Poised for 'Nuclear Deleveraging'?

It's rare, but there are a few rocket scientists who understand the Wall Street shell game better than most who are also willing to tell it like it really is.

Usually, people like that are paid so well or have spent so much time and energy figuring out ways to rip people off with super-creative paper shuffling that they have little interest in rocking the boat or upsetting the gravy train (a bit heavy on the metaphors, I know).

Satyajit Das is the exception. Aside from being the author of several key reference works on the subject of derivatives and risk, he has worked for a variety of financial and other firms, including TNT Group, Commonwealth Bank of Australia, Citicorp Investment Bank and Merrill Lynch Capital Markets.

In "Credit Crisis Far From Over," the Australian offers insights from Mr. Das that make it clear any talk that the worst is behind us is just that -- talk.

A derivatives expert who two years ago warned of a potential meltdown in global credit markets has cautioned that the crisis is far from over, and has endorsed recent calls to relax controls on inflation and allow higher prices to help markets trade their way out of their problems.

Longtime critic of derivatives markets, Satyajit Das, says those who believe the US sub-prime loans crisis, and the drought in credit markets it triggered, are nearly over are wrong.

"I think the cycle has some way to run yet," he told a Financial Services Institute of Australasia function in Sydney yesterday. "It's a matter of years, not a matter of months."

In particular, investors in the US stock market, which has climbed off its lows amid a growing mood that the worst of the crunch was over, were being too optimistic, he said.

The author of Traders, Guns & Money warned that many of the problem financial instruments were still hidden and the total amount of debt attached to them largely unknown.

Losses incurred by US banks were certain to rise as $US1 trillion ($1.06 trillion) in sub-prime housing loans was due to reset to higher interest rates in the next two years.

The use of credit card debt -- now totalling $US915 billion -- was cushioning US home owners. But, in an ominous sign, card issuers were rapidly increasing their provisions for bad debts, by as much as 500 per cent in the case of one bank.

The use of sub-prime debt structures was also a feature of other markets, such as private equity, where $US300 billion in loans were due to be refinanced in the next two years.

Mr Das said another $US1-$US5 trillion of assets would have to come back on to US bank balance sheets as a result of defaults on housing and other debts, and it was unclear how the banks could fund them -- issuance of preference shares by US banks was already at a record high. He said losses at financial institutions from the credit crunch were likely to almost double to $US400 billion.

There were also second-round effects to come as the damage done to the real economy from financial sector losses fed back into further bank losses.

Mr Das said there needed to be a massive reduction in debt levels globally or a "nuclear deleveraging" before the crisis could be said to be over. That could be achieved through an economic crash "on the scale of 1929" but allowing inflation to rise would help to avoid that scenario. Higher inflation was a legitimate policy option since it reduced the real value of debt and gave companies and individuals breathing space to reduce their leverage by helping to put a floor under asset prices.

His comments come as some economists urge Australia's Reserve Bank to relax its inflation targeting policy to help avoid a severe economic downturn.

He acknowledged that as inflation rose higher it was more difficult to control it, but noted the global economy was moving into a period of higher inflation anyway. "It could be the lesser of two evils," he said.

Comments

[Boom2Bust.com]

"There were also second-round effects to come as the damage done to the real economy from financial sector losses fed back into further bank losses."

Last fall MSN Money interviewed Mr. Das, who at the time said that the next serious phase of the unwinding would begin in late 2007-early 2008. I'd be curious to find out what his latest timeframe is for something like this to occur...

[Bruce]

I've said it before, but I'll say it again: The wheels aren't going to fall off the economy until after the election this fall. Call it a hunch or just gut instinct, but it's my opinion that Bush will NOT let an economic collapse happen under his tenure. I'm also quite sure that "helicopter" Ben and good 'ole Paulson will do anything in their power to keep the game going as long as they can... Stay tuned.

[Waiting for the Other Shoe to Drop]

"...but allowing inflation to rise would help to avoid that scenario."

Baloney!!!

The debt crises is happening because poeple don't have enough money to pay thier bills. Without significant inflation in peoples wages, inflation of the things they buy and use will just serve the same purpose that debt does. It sucks thier money!

The solution to the debt crisies is very simple. Just just raise peoples wages more than the (actual) rate of inflation. The trickle up theory!

But don't hold your breath. As long as big businees controls ther FED and our elected officials, expect bank bailouts to continue and house foreclousure rates to climb.

We are in for a world of hurt!