Exclusive: Wall Street wants us to panic… by The Other Katherine Harris

by The Other Katherine Harris
Featured writer
Dandelion Salad
Sept 30, 2008

Wall Street wants us to panic, but stocks are just way overpriced.

If you’re hyperventilating about the stock market this morning, please calm down.  What’s underway is simple Market Justice.  Artificially inflated prices can’t be sustained forever — not for $700 billion or any amount of cash.

For years and years, the housing bubble fed the stock bubble and vice versa.  Far too much money poured into both asset classes, so this isn’t a problem more money will solve.

In every speculative market, there comes a time when those who bought too high get rebuked by reality.  Wall Street doesn’t like reality any more than homeowners who paid too much do, but the fall has to happen.  It’s healthy.

Just as the housing market will recover when the median price of a home regains its logical relationship with the median household income, stock prices will stabilize at a level that reflects their fundamental value.  Trying to keep these prices unreasonably elevated by any sort of heroics is destined to fail.

Housing will find a realistic bottom less painfully than many stocks will, because 1) buildings and land are useful things and 2) the prices weren’t juiced as much.  A total fall of 40 percent in the most overheated markets is right, which is why banks are now selling off mortgages in bulk at 60 cents on the dollar and finding plenty of buyers. (They should be offering that price to the residents, of course, but this is a topic for another day.)

Stock prices often veered much farther from sanity, particularly in the zany shadow realm of derivatives (secondary bets derived from the presumed value of debt and other underlying assets).  More than a QUADRILLION DOLLARS’ worth of them are currently outstanding.  This is nuts, considering that the entire world’s annual GDP was only $60-65 trillion in 2007, the domestic capitalization of every stock exchange on the planet comes to barely over $60 trillion and combined personal wealth around the globe was measured last year at $109.5 trillion. To make a quad takes 1,000 trillion: more money than even exists!

Such craziness is possible because, in the surreal alternate universe of derivative securities, leverage goes as high as 100-200 percent.  Their hyper-inflated “notional” value acquires a hyper-inflated real-world price tag when one party to a bet is proved right and the other wrong.  Styled as hedging devices, most derivatives are pairs representing opinion and counter-opinion — but they go far beyond normal risk management, in that you can buy the same coverage over and over and it can involve matters that don’t otherwise concern you. (Imagine taking out 200 insurance policies on somebody else’s $25,000 car and expecting $5 million, if it’s wrecked.)  Complicating things still further, the paper migrates among owners, when someone is willing to take it as payment or collateral.  Eventually contracts expire, due to a specified timeframe — usually five years, so tons will keep ticking well into the next decade — but up to half of the total face value of active derivatives COULD turn terrifyingly actual at any moment, requiring the loser or insurer of his bet (e.g., the defunct AIG) to pay the other.

The whole world couldn’t come up with even half of a quad, at gunpoint, yet that’s what today’s “financial innovators” have stupidly obligated themselves to pay on derivative contracts, if each ends up with a winner and a loser.

Can’t be done and the players know it, but they’re still trying to squeeze some profit out of these dog bets by selling the worst of them to us:  those marked Level III, which are based on subprime debt.  In the real market, they’re going for six cents on the dollar, but Hank Paulson kindly hopes to overpay.

If the banks really wanted to get back to ordinary business, they could start immediately, simply by agreeing to nullify these contracts and refund whatever sums were paid up-front.  Some firms might need taxpayers’ help to pay the refunds, but it would be a manageable figure, a tiny fraction of what they’re trying to get out of us for frighteningly overleveraged garbage.

Nobody’s ever happy about losing paper wealth, but that doesn’t mean it can or should be sustained forever.

UPDATE (3 PM Mountain Time) – See, the sky didn’t fall because the banksters weren’t able to railroad Congress into a wrongheaded $700 billion bailout.  Wall Street just closed its best day in six years, as buyers picked over the merchandise that sellers kicked over yesterday.  Stocks that are still hurting deserve to be!

As for the credit markets, their remaining tight isn’t for want of money.  If cash were the issue, they’d be in puppydog heaven, based on Bernanke’s plans to pump another $630 billion into the system.  He announced this yesterday BEFORE the House vote, while nobody was looking in the Fed’s direction.  (See the Bloomberg story quoted HERE and weep. Then don’t miss the rest of what Karl Denninger has to say. I just read his no-cost plan for financial recovery and it’s much in line with what I’ve been thinking, although it doesn’t call for outright nullification of derivative bets.)


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