The Worst-Case Scenario

Between 1990 and 2007, the total mortgage debt held by Americans rose from $2.5 trillion to $10.5 trillion. This rise was part of a societal credit bubble that burst in 2008. To cushion the pain of that collapse, federal authorities decided to replace private debt with public debt.

In 2008, the Bush administration increased spending by about $1.7 trillion, and guaranteed loans, investments and deposits worth about $8 trillion. In 2009, the Obama administration spent $800 billion on a stimulus package, $1 trillion on a second round of bank bailouts and committed another trillion on health care reform and other bailout plans.

Americans generally welcomed the burst of public activism. In “Democracy in America,” Alexis de Tocqueville wrote about what happens to a people beset by anxiety: “The taste for public tranquility then becomes a blind passion, and the citizens are liable to conceive a most inordinate devotion to order.”

In normal times, Americans would have been skeptical of proposals to double or triple the size of federal programs, but amid the economic fear, that skepticism fell away. Wall Street traders hungered for a huge federal bailout replete with strings. Economists produced...

The Obama administration was staffed with moderates who found that there was no reward for moderation. Liberals attacked them for being tepid. Republicans attacked them because it was enjoyable to see Democrats attacked. Over time, the administration drifted left and created what you might call Split Level Technocratic Liberalism.

President Obama defended spending initiatives in broad terms. He had enormous faith in the power of highly trained experts and based his arguments on models and projections. The actual legislation was cobbled together by Democratic committee chairmen, often acting beyond the administration’s control...

The crisis was labeled an economic crisis, but it was really a psychological crisis...

It's most of it quite true, but it's not exactly news. The currency crisis with ERM in 1992 was fueled by derivatives, as was its successor crisis with the Asian tiger economies in 1997-98.

1997-98 was exacerbated by the abuse of derivative products by LTCM (as well as a good number of unsound banking practices by LTCM's counterparties), and the incompetence of the Harvard quants who 'advised' Russia almost into national bankruptcy. When you see the name Jeffrey Sachs involved in any enterprise, run, do not walk, in the other direction. As fast as you can. Immediately/

The notion of maximising leverage in order to enhance investment/trading returns is and always has been insanity in action.

Maximised leverage is identical to minimised margin or capital requirement, right? Right.

''Minimum margin is a sign of minimum intelligence.''
-- Harrison Roth, LEAPS, 1995

One of the very few places that I would advocate more regulation is in the permissible amount of leverage by goobermintally-insured financial institutions...and HERE, it is absolutely essential.

Or else we'll just keep having these debacles fr/time to timer. Not a very good idea. The Eurozone banks, btw, at the time of the crunch last Aug/Sep, were levered up to 4 times as much as American banks.

You've seen the troubles American banks have got into; this is **nothing** compared to the deepshjt the Euro banks are coming up upon. The EC (as typical for Wonderland, which is my name for the European Union) are trying desperately to put off the day of reckoning as far as possible.

It ain't gonna be too far, either, mate. The reckoning for the BS lending (much of it via derivatives, how about that!?) to Eastern Europe is going to come due with a huge and very destructive BOOM!

Here's Ambrose Evans-Pritchard on Wonderland's problems with Eastern Europe et al. He's got most of it right, too, although his comments about crude are fatuous and factually incorrect. Urals grade crude, the Russian benchmark, is rather higher than he implies, but he is entirely correct about Russia's financial shape.

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Failure to save East Europe will lead to worldwide meltdown The unfolding debt drama in Russia, Ukraine, and the EU states of Eastern Europe has reached acute danger point.

By Ambrose Evans-Pritchard
Last Updated: 2:05AM GMT 15 Feb 2009

If mishandled by the world policy establishment, this debacle is big enough to shatter the fragile banking systems of Western Europe and set off round two of our financial Götterdämmerung.

Austria's finance minister Josef Pröll made frantic efforts last week to put together a €150bn rescue for the ex-Soviet bloc. Well he might. His banks have lent €230bn to the region, equal to 70pc of Austria's GDP.

"A failure rate of 10pc would lead to the collapse of the Austrian financial sector," reported Der Standard in Vienna. Unfortunately, that is about to happen.

The European Bank for Reconstruction and Development (EBRD) says bad debts will top 10pc and may reach 20pc. The Vienna press said Bank Austria and its Italian owner Unicredit face a "monetary Stalingrad" in the East.

Mr Pröll tried to drum up support for his rescue package from EU finance ministers in Brussels last week. The idea was scotched by Germany's Peer Steinbrück. Not our problem, he said. We'll see about that.

Stephen Jen, currency chief at Morgan Stanley, said Eastern Europe has borrowed $1.7 trillion abroad, much on short-term maturities. It must repay – or roll over – $400bn this year, equal to a third of the region's GDP. Good luck. The credit window has slammed shut.

Not even Russia can easily cover the $500bn dollar debts of its oligarchs while oil remains near $33 a barrel. The budget is based on Urals crude at $95. Russia has bled 36pc of its foreign reserves since August defending the rouble.

"This is the largest run on a currency in history," said Mr Jen.

In Poland, 60pc of mortgages are in Swiss francs. The zloty has just halved against the franc. Hungary, the Balkans, the Baltics, and Ukraine are all suffering variants of this story. As an act of collective folly – by lenders and borrowers – it matches America's sub-prime debacle. There is a crucial difference, however. European banks are on the hook for both. US banks are not.

Almost all East bloc debts are owed to West Europe, especially Austrian, Swedish, Greek, Italian, and Belgian banks. En plus, Europeans account for an astonishing 74pc of the entire $4.9 trillion portfolio of loans to emerging markets.

They are five times more exposed to this latest bust than American or Japanese banks, and they are 50pc more leveraged (IMF data).

Spain is up to its neck in Latin America, which has belatedly joined the slump (Mexico's car output fell 51pc in January, and Brazil lost 650,000 jobs in one month). Britain and Switzerland are up to their necks in Asia.

Whether it takes months, or just weeks, the world is going to discover that Europe's financial system is sunk, and that there is no EU Federal Reserve yet ready to act as a lender of last resort or to flood the markets with emergency stimulus.

Under a "Taylor Rule" analysis, the European Central Bank already needs to cut rates to zero and then purchase bonds and Pfandbriefe on a huge scale. It is constrained by geopolitics – a German-Dutch veto – and the Maastricht Treaty.

But I digress. It is East Europe that is blowing up right now. Erik Berglof, EBRD's chief economist, told me the region may need €400bn in help to cover loans and prop up the credit system.

Europe's governments are making matters worse. Some are pressuring their banks to pull back, undercutting subsidiaries in East Europe. Athens has ordered Greek banks to pull out of the Balkans.

The sums needed are beyond the limits of the IMF, which has already bailed out Hungary, Ukraine, Latvia, Belarus, Iceland, and Pakistan – and Turkey next – and is fast exhausting its own $200bn (€155bn) reserve. We are nearing the point where the IMF may have to print money for the world, using arcane powers to issue Special Drawing Rights.

Its $16bn rescue of Ukraine has unravelled. The country – facing a 12pc contraction in GDP after the collapse of steel prices – is hurtling towards default, leaving Unicredit, Raffeisen and ING in the lurch. Pakistan wants another $7.6bn. Latvia's central bank governor has declared his economy "clinically dead" after it shrank 10.5pc in the fourth quarter. Protesters have smashed the treasury and stormed parliament.

"This is much worse than the East Asia crisis in the 1990s," said Lars Christensen, at Danske Bank.

"There are accidents waiting to happen across the region, but the EU institutions don't have any framework for dealing with this. The day they decide not to save one of these one countries will be the trigger for a massive crisis with contagion spreading into the EU."

Europe is already in deeper trouble than the ECB or EU leaders ever expected. Germany contracted at an annual rate of 8.4pc in the fourth quarter.

If Deutsche Bank is correct, the economy will have shrunk by nearly 9pc before the end of this year. This is the sort of level that stokes popular revolt.

The implications are obvious. Berlin is not going to rescue Ireland, Spain, Greece and Portugal as the collapse of their credit bubbles leads to rising defaults, or rescue Italy by accepting plans for EU "union bonds" should the debt markets take fright at the rocketing trajectory of Italy's public debt (hitting 112pc of GDP next year, just revised up from 101pc – big change), or rescue Austria from its Habsburg adventurism.

So we watch and wait as the lethal brush fires move closer. If one spark jumps across the eurozone line, we will have global systemic crisis within days. Are the firemen ready?

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