Doom and Gloom Thursday

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The contradiction facing those who seek to lower prices is that the more money Bernanke puts out to fight off the collapse of housing prices, the more he weakens the purchasing power of the dollar, which in turn results in higher prices for oil--and a lot of other things.


Bernanke knows this. He is not a perversely obdurate man but one who is terrified at what might happen if housing prices continue to drop, since so many financial instruments are directly or indirectly affected by what happens with those mortgages, both the prime and not so prime. Entities as distant as drudgy, dependable municipal bonds can rise or fall on what happens with housing. Many municipal bonds, used to finance such exciting projects as street lights and storm sewers, are dependent on real-estate tax revenue expected from particular subdivisions. Thus, if the homeowners default, there may not be enough taxpayers left to pay the interest on the munis.

But municipal bonds aren't keeping Bernanke up at night. He is looking at the monsters of the Wall Street depths--financial arrangements with ugly names like credit default swap.

This kind of swap is a form of insurance dreamt up in the early 1990s for real-estate bond buyers to ensure that they got their money back in the event that the bonds defaulted. The market for credit default swaps now exceeds $45 trillion, more than the combined value of every residence in the United States. What started out as a sensible insurance mechanism has turned into speculation dwarfing the annual handle of all the casinos in the world.

Hanging in the air over lower Manhattan is what may happen if housing prices continue to fall, the bonds backing the mortgages on the foreclosed housing go into default, and those who sold the swaps aren’t able to come up with enough money to cover the losses. Maybe the trillions of dollars in commitments get worked out some way or another, or maybe, faster than the Fed chairman can get to his office to stop it, the system implodes into something the size of a billiard ball.

RTWT

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This page contains a single entry by Papa-Lu published on June 12, 2008 3:48 PM.

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