How Will The Derivatives Bust Affect The Economy?

First posted at the Smirking Chimp on August 11, 2007. Apparently, as "economists" go I am at least as qualified as Ben Stein. Certainly more prescient.

Here is a quote from a current National Review Article by Jerry Bowyer:
"Ben Stein said it well this past Saturday on Fox's Cavuto on Business: The sub-prime mortgage problem is grossly overstated; the sector is just too small."
Note that his source of wisdom here is Ben Stein. BEN STEIN! Actor, game show host, financial guru...you don't actually need any credentials to be a commentator in the financial press.
This article is disingenuous at best.

If sub-prime loans were really a non-factor, the Fed wouldn't need to be pumping over $1 billion PER DAY of "liquidity" (in
other words, printing more money) into the banking system. Over $1 trillion of CDO's have already become worthless. CDO's (collateralized debt obligations) are securities based on the income streams of interest payments paid to banks on mortgages.
Many loans are packaged together, and then carved up into individual securities.
CDO's are derivatives, what Warren Buffet has termed "financial weapons of mass destruction". The reason is this--even though they are called "collateralized", there is actually no collateral behind them. The banks are selling the income streams, not the loans themselves. When a loan defaults, the bank keeps the collateral (the home that was financed. Two things then happen--the bank ends up owning a home that is usually worth far less than the principal still owed. The bank
then cannot pay the interest to the CDO pool for that loan. This reduces the amount of income flowing into the CDO pool, which, in turn, makes the price of the derivatives drop. It only takes a few of the loans in the package to default to make the securities nearly worthless. There is almost no secondary market for derivatives that are paying less than the "guaranteed" payout, just like there is really no market for bonds that don't pay out fully (unless they are repackaged and cut up into even more derivative securities).
This has started a chain reaction. The number of CDO's that become worthless has also depressed the prices of other mortgage-backed debt securities, including REMICs, which were once regarded as a nearly "bullet proof" investment. In turn, the banks are forced to raise interest rates to make up for the lost income. This, in turn, has started to dry up the amount of money available for transactions like "leveraged buyouts" (LBOs). LBOs have been buoying the stock markets for the last couple of years or so. The drop in this activity has caused the prices of stocks to fall. And so on...
At least 3 multi-billion dollar hedge funds have become worthless in the past week because of this.France has already suspended investments by its pension funds and certain mutual funds into CDOs. Other countries are bound to follow. This further depresses the value of a dollar that has already fallen greatly due to the excess liquidity that the Fed is creating, as well as to the rising amount of outstanding government securities (our national debt). This is causing the Federal government to raise the interest rates paid by Treasury securities, which forces Congress to raise both the "debt ceiling" and amount of total interest allowed to be paid out by the Treasury.
We've seen all of this before. Railroad bonds backed by insufficient collateral became worthless in large numbers late in the 19th century, eventually devaluing all markets and causing a period of "deflationary recession" (also known as a depression) in the 1880's and 1890's.
Over the years in my life as a financial professional, I have read many articles from many different sources in the financial press. I have taken note for years that the most conservative elements of the press always try to play up the effects and longevity of "booms", and play down the severity and longevity of "busts". They must constantly try to paint a rosy picture of the economy in order to defend the reckless financial practices of banks, the Fed, and the Bush administration