've built fishing rafts, coconut milling machines, and a taro industry. Out of this production, they built private, well-stocked huts and beautiful picnic table works with free wireless radio access for all citizens. Life was predictable, cozy, secure.

In the business of life, the Skipper traded some of the Professor�s Oceanic Consulting services in exchange for the fish he�d bring in later that month. Ginger owed Mrs. Howell some of her new specialty, Thai Taro. MaryAnn promised to knit the Professor a sweater for the upcoming rainy season, and Gilligan owed MaryAnn coconuts. Nobody was in a special hurry to collect their debts, as nobody was going anywhere and they were certain they would be paid.

This is similar to a normal, business-oriented credit system.

As the Professor knew he�d be paid a load of fish sometime that month, he had no problem buying MaryAnn�s coconut-fleece cardigans on credit. MaryAnn could buy raw coconuts from Gilligan Coco-Nuts! LLC, and to make it all easier, they standardized the prices and denominated transactions on leaves called �Palm Promises.�

The math looks like this:

Assets: 1 fish + 1 meal + 2 services + 1 coconut = 5 Palms in assets

Liabilities: Owed 1 fish, 1 meal, 2 services, and 1 coconut = 5 Palms in debt

This is a virtual cash economy. The system is slow but certain, so over time, the Skipper borrows 2 months out in consulting. Professor borrows 2 months of coco-fashion. MaryAnn borrows 2 months of coconuts from Gilligan, and Ginger stocks up 2 months of Mahi-mahi. Like this:

Assets: 1 fish + 1 meal + 2 services + 1 coconut = 5 Palms in assets

Liabilities: Owed 2 fish, 2 meals, 4 services, and 2 coconuts = 10 Palms in debt

They call this the �FIT� economy: Fish, Industry, and Taro. Although there is modest credit of 30-90 days of inventory clearing, it's a normal production-based economy found at cycle bottoms.

And the system goes swimmingly. It goes so well that slowly everyone borrows 10 promised items for every item actually on the island:

Assets: 1 fish + 1 meal + 2 services + 1 coconut = 5 Palms in assets

Liabilities: Owed 10 fish, 10 meals, 20 services, and 10 coconuts = 50 Palms in debt

This is Fractional Reserve Lending. For every 5 Palms in assets, there are 50 Palms in debt. Where are the assets backing those Promises? In the future. People believe the real goods are out there, but really, they haven�t been made yet. This is like the stock market. Stock prices are potential goods. However, they can never be translated into real goods unless and until they are sold.

But things are good. It�s Paradise after all. The Island GDP is expanding from 5 to 45, and the 10:1 leverage ratio is so modest as to be seen only in primitive societies and cycle bottoms. Monetary velocity is also rising as it�s quicker to extend promises than to make and deliver real goods. The Wealth Effect is in full swing.

It�s indeed easier to make promises than to make products. The Skipper promises he will catch fish further out. Mr. Howell promises to get him a bigger raft. The Professor promises to buy more sweaters. MaryAnn promises to knit him more. Gilligan promises to grow more, and so on, as they all book long-term contracts which show up in GDP. This expected prosperity is measured in the Promise/Effort ratio or P/E. As in other stock markets P/E rises when people believe bigger and bigger things can reliably happen further and further into the future. This is the same way the P/E ratio of stocks rise up from cycle bottoms over decades, from 5 or 10:1 to 20 or 30:1.

Mr. Howell is bored by this slow, boring economy and decides things would be more interesting if they could make a little side bet. He convinces the Skipper to wager 5:1 that MaryAnn's Coconut Fleece Cardigan Company will go under before the end of the year. The Skipper agrees, knowing that coconut fleece lasts only 3 weeks and the Professor will always need more. Both are sure to win so they BOTH book the bet as income. This is the derivatives market. Through creative accounting both parties can claim the bet as income. Their income�really future income--is also added to GDP. The booked revenue also shows up in profits of the Skipper's �Fish-n-Huts� shares, which promptly rise and everyone is rich. But notice that both parties cannot win. Also notice that this portion of the Gross Domestic �Product� produces exactly nothing. The side bets merely determine how the same items will be distributed. What items? The only real items on the Island:

1 fish + 1 meal + 2 services + 1 coconut.

But wait a minute�didn't Mr. Howell just bet 5 Palms with the Skipper? But isn't 5 Palms the GDP of the whole island?

This is like the present derivatives mountain, which according to the Bank of International Settlements could be anywhere from $500 to $1,000 Trillion. Yes, Virginia, there is a Quadrillion. By comparison, total world GDP is a mere $66 Trillion. So in side-bets alone, the Mr Howells of the world have bet 10 or 20 years worth of hard work and real production. But since side-bets create nothing but merely redistribute existing wealth, is it theirs to bet? Can they bet more than their collective firms are worth? What happens when one firm goes under, but owes 20 firms worth of debt to their counterparties? Who un-books the income? Who un-dispenses the profits? And this is in addition to the actual, functional public and private debts which in the US are $53 Trillion, or 5x the US GDP of $13 Trillion. This is what Bastiat called, �everybody living at everybody else's expense� and it's like picking up a bucket while you're standing in it.

And so it goes through the South Pacific summer. The Skipper bets the Professor another 5 Palms that Gilligan can't deliver his promised coconuts. This is a Credit Default Swap, or CDS. The Professor creates an equation calculating the odds of wins, losses, and profits, and bets another 5 Palms himself. This is a �quant� or Quantitative Modeling. He sells part-interest of his model to Ginger and MaryAnn. This is a Hedge Fund. Everybody owes bets to everyone.

Slowly the mix of GDP changes from a FIT economy to GILT: �Gambling on Incredibly Leveraged Trades�. This is like the FIRE economy of the US and G7, based on �Finance, Insurance (side bets) and Real Estate�. Yet no one notices. The number of Promises owed increases every year. Everyone's savings account is filled with Promises. GDP is high because it largely measures the rotating transfer of Promises and the increasing volume of circular bets.

To compare the Island to ourselves, let's use present world leverage of $1,000 Trillion in derivatives, and let's assume that standard debt among the top 15 nations are only half as indebted as the US, or 2.5 times their combined GDPs, $138T. That's $1,138 Trillion balanced against GDP of $55T�and like the example above, much of that GDP is not real production but phony churning. Not all of these line up timewise, but they give you a feel for the leverage out there, or 20:1, a common peak for economic cycles. What's 20:1 leverage on the Island?

Assets: 1 fish + 1 meal + 2 services + 1 coconut = 5 Palms in assets

Liabilities: Owed 20 fish, 20 meals, 40 services, and 20 coconuts = 100 Palms in debt

As long as nobody actually withdraws any promises, the system is perfectly sound. Everyone actually believes there are 100 Palms of value available to them and that if they sell, there will somehow be all 20 times the fish, services, meals, and coconuts that there actually are.

The reality is far different.

Enter Winter

Every place has its seasons and when the rainy season finally comes, the fish are not so easy to catch and the huts need fixing. This is similar to the sagging energy input from Peak Oil and the drag of aging infrastructure. In the rain, people work less and begin to stay at home, buying less. This is the same as the bulge of G7 retirees, who will now draw on their promises owed. Let's see how that goes.

100 Palms in circulating Promises are now bidding on 5 Palms in assets. What does that mean? It means a real fish is now worth 20 promised fish, and a real coconut today is worth 20 coconuts tomorrow. Worse, at 20 Promises per real real fish instead of 1, no one can afford custom tailoring, consulting, or eating out, and the 60 Promises that used to buy those things are added to the bidding. 100 Promises are bidding on 1 fish and 1 coconut. Today's price? 50 Palms each, or 500% inflation. Or put another way, to re-establish equilibrium, the Market in Palms must fall over 90% relative to the price of real goods. Either promises fall, or real goods rise, but the result is the same: a Bear market in paper promises and a Bull market in real goods. This is similar to the value markets commonly fall to after a bubble; in 1970 (via inflation) or in 1930 (via deflation), or in the hundred other times and places it has happened.

Into the breach steps Mr. Howell. Although the winter rains are only starting, the Promises market has already fallen 20%. He decides to PREVENT the value of Promises from falling. Food has risen 20%. So obviously all they need to do is print 20% more Palms and give them to people. This is the tax rebate and it works until it is spent. Then people immediately return to selling Promises for food, solving nothing.

Seeing the Market continue down, Mr. Howell decides this must be a timing issue. He replaces all the Promises due today with Promises due in a year. This is called �adding liquidity� and is part of the TAF and other Treasury-swapping deals. So everyone who can simply trades their long-term Promises for short-term ones and continues right on bidding for the fish they need today, solving nothing.

Then Mrs. Howell gets in a jam. She owes some Promises which are due tomorrow, but she over-booked her calendar and can't keep her Promises to everyone. Instead Mr. Howell merges their Promises and takes her on a 2nd honeymoon. This is the Wall St. buyout cycle. The debts are still there, but are simply owed by someone else.

Mr. Howell refuses to deliver Promises owed during honeymoon week. This is like the partial default seen in the GSEs, Countrywide, and perhaps Merrill, which has wiped out many funds. As these Promises-to-pay, or debts on one side, are also key financial assets on the other side, their loss of these holdings and cash flow may bankrupt many more banks within the 30, 60, or 90-day reporting window.

Seeing the carnage, Mr. and Mrs. Howell decide that what's really wrong with the market is that they are holding the collapsing Promises. If the price of Promises are falling, it would be much, much better if the other Islanders held them. This is the Wall St. bailout, where the debts are being passed from the corporations to the taxpayers. And that's where we are today.

Once this is accomplished, Mr. And Mrs Howell own none of these worthless Promises and the math looks like this:

Assets: 1 fish + 2 Services + 1 Meal + 1 coconut = 5 Palms in assets

Liabilities: Owed 20 Fish, 35 Services, 20 Meals, and 20 Coconuts = 95 Palms in debts (5 were defaulted)

Did the financial situation of the Island improve? No. It doesn't matter if it's a household, an Island, a Nation, or a World, the problem is not what the Promises are worth, it's not who holds them; the problem is that there are too many Promises and not enough underlying goods. The solution is equally simple: you must reduce the number of promises through default or repayment, or else increase the number of goods through hard work and production.

Thanks to the bailout the Non-Howells now owe all 95 Promises. However, as they find their debt to be high, food to be scarce, and 30% are unemployed due to the layoffs of the service industry, they still cannot buy goods. This is similar to the $6,000 per taxpayer of additional debt already levied via Wall St. bailouts. How will the Islanders buy more when they are $6000 further in debt than last month, with as much as $22,000 more per person poised to land on them this month alone? Wouldn't they buy less and less as they find themselves further in debt? And if the Islanders buy less and less, won't the economy continue to crumble? And until they can afford to pay, aren't thePromises held by the financial industry really worthless? So doesn't the Wall St. bailout really hurt themselves?

Mr. Howell has a plan. When the Promises, and the additional Promises, and the more additional Promises were laid on the Other Islanders, a disproportionate number landed on Gilligan. Gilligan despaired and even talked about quitting work and defaulting on his Promises, which would ruin the market in Promises. Because Mr. Howell likes Gilligan, he has a plan to remove the weight of those 22,000 new Promises. The 5 non-Howells now owe 22,000 Palms apiece, or 110,000P. There are 5 actual Palms worth of value on the Island�2 now, actually, since the service providers are unemployed. Therefore, the price of the remaining 2 items are now up 55,000%. But that wouldn't be so bad if Mr. Howell and Gilligan could write themselves a blank check, grant themselves a little extra power so they could print up another 11,000 Palms where no one can see. You see, then Gilligan could pay off his debts and right the ship, get things back under control. So could everyone. So with Gilligan's approval, Mr. Howell counterfeits another 11,000P for each Islander, plus two for himself and three for Mrs. Howell. And this is the $700B rotating bailout before us this week, completely hidden, without oversight and without limit. It's like a red-hot counterfeit press in the basement. As top economist Nouriel Roubini says:

"He's asking for a huge amount of power...He's saying, `Trust me, I'm going to do it right if you give me absolute control.' This is not a monarchy."

I know this sounds crazy, but this is exactly what governments do. Not just one, but many, many governments have seen the inflation they created, have traded in their previous, inflated currency for a new one at 1000:1, 30,000:1, 1,000,000:1, lopping off ten zeros like an overgrown Paul Bunyan, and then keep right on printing into the billions or trillions. Intelligent, respectable, hard-working countries like Germany, Austria, Hungary, China, and France have done it, along with many others including the Colonial and Confederate United States. What happens with Mr. Howell's new Compassion Plan? Just what you think:

Assets: 1 fish + 1 coconut = 2 Former Palms in assets, now worth 110,000 Palms each.

Liabilities: 220,000 Palms in debts with the Howell addition.

Ratio of debts to assets? Not 1:1, 10:1 or even 20:1. With the shrinking of the real economy, it's now 110,000:1. Because when the currency�even counterfeited currency�is an unbacked fiat currency, it is a PROMISE, and the more currency you create in that system, the MORE debts or promises you create, not less. The WORSE things become, not better. In this system, the Islanders owe 44,000 years of labor per person, yet in an economy where everyone owes thousands of times more than they own, no one can afford to hire anyone or build anything. With only 2 items for sale, the people starve; yet with savings wiped out and the instability of constant economic interference, they cannot wisely plan for and then construct the equipment that would create a surplus. From a comfortable paradise, they descend into a starvation existence like Cuba and fight among themselves for the scraps. Food is now doled out according to power and connection instead of innovation and production, so hunger and oppression continue for 50 years. This is truly the �Land of the Lost�; a spectacle almost too tragic to bear.

Let's go back to the 20% point.

After a review of the problem, the Islanders ask the Professor to tell Mr. Howell �thanks but no thanks.�

This is what you can do when you call your Congressman or Representative.

There are still only 5 real items on the Island and still 100 Promises. The rain still has cut supply and increased demand and the price of Real goods still rises sharply in relation to the price of Promises. The value of Promises fall 90%. As the price of goods rise, however, the Islanders abandon the GILT economy and shift to the now-more-profitable FIT economy. High prices force everyone's attention to conserving precious goods as well as creating more. Promises are painfully paid off and not issued as carelessly. Slowly at first, then increasingly often, the Islanders find their hard work and intense focus paying off. At the bottom of the cycle, there are still 70 Promises left on the Island, but the number of real goods produced has increased to 10, the 7:1 P/E ratio seen at market bottoms and is like the work the country did in the Depression or after the Civil War. When the Islanders can see and are sure there is enough for everyone, the recession is over and life goes on.

...Until next time. After all, this is only a 3 hour tour.

So would you rather live in the Gilligan's Island or the Land of the Lost?

Vote for your favorite. Your Congressional Representative is standing by.




Copyright � 2008 Eric Andrews


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Eric Andrews | Buffalo, NY USA | Email

mike,

So am I to understand that the current financial crisis was the result Wall Street/Investment Banks gaming the system rather than a liquidity shortfall caused by a sudden increase in home mortgage loan defaults?

yes

Pretty much. The liquidity shortfalls are a result of the increase in mortgage defaults to the extent that the various banks made bets called derivatives based on mortgage loans of dubious quality. When they tried to sell those products they found that there was no market for them. With no market because of the doubtful quality it has to be marked to whatever the market will give for it, and if it cannot be sold at face value, it must be called a loss. That loss has to be covered with cash-liquidity. Not enough cash means insolvency-unless the taxpayer can provide the market and the cash to prevent that, which is what is happening now by our public serpents.

I dunno, it hard for me to believe that our entire financial system was running so close to the line that an increase in home mortgage defaults could tip over the entire apple cart.

What is the magnitude of this mortgage loan default problem relative to the total credit base anyhow?

I don't know what the proportions are, but I have to believe there's a whole lot of very profitable credit instruments out there that are also being held by these financial institutions (i.e. corporate loans, municipal borrowing etc.), so why did problems the home loan business sector cause everthing else to tumble?

Every lender (including the local loan shark) has good clients and bad ones.

Seems strange to me, unless there were extraordinary profit margins involved, that lenders (even a lone shark) would risk their entire business survival by overextending themselves with high risk clients.

You guys know a lot more about this stuff than I do, but you can see from a common sense point of view, this is some crazy schit!

Good post Mike.

The "sub-prime" debacle is only a poster child for a grossly over-heated, over-priced economy. Sub-prime may have been the straw that broke the camel's back, but something else could have just as easily exposed what has been taking place for a long time.


We had a economic correction starting in 2000-2001. Then along came 9/11........The White House panicked, the Treasury Dept panicked, Congress panicked, and the Fed Reserve panicked. And the economy was FLOODED with liquidity--creating a super bubble.

We are now seeing the era of government attempting to provide us with a "no-pain" lifestyle. The painless war, the painless stock market, and now the painless economy.

At best, the inevitable $700,000,000,000 bailout has a 50% chance of even partially succeeding. And even then, it may just be moving the inevitable out a few more years into the future.



Casey

But it IS running that close to the line. This whole system invented by those at the Federal Reserve and Treasury over the last 95 years is built upon a house of cards called credit. That system of credit has been allowed to expand so that now, like a junkie, we can't operate on a day to day basis without it. Actiually we can, but our minds tell us that we need the next fix or we'll die. Any disruption in the supply now, causes major withdrawal pains. The pushers don't want you to experience the withdrawal, because you might then figure out that you don't need their product. That effectively puts them out of business. There goes the bonuses, houses at the Hamptons, power over others-up in smoke. Can't let that happen, even if it means killing the user.

If some hedgefund decided to short the ABX tranches with huge amounts of bogus entitlements at the same time the mortgage defaults spiked, the banks with mortgage backed securities might have difficulty maintaining liquidity. All it takes is a small spike in defaults coupled with large volume of naked shorting to send it all into a leveraged crisis.

Here's another version of this same theme. kwg

http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aSKSoiNbnQY0

Goldman Sachs was involved in many sub-prime securitizations, and then was instrumental in setting up the ABX index, which Goldman then shorted to death after selling the index to its clients. By shorting the ABX index, Goldman not only made huge profits, but also eliminated all financing for real estate securities by spreading the notion that they had no resale value, because the value "indicated" by the ABX index was so low. The notion of "toxic securities" was sold to the world by Goldman and their confederates. Once new real estate lending was substantially restricted, a broad decline in real estate prices was a certainty, and recently adopted "mark-to-market" accounting rules forced lenders to report balance sheet losses even for loans that were current.

Goldman also helped develop and sell complex securities, that have magnified the extent of the damage done. Collateralized debt obligations and credit default swaps can magnify any actual loss, since there are many more credit default swaps sold than actual loans made. A $1 actual loan loss can become $10 or more of losses to one side of the swap transaction, and $10 or more of gain to the other side of the transaction.

Paulson has made the financial crisis much worse by his publicly stated intention to "punish" some companies. While Bear Stearns was "bailed out", Lehman was allowed to fail. Fannie and Freddie were "rescued" in a way that arbitrarily removed $10 to $15 billion of capital from banks that had invested in the preferred stock, which then reduced those banks' lending capacity by $100 billion, making the "credit crisis" much more severe than it was before the "rescue". Instead of stopping a run on Washington Mutual by providing cash loans, Washington Mutual was unnecessarily liquidated, to demonstrate the urgency to authorize $700 billion to Paulson's Treasury.

Of course because of credit default swaps sold around the world, financial institutions' losses on the Washington Mutual liquidation are vastly larger than the cost of keeping Washington Mutual open as an independent entity.

Now we come to the $700 billion. If this is used SOLELY to purchase whole loans, then the institutions now holding those loans do not experience losses that get magnified by credit default securities, and the government is in a position to rework the loans with affordable payment terms, so that people keep their homes, and the government recovers its entire investment. If this money is used to purchase "downstream securities", such as securitization interests, CDOs, and credit default swaps, then vastly more money is required, and homeowners still lose their homes.

Why would Paulson seek the authority to buy "downstream securities"? Could it be that Goldman and its confederates hold these securities, and make vastly more money at taxpayer expense by selling these securities than by allowing people to remain in their homes, eliminating the defaults that make these credit default swaps so valuable to one side of the contract, and so costly to the other side of the contract, the US taxpayer, if Paulson gets his way.

I'm all for blaming politicians, but if you follow the money you will find both parties taking campaign donations from the winners in the credit crunch debacle. The dems more so, but both sides are in bed with the regulators and den of thieves.

"This whole system invented by those at the Federal Reserve and Treasury over the last 95 years is built upon a house of cards called credit."


Our word 'credit" comes from the Greek word "credo" which means to believe. The whole thing is built upon the belief of the US public (and the rest of the world, for that matter). When that trust/belief falters the house of cards tumbles to the ground. And I think the fall of this great (yet flimsy) house is long overedue and much needed.

Let it fail. Push it over the edge and let the "cards" fall where they may. The addiction (good analogy, btw) is only going to get worse and wrose, why wait?

It has already failed. The question is: "Where is the dealer (the fed) gonna push the chips?" Who will be the next generation of Kennedys?

Mike, I have to admit that I didn't take the time to read and digest the whole article. Does it mention the thieves heading off into the sunset with attractive severance packages while their victims take the losses?

It depends upon the choices made by the islanders. If they go with the "Howell's" plan (Paulson/Bernanke) then yes it does end that way. It may put off the day of reckoning for awhile, but it will end badly.

If this deal is approved, expect to see a major rally in the stock market on Monday. Then the players will sell most of their holdings and move into cash or precious metals. The problem is still there, it has just been postponed for a time. They won't pass up an opportunity to protect themselves at your expense.