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Minyan Mailbag: More Debt Than You Know


The "shadow" banking system and derivate debt.

Mr. Practical,

Why is the crisis clearly more severe this time than ever before, and why are remedies that worked relatively quickly in the past (remember the fast turnaround of the market after October 1987, and the rapid recovery from the rescue of Long Term Capital Management?) failing today?

The answer is, simply, that the world has never in its history carried the level of debt that it is carrying today. The remedies that worked when America's private debt to GDP ratio was a mere 150% are inadequate when that ratio is 275%

Click to enlarge

Those remedies worked in the past, not because they "solved the problem," but because they encouraged the renewal of the debt accumulation process. Each Federal Reserve rescue was followed by a renewed growth of debt relative to income–without which, the economy would have gone into a slump, rather than a boom.

The traditional cure to a financial crisis – to restart the debt accumulation engine – can't work this time, because in America today, there's no one left to lend to (there is no sub-subprime borrower), and no lender willing to risk its capital in yet more debt.

So the real fun on the markets will begin in three months' time, when the credit extended by the expansion of the liquidity window by the Fed has to be repaid.

-Minyan R.


Most Minyans have seen this chart before. Even though it illustrates the magnitude of the amount of debt in the system, it's wrong. The chart doesn't include a new phenomenon, one that has taken place just over the last five years. The total debt figure doesn't include the debt of the "shadow banking system," which is debt embedded in derivatives like securitized loans and credit default swaps (CDS).

If you include that debt the current number is probably more like six times total debt relative to GDP. This compares to two times just ten years ago. The numbers could be even worse based on how manipulated current GDP numbers are. When Bear Stearns (BSC) almost went under the real problem was the CDS contracts it had swapped with other banks: all this debt is tied together in a web where if one strand breaks the whole web could collapse.

This is why bureaucrats are doing crazy things and why the solutions so far have not worked: it's not a liquidity problem where more debt will solve things. It's a solvency problem due to too much debt.

Not until total debt comes down to a realistic number can a real recovery take place. If debt is to be destroyed to that magnitude the deflation will be monstrous. No doubt the U.S. government will certainly nationalize or monetize or socialize this debt in a trust that will bilk taxpayers over time. All the Fed's doing by pumping Term Auction Facility (TAF) and guaranteeing debt is keeping the monster from suffocating immediately.

When the government does announce a $1 trillion trust to buy mortgages it will be with our kids' standard of living.

-Mr. Practical
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