Economic Collapse Overview

A Primer on Economic Disruption

James Li, June 2007

It’s the summer of 2007. The stock market is in a rally. Consumer spending has hit a new high. The Japanese economy, despite weak production, is recovering. Things seem to be looking up. So why are the top analysts saying that our economy, as it stands, will soon collapse? We can never be too careful about the economy, but are the warnings from financial giants such as Warren Buffet just tall tales, or words of wisdom we must heed in the coming decade to rescue our global economy? This paper will serve to identify and compile scenarios & predictions of experts from diverse fields, and examine their implications for the future of the economy. It will also serve as a primer to the possibilities of an economic crisis emerging from three areas that could have enormous impact and scope in the near future: the ballooning American debt, the aftermaths of the housing bubble burst, and the unpredictable impact the derivative market currently has on the financial sector.

1. American Debt

On the positive side, debt represents opportunity: people can afford more possibilities in their lives. On the negative side, in the case of inability to repay one’s debts, they not only become the borrower’s burden, but also impose a cost upon society.

American debt is growing at an alarming rate, on both the governmental and personal levels. Currently, the federal budget deficit is at an enormous 8.8 trillion USD and growing.[1] Rapidly accumulating debt that grows over long periods of time, with little possibility of repayment without a fundamental change in the econo-political structure, portends an inevitable doom for the current system. But the problem runs deeper than that. What most people fail to realize is that the United States is currently subjected to two debts, both of which “suggest America may well be headed for a financial meltdown,” according to Peter G. Peterson, author of Running on Empty.[2] While most people are aware of the government deficit that currently exists, fewer people are concerned with the trade deficit of the United States. Personal insolvency and indebtedness are also quickly becoming problems much recognized by public officials and Americans.[3] There are profound implications for the indebtedness of the government and of the American people: some obvious, others hidden, but all point to an enormous disruption of the economy at large.

• 1.1 Government Deficits

• 1.1.1 Federal Budget Deficit

As previously mentioned, the federal budget deficit is at 8.8 trillion USD and growing, with 5 trillion being held by the public and the remaining 3.3 trillion intragovernmental holdings.[4] This roughly amounts to be $30,000 of debt per capita.[5] Numbers are superficial. But 8.8 trillion dollars is hardly something to be dismissed as just being “just numbers on paper,” as put by President Bush.[6] Perhaps more importantly, without any fundamental changes with regards to how our government spends and saves money in the near-future, this debt will only continue to grow, as huge tax cuts by the government coupled with enormous spending cause high government deficits.

The 2001 and 2002 tax cuts, two of the largest in recent history, have pushed the nation further into debt, decreasing the ten-year budget surplus of 5.6 trillion USD down to 1 trillion USD.[7] Despite increasing fiscal demands such as homeland security and the increased military budget, a third tax cut was announced in 2003.[8] The rationale behind the tax cuts of current administration is supply-side economics, which essentially claims that tax cuts stimulate the economy into further growth by allowing more consumption and more investments. The increased tax revenues resulting from such growth would then compensate for the lost government revenues. Today, in 2007, with a federal deficit of 8.8 trillion USD (having risen from 5.7 trillion USD[9] in 2001), that rationale is quickly losing its popularity with the public.

On top of the staggering budget deficit, there is the looming issue of health care and social security. With at least 82,826,479 of the Baby-Boomer generation easing into the retirement age group, the future work force will be faced with an unprecedented Social Security and health care financial burden.[10] In 2005, the Social Security and Medicare trustees disclosed an estimated gap of $33 trillion USD between costs and funds coming from these two programs between now and the year 2078.[11] The US GDP for the entire fiscal year of 2006 was $13 trillion.[12] The entire Federal Budget of 2006: $2.5 trillion.[13] By 2080, these two programs alone will equal 20% of annual GDP.[14] Put into context, this means that the United States government is soon going to be confronted with the choice between huge tax hikes or huge spending cuts, as the economy simply cannot outgrow its debt. Unfortunately, those most affected by tax hikes are too young to vote, while some have yet to been born. As Peterson ominously states, “left uncorrected, this fiscal gap will force our nation to make an odious choice, between our obligations to our children and our obligations to our elders.”[15]

• 1.1.2 Current Account Deficit

Another problem facing the United States is the current account deficit. Essentially, the current account balance is derived from the import/export ratio between the United States and the rest of the world. A nation that consumes more than it produces must borrow from overseas. In the year 2006 alone, the US imported $1.869 trillion while having exported only $1.024 trillion, resulting in a current account deficit of $862.3 billion USD.[16] Stronger imports than exports cause domestic demand for foreign currency to rise, as that is how we purchase their products (by buying their money with our money first, then buying their products with their money). Increased demand for the foreign currency causes the “price” of that currency to rise, simultaneously putting downward pressure on the US dollar, causing it to depreciate.

There are currently two problems associated with this process. Firstly, the dollar is not depreciating quickly enough, having fallen only 14% in the year 2006, which is a small adjustment compared to the current account deficit.[17] This implies that the dollar currently is facing strong downward pressure. With the demand for the dollar decreasing, the Fed will have to raise interest rates to keep the value of the dollar stable, resulting in economic contraction of varying degrees. Another, more fundamental trade balance problem results from the net capital account surplus. A depreciating dollar indicates stronger foreign currency, which then leads to an increase in investments in US bonds and equities from abroad. This is known as capital inflow, as businesses now have more funds to work with. This is naturally considered a good thing, given that businesses use such capital to produce durable goods and to increase productivity, which generally cause substantial increases in the GDP. Currently, however, most of such capital inflow is directed towards the production of immediate, consumer products. Consequently, according to the Production Possibilities Frontier modelA of economics, over a long-run timescale (approximately 5-10 years), increases in the GDP will be less apparent, and growth will be less pronounced.

“Paradoxically, the time to begin to worry about the current-account deficit is when it begins to improve, because growth and investment opportunities outside the U.S. are beginning to look more attractive,” says Jonathan Wilmot, London-based chief global strategist at Credit Suisse Group.[18] Once that happens, foreign holdings of American equities will dramatically drop, potentially resulting in dumping in the US Stock Market, which, given the substantial number of foreign holdings, means that prices necessarily will drop. In fact, since nearly $3 trillion dollars of American Dollars are being held by foreigners, this will create quite a stir in the financial sector, with negative repercussions on the real sector of the economy as well.[19]

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• 1.2 Household Insolvency

• 1.2.1 Household Debt, Sources of and Public Awareness

Personal insolvency has become a rising problem in the United States. The chart below shows that while Business bankruptcies have remained relatively stable between 1980 and 2005, consumer bankruptcy has risen dramatically from 300,000 to almost 2,000,000 in the same time period.[21] A recent study done in Purdue University that examined the various causes of personal bankruptcy found that while divorce, job loss, and medical reasons constitute some of the causes, the top cause for personal insolvency is simple “overextension,” or households simply sinking into debts consuming more than they can earn.[22] In the study, out of the total 284 individuals surveyed, 114 of them filed under the reason of credit misuse— which is more than job loss (34), marital disruption (37), health care bills (31) combined; 56 filed under lawsuit/harassments .[23] Recent factors that contribute to rising bankruptcies include: quadrupling of outstanding credit card debt, uncapped interest rates charged by financial companies, 45% of middle to lower income adults without medical insurance.[24]

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In a more recent survey done by the Greenberg Quilan Rosner Research Center, public awareness of this issue has been dramatically raised since 2001.[26] According to the report, almost half the individuals surveyed claim that everyday items (mortgages, credit card bills, car loans, etc.) pose a very serious issue to them.[27] Furthermore, 62% of respondents, most of whom are college educated, express anxiety with respect to at least one debt-related concern.[28] To highlight the results, a table from the study is presented:

How do personal insolvencies affect the economy at large? Besides the direct relationship between bankrupt families and their inability to consume or to invest, their unpaid funds become liabilities in the hands of their creditors, such as banks, credit card companies, financial companies, etc. Rising insolvencies eventually lead to higher costs for such institutions, which in turn results in either higher interest rates being charged -- thereby crippling consumption for those with low credit -- or higher rates of insolvencies among institutions that essentially form the financial backbone of the economy.

• 1.2.2 Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA)

In response to the escalating bankruptcy filings, the 109th Congress passed the Bankruptcy Abuse and Prevention and Consumer Protection Act in 2005.[29] Some of the notable provisions of this new law include a Means Test that would prevent people from filing under Chapter 7 bankruptcy, where most of their debts will be discharged, instead of filing under Chapter 13 bankruptcy, where none of their debts are essentially forgiven. Furthermore, additional attorney, filing and mandatory counseling costs are imposed upon filers to discourage those who are on the verge of decision. The bill also cuts back some of the previously-enjoyed benefits, such as the Homestead Exemption. House Judiciary Committee Chairman F. James Sensenbrenner Jr. explained that the aim of this law, colloquially labeled the “New Bankruptcy Law”, was to “restore responsibility and integrity to the bankruptcy system by cracking down on fraudulent, abusive, and opportunistic bankruptcy claims.”[30]

The numbers told the story. After the bill passed, the numbers of bankruptcy filings sharply dropped, showing great signs of hope. However, this drop in numbers may prove illusionary, since there was a “filing rush” that spiked the number of filings in 2005 just before the new law was passed. In fact, the average of the numbers of filings in 2005 and 2006 is approximately 1.45 million, while the annual numbers averaged between 1.2 million and 1.6 million in the past decade.[31] In a study conducted by Professor Ronald J. Mann from University of Illinois Law, Dr. Mann concluded, “I doubt that the Act will deter borrowing to any significant extent. I am also skeptical that it will reduce the number of bankruptcies in any substantial way.”[32] Professor Mann bases his conclusions on analysis of current business models of bankruptcy filing and the low effectiveness of this new law on deterring consumer borrowing from credit card companies.

What of the future? Chris Lundquist, head of the Lundquist Consulting, a firm that tracks bankruptcy trends, predicts that bankruptcy filings, over the long-run, may “easily return to 90% of its original rate,”[33] depending on the long-term effects of the new law. The comments of Sam Gerdano, head of the American Bankruptcy Institute, are perhaps more insightful, "I would look to things like more delinquencies on revolving credit as well as home mortgage delinquencies and foreclosures as pre-indicators."[34] If we were to trust Mr. Gerdano’s words, we must then turn to the next section, “Dangers of the Housing Bubble,” to understand what the future may hold for bankruptcy filings.

2. Dangers of the Housing Bubble

Increasing foreclosures, decreasing home sales, decreasing housing prices are all symptoms of a weakening housing market, which can have a seriously negative impact on the economy. Whenever a mortgaged property is used as asset to be borrowed against in the purchase of consumption goods, the risk becomes greater. The risks are still higher even if the individual used the funds to pay for the purchases since historical default rate on mortgages has been much greater than that of consumer debt.[35] Essentially, the borrower is borrowing against something he does not completely own, hence increasing his likelihood to default on payments, resulting rising foreclosure rates and higher personal insolvencies.

Reports of mortgage companies going bankrupt or subprime investing becoming worthless have been flooding the economic and financial sections of the news. Comparisons of trends in the past decade within the housing market have been made to the rise of the stock bubble in the nineties. While housing construction and housing prices are expected to rise with population and economic growth, recent growth trends, according to many experts, have been disproportionate, leading to what many believe to be a “bubble wealth” accumulating in the market. If the housing market were to be thrown into turmoil, the effects would be more devastating and everlasting than a stock market crash, since housing is more prevalent in the economy.

• 2.1 The Significance of the Housing Market

• 2.1.1 A Blow to the GDP

The housing market is intrinsically tied in with the national economy. While some connections are intuitive, there are other, hidden economic consequences of any changes in the housing market. In particular, housing prices are linked closely with what is known as the wealth effect. The wealth effect in economics is predicated upon the premise (both through theory and empirical studies) that consumers are more willing to spend when they feel wealthier. Measurements of wealth come from various sources, although the most common include properties such as houses or businesses and equity holdings. Hence, it is apparent that higher housing prices contribute significantly to consumers’ feeling of wealth, thereby causing them to spend more and stimulate the economy. Conversely, housing prices on the fall will cause consumers to be more careful with their money, as they will feel less wealthy since their properties are worth less. In other words, falling prices in the housing market—or the stock market, for that matter—will quickly lead to falling demand in other sectors of the economy, hence creating a domino effect that will echo throughout the economy.

Dean Baker, co-director of the Center for Economic and Policy Research, estimated in 2000 that with approximately 5% of the GDP consists of housing construction and housing construction possibly falling 40% with a housing bust, this would imply that approximately 2% of the GDP would be wiped out from the initial shocks of the bust.[36] This does not account for the aftermaths and wealth effects of the bust. Just how accurate are his estimates? Frank Nothaft, vice president and chief economist of Federal Home Loan Mortgage Corporation—more commonly known as “Freddie Mac”—recently reported, "thus far this year, the housing sector directly shaved 0.8 percentage points off real economic growth in the first quarter, compared to the 1.2 percentage points it lopped off growth in the second half of 2006."[37]

In analysis of recent events, Baker warns of a vicious cycle of falling house prices. While housing demand is falling in all sectors, causing presently-owned houses to decline in price, tightening of lending standards will prevent many potential buyers from entering the home market, thereby creating another drag on the housing demand.[38] The signs of trouble can already been seen, “At the end of the first quarter of 2007, the ratio of equity to home value stood at 52.7 percent, another record low.”[39] Equity refers to the amount of the mortgage that borrowers have already paid off, or what the home owner would receive if he were to sell off his mortgage. A lower ratio of equity to home value, therefore, represents a higher possibility of default mortgages.

Dr. David Martin, CEO of M-CAM, Inc., reminds us how our consumer economy is intractably tied with the housing economy, “ninety percent of the growth of the GDP in 2001 to 2002 was in the housing market.” As our home property values rose, consumer confidence picked up, and the wealth effect took place to increase spending. In 2006, the United States actually incurred a negative savings rate for the first time since 1933.[40] Consumer debt, therefore, depends heavily upon the housing debt, which in turn, depends on housing demand and low interest rates. In other words, if the housing market is to crash, then consumer spending would not only decrease dramatically due to the wealth effect, but consumers debt default rates can also be expected to shoot through the roof.

• 2.2 On the Way Down

• 2.2.1 Fundamentals (Or the Lack Thereof)

Population growth, inflation, economic growth and rent increases are generally seen as the fundamental reasons for rises in housing costs. Recent trends, however, have not followed historical ones, which is one of the reasons that Dean Baker argued for the importance of the housing bubble. In fact, “the economy is building over 2 million housing units annually, while the number of households is growing by about 1.4 million a year.” Furthermore, “rents…actually have been falling behind inflation in the last two years,” indicating that the run-up in house prices is not being driving by fundamental factors in the housing market.”[41] In the following graph, one can see that the surging of home-price index is matched neither by population growth nor by building costs. If the fundamental reasons are not driving up the house prices, what is? Dean Baker offers the following explanation, “in assessing whether housing prices in a particular area make sense, it is useful to think of higher-than-average house prices as comparable to a tax. Cities like San Francisco, Los Angeles, and New York City have features that make them more desirable than other places, so people are willing to pay a premium to live there.”[42]

[43]

Why is this especially dangerous for the housing economy? Simply because the reasons for the housing boom are not sustainable. Higher housing prices can be seen as an area tax; people are willing to pay this tax in return for convenience, weather, neighborhood, etc. However, should these areas lose their attractiveness to home buyers, housing prices will plummet. “At some point, the economies of these bubble regions will not work – the rest of the country and the world will pay no more for the legal services, financial services, apparel, or whatever else is produced in these areas than it will for the same items produced in Peoria, Illinois or Bangalore, India.”[44]

• 2.2.2 Subprime Lending

Subprime lenders do business with people turned away by prime rate lenders for having bad credit history or little to no collateral, thereby representing a higher risk of defaulting on the debt for the lending institution. In 2001, record-low interest rates set by the Federal Reserve and escalating housing prices spurred on an entire market of subprime lenders, who translated such low interest rates into loans with few restrictions and artificially low interest rates to subprime clients.[45] In return for these benefits, borrowers face massive increases in uncapped interest rates several years down the road.[46] Consider that fact with another relevant statistic provided by Dr. David Martin, “somewhere between the 17th month and the 24th month…everything that looked like a good credit starts to look like a bad credit.” Dr. Martin provides another estimate, “Christmas of 2005, January of 2006 is…when we over extended our credit…17 to 24 months would put us in January 2008.”[47] Glenn Costello, an analyst at Fitch Ratings in New York, offers similar estimates, “Delinquencies tend to peak two to three years after subprime loans are originated.”[48] Today, with mortgage default rates highest in recent home-lending history, there is substantial evidence for such ominous predictions.

Some results of “too-easy credit”: Southstar Funding LLC filed for voluntary bankruptcy protection on April 11, 2007;[49] on April 2nd, 2007, New Century Financial Corporation, previously the second largest subprime mortgaging financial institution, filed for Chapter 11 bankruptcy;[50] foreclosure filings are up 65% from last year.[51] Perhaps the future of the housing market is as suggested by Dr. Martin, “all of a sudden, the fecal matter hits the rotary oscillator and it’s bad.”[52]

• 2.2.3 Mortgage-backed Securities

The flood of new mortgages and refinances of old mortgages has caused an eruption in the mortgage-backed securities (MBS) market. Essentially, MBS are securities that rely upon repayment of mortgage loans. With the recent explosion of the housing economy, the returns on MBS’s have simply been too great for investors to ignore, despite warnings of a failing housing sector. While “safer,” higher-graded mortgage loans return an average of approximately 5%, riskier investors can buy MBS that returns up to as high as 15% on sub-prime mortgages and adjustable rate mortgages (ARM). Compare these numbers with the return rates on treasury bonds, coupled with supreme (or seemingly supreme) confidence in the housing market, it is no wonder investors did “gobble up” these securities. Among the buyers of such securities are US Pension funds, investment banks, hedge funds, but perhaps most importantly, Asian countries, particularly China. According to Inside MBS & ABS, a trade publication, foreigner holdings of MBS has increased by 26% in the last year. [53]

Securities on mortgage loans payments, pushed by brokers and banks who sought after the profits involved, are then purchased up those in the stock market and other buyers aforementioned. Hence, when foreclosures rise and mortgage payments are not being made, the securities will lose their inherent values. Furthermore, the high probability of downgrading of mortgage credit ratings will have dramatic consequences. Since US pensions are mandated by law to hold a certain quality of debt, these downgrades in mortgage credit will be forcing many financial institutions to sell their holdings of the securities and hurling the entire market into further turmoil. Debashish Chatterjee, a senior analyst in the residential mortgage-backed securities area at Moody's Investor Services, projected a 25 – 30% increase in expected downgrades due to recent changes in credit evaluations.[54]

Armed with an understanding of the current housing situation, one might be inclined to panic. With the jump in numbers of foreclosure filings and the closing down of subprime mortgage agencies in the past year, it seems as if the time all the experts have been warning about draws nigh. In a recent paper published by Joseph Mason and Joshua Rosner, "How Resilient Are Mortgage- Backed Securities to Collateralized Debt Obligation Market Disruptions," the authors claimed that “insufficient transparency in the CDO market, significant changes in asset composition, and a credit rating industry ill- equipped to assess market risk and operational weaknesses could result in a broad financial decline,” while it will be the tightening of lending standards that will offset the entire process.[55] When these securities default, the ultimate burden will be born mostly by Asian nations such as China, US pensions and financial institutions.

3. Derivatives: “financial weapons of mass destruction”[56]

Derivatives are contracts that derive their values from some underlying asset. Most commonly traded derivatives base their values on stock options, swaps, future contracts, international currency, etc. A better understanding of derivatives may come from the following example: say I am a chicken farmer, and you are a supermarket warehouse manager who wishes to buy eggs from me. While you can currently purchase my eggs at $1 per dozen, that price is not constant, and may rise or fall in the future. If you think the prices of eggs will rise in the future, you can purchase an option on, say, 50 dozen eggs. Prior to expiration, this option affords you the right, but not the obligation, to purchase 50 dozen eggs from me at $1 per dozen, regardless of its market price at the time of purchase. If in fact egg prices rise to $2 per dozen, then you would have made a profit of $50 from the option alone, minus the cost of the option. Similarly, if you believe that the price of eggs will drop, you can purchase a right to sell your 50 dozen eggs at $1.50, so when the price of eggs drop to $1 per dozen, you would have avoided a greater loss had you decided not to purchase the option.

Financial institutions from all over the world employ derivatives-trading as financial instruments to manage the ups-and-downs of the market. The derivative market has existed over the centuries, although the Black-Scholes breakthrough in 1973 by Merton propelled it forward as the primary speculative tool for all investors. The Bank of International Settlements, at the end of 2006 4th quarter, reported a staggering 415,183 billion dollars worth of total derivative contracts outstanding. Compare that with 257,894 billion in December 2002, which is still a 60% increase in activities within the derivative market within just 4 years![57] Even so, as many financial experts have expressed, the importance of derivatives can hardly be overstated, especially since such importance comes not only from sheer numbers, but from the explosive nature of derivatives themselves.

• 3.1 The Explosiveness of Financial Derivatives

“For the economy as a whole, a collapse of a large derivatives user or dealer may create systemic risks. On balance, derivatives help make the economy more efficient. However, neither users of derivatives nor regulators can be complacent,” warned René M. Stulz, Reese Professor of Banking and Monetary Economics in Ohio State University and Research Associate of the National Bureau of Economic Research. While expressing hope and optimism for the impact of derivatives on the financial sector and the global economy as a whole, Professor Stulz still cautions us about the tremendous influence individual financial firms now hold over the global market.[58] More so than ever before, the financial decisions of a collected few hold sway over the entire financial market.

Derivatives are used prevalently in the financial sector, especially amongst hedge funds and investment banks. While the pricing and distribution of derivatives are understood by few other than investment bankers and experienced traders, one can see the tremendous risks involved in the rampant speculation of the financial market. When derivative trades fail, established financial institutions become bankrupt (i.e. Barings in 2000), making headlines, and rattling the entire economy. Bears Stearns, a hedge fund heavily invested in housing mortgage bonds, had to be bailed out by Morgan Stanley (seizing and selling $800 million worth of bonds) after losing 20% of its funds in 2007.[59] Such an incident is both rattling and comforting at the same time: while one is comforted by the fact that there are institutions and powerful individuals who act to buffer the rest of the economy from financial shocks, the speed, magnitude, and lack of forewarning that accompanied such an event make it difficult for anyone to feel secure.

It would seem that using derivatives like options, forwards, futures, and others would reduce the risks the purchaser must otherwise be exposed to, so why is the derivative market, as a whole, considered so risky? According to studies and experts, there are several important reasons.

In “Financial Derivatives and the Rise in Circulation,” written by Edward LiPuma and Benjamin Lee, the authors provided some rationale behind why the derivative market is so volatile and can impact the economy in a never-before experienced manner. The numbers reveal some sobering information: more than 99% of total dollar volume of derivative trades are based on the monetary sector of the economy rather than on the real sector (i.e. production of tangible assets, goods, and services).[60] Perhaps the most direct implication of this is that the risks involved with derivatives and speculation of money are no longer tied down to the limits of real assets and commodities. Instead, they are tied to the cost of money itself and the floating relationships between currencies. Since “the only thing both cross-currency and interest rate relationships have is a volatility,” derivative traders often thrive upon the instability of the markets. Furthermore, LiPuma and Lee explained, “freed from the constraints imposed by production, there appears to be no real limit to the size of the market for financial derivatives,” thereby allowing them to “develop a directional dynamic towards an autonomous and self-expanding form.”[61] As monetary markets become more and more independent from the real sector of the economy, the same set of risks and rules no longer apply.

Global connectedness and the derivative market are engaged in a positive feedback system, with the influence of one reinforcing the other. As technology makes it possible to gather large amounts of information, transfer funds quickly and cost-efficiently, the derivative market skyrocketed in recent years. LiPuma and Lee claimed that “while a specific derivative may assist a particular company to hedge its risks, the amplified role of speculative capital ensures that the volume of transactions far exceeds the use values of hedging for the particular firms…Accordingly, the derivative has a bipolar personality.”[62] Essentially firms across the globe are deciding to pay premiums for a service that buffers them from the internal shocks of an economy by adding to more volatility in the derivative market. This process, in a sense, circulates and globalizes the risk of individual firms. And since the speculative capital needed to initiate a derivative trade is much lower than that of purchasing the underlying assets, the sheer volume of derivative transfers can easily compare to an entire national economy, causing central banks around the world to fret about how a collapse of this volatile market would impact their national economies.

• 3.2 The Lack of Transparency

Derivative trading and the derivative market are rather difficult to gauge accurately. Given the decentralized and unregulated nature of the majority of derivative contracts, which are traded “over-the-counter” rather than at exchanges like stocks, institutional estimates of the derivative market (such as those by the Bank of International Settlements) are not as accurate as other measures of economic fundamentals. Underestimation of the derivative market can cause central banks to believe that it is less volatile than it actually is. Furthermore, the complicated nature of derivative trading can, and did, lead to false accounting by financial institutions. Perhaps the most famous example would be the 2001 Enron scandal that angered and bereaved Americans throughout the nation. Professor Stulz indicates that “the accounting treatment of derivatives is sufficiently complex that canny use of derivatives can decrease or increase reported earnings,” which proved to be disastrous in 2001 without responsible oversight and may prove to be similarly disastrous in the future.[63]

• 3.3 The Sage from Omaha

In his 2002 annual Berkshire Hathaway Annual Report, investment guru Warren Buffet severely criticized the way financial derivatives are employed at the time. Buffet cites the Enron scandal as an example of using derivative trading to counterfeit the books, and argues that derivatives are less liquid than one might think. Although such derivative contracts are bought and sold quickly, they often come with long term contract dates, which can require the firm having to pay a high price to the creditor in the future. Buffet also felt that derivatives are being concentrated too greatly in the hand of a few traders, who control entire economies with their power. In the 2002 annual report, Buffet concluded firmly and clearly on the subject, “derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”[64]

• 3.4 Disasters of the Past

In envisioning a potential financial crisis originating from derivative trading markets, we can look to patterns of similar events in the past. The two cases discussed here serve to illustrate both the tremendous risks faced by financial institutions and their increased fragility within such a market. Whereas human error was inherent in causing both crises, the question is not how we can prevent human error, but rather how we can limit the impact of human error on the institution, the market, and consequently the economy at large.

A hedge fund started up in 1994, Long-Term Capital Management began with $1.4 billion of its own capital and began earning annual returns averaging over 25%, until at the end of July 1998, LTCM held assets worth $125 billion.[65] The same year, the Russian government defaulted on its payments, initiating a general rush towards less risky bonds such as American bonds, which LTCM has shorted in the previous years. While LTCM tried to sell off some of its assets to increase its liquidity in the short-run, traders began to bet against the corporation, hoping to maximize their profits, which further pushed it towards bankruptcy. Understanding the peril of the situation for the entire financial market, Warren Buffet with AIG and Goldman Sachs bid $4 billion for the LTCM portfolio, but was quickly rejected by the corporation. Ultimately, a bail-out of $3.6 billion was organized by the major creditors to control the damage. While the effects of the collapse of LTCM did not quite reach the financial sector in full force, it nevertheless proved that any financial institution, even one riding on the waves of success, can fall rapidly and drastically with derivative trading.[66]

Another financial company in England was not quite so fortunate. Baring Brothers has been one of the most prestigious and long-lasting bank in the United Kingdom when in 1995, a young trader by the name of Nick Leeson lost $1.5 billion in the Singapore derivatives market. Leeson not only lost money in the derivative market, but hid it away from the company account so as to not be discovered until it was too late. By late February, the Barings Brother Bank has collapsed.[67] Once again, we are presented with the situation when the errors of a single individual can wipe out an entire institution—such is the power of derivative trading.

4. Conclusion

“We first make our habits, and then our habits make us.”

- John Dryden

Dominated by heedless consumerism, huge governmental debts, bubbles in the housing sector, and a potentially implosive derivative system, the United States economy reflects the reality of Dryden’s quote. To avert the potential financial crisis American consumers must educate themselves on the issues, break old habits and demand government and corporate restraint. The last major international depression led directly the rise of Fascism and the bloodiest war in human history, and since that war nuclear weapons and advanced military technology have spread across the globe, raising the stakes further still. To the extent that we do heed warnings and take effective action, the global economy may continue on its robust course. But American complacency must end; by not addressing the flaws in our financial system we risk our happiness, our prosperity, and even our lives.

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